Recharacterization

Notwithstanding these formalities designed to ensure that 'spare parts transactions' between GmbH and DANA were treated as ordinary course, arms'-length business transactions, evidence adduced at trial established that: 1) DANA did not pay its invoices from GmbH within 30 days; 2) DANA and GmbH had an informal agreement whereby DANA would not be required to repay its debt to GmbH until DANA became profitable; and 3) GmbH treated DANA 'specially' because GmbH viewed DANA as a vehicle for expanding its business into North America. Dornier Aviation, 453 F.3d at 230. Moreover, an audit report prepared by GmbH's external auditors concluded that GmbH 'assumed' a significant amount of DANA's operating losses as a result of the companies' close corporate relationship, as well as DANA's 'financial dependency' on GmbH. Id.

GmbH filed a $146 million claim against DANA, which included $84 million in claims relating to spare aircraft parts provided to, but never paid for, by DANA (the 'Spare Parts Claim'). The Official Committee of Unsecured Creditors in DANA's Chapter 11 proceedings (the 'Committee') objected to, inter alia, the Spare Parts Claim, asserting that it should be equitably subordinated pursuant to ' 510(c) of the Bankruptcy Code or, alternatively, recharacterized as equity pursuant to
' 105(a) of the Bankruptcy Code. Id. The bankruptcy court rejected the Committee's equitable subordination argument, but found that the entirety of the Spare Parts Claim should be recharacterized as equity. Id. The United States District Court for the Eastern District of Virginia affirmed the bankruptcy court's decision and the case was appealed to the Fourth Circuit. On appeal, the Fourth Circuit affirmed the decisions of the bankruptcy court and the district court.

The Substantive Issues

GmbH argued that the Bankruptcy Code does not authorize recharacterization of debt to equity unless the claim at issue: 1) is disallowable under ' 502(b) of the Bankruptcy Code; or 2) can be equitably subordinated under ' 510(c) of the Bankruptcy Code. Reply Brief of Appellants at p. 13. GmbH asserted that Congress implemented policy decisions in the Bankruptcy Code by providing specific means by which a bankruptcy court could recharacterize a claim from debt to equity. Specifically, Congress provided that a bankruptcy court could disallow a claim under ' 502(b) of the Bankruptcy Code or, upon a showing of 'inequitable conduct,' equitably subordinate a claim under ' 510(c). Id. at 12-13. Accordingly, GmbH alleged that because no section of the Bankruptcy Code other than ” 502(b) and 510(c) specifically authorizes recharacterization of a claim, the bankruptcy court lacked authority to do so. Id. Indeed, GmbH asked the Fourth Circuit to 'end the confusion ' about where recharacterization fits in the Bankruptcy Code or what distinct purpose it serves by holding that bankruptcy courts lack the power to 'recharacterize' a debt claim as equity unless the claim is disallowable under 11 U.S.C. ' 502(b) or can be equitably subordinated under 11 U.S.C. ' 510(c).' Reply Brief of Appellants at p. 13.

In holding that recharacterization was well within the scope of the bankruptcy court's authority, the Fourth Circuit did indeed 'end the confusion' regarding the two issues presented by GmbH, ie, 1) what section of the Bankruptcy Code authorizes recharacterization in the absence of disallowance and equitable subordination; and 2) what purpose recharacterization serves, distinct from disallowance and equitable subordination.

Section 105(a) Authorizes Recharacterization

The Fourth Circuit addressed GmbH's first argument by holding that a bankruptcy court could utilize ' 105(a) of the Bankruptcy Code ' which authorizes a bankruptcy court to 'issue any order, process, or judgment that is necessary or appropriate to carry out the provision of' the Bankruptcy Code ' to recharacterize an allowed claim that is not eligible for equitable subordination. Dornier Aviation, 453 F.3d at 231. In making this holding, the Fourth Circuit opined that a bankruptcy court needed authority to recharacterize debt as equity under ' 105(a) in order to implement the priority scheme established by ' 726 of the Bankruptcy Code. Id. Absent this authority, the court explained, 'any equity investor could label its contribution a loan and guarantee itself a higher priority ' and a larger recovery ' should the debtor file for bankruptcy.' Id. By tying the authority to recharacterize a claim from debt to equity under ' 105(a) to the priority scheme established by ' 726 of the Bankruptcy Code, the Fourth Circuit circumvented the well established principle that a bankruptcy court may exercise its equitable power under ' 105(a) only as a means to fulfill some specific Bankruptcy Code provision. See, eg, In re SPM Mfg. Corp., 984 F.2d 1305, 1311 (1st Cir. 1993).

Recharacterization Serves a Different Purpose

The Fourth Circuit then swiftly disposed of GmbH's argument that recharacterization serves no purpose distinct from disallowance or equitable subordination. Dornier Avia-tion, 453 F.3d at 232. The Fourth Circuit first noted that, unlike recharacterization and equitable subordination, disallowance under ' 502(b) was 'appropriate when the claimant has no rights vis-'-vis the bankrupt ' ' Id. (emphasis in original). In contrast, 'when a bankruptcy court recharacterizes [or equitably subordinates] a claim, it necessarily recognizes the existence of a relationship between the debtor and the claimant ' ' Id. The Fourth Circuit next held that while a decision to equitably subordinate a claim rests on the bankruptcy court's assessment of a creditor's behavior, recharacterization rests on the bankruptcy court's assessment of the substance of the transaction. Id.

The Practical Problem

The Fourth Circuit's analysis and conclusions in Dornier Aviation present a practical problem for companies who may have business dealings with affiliates and subsidiaries.

GmbH took steps well beyond those employed in many similar inter-company transactions to ensure that the 'spare parts transactions' were ordinary course business dealings that would be honored in the event of a bankruptcy. GmbH regularly invoiced DANA for the spare parts, provided DANA with stated payment deadlines and performed annual reconciliations with DANA regarding amounts due for the spare parts. Dornier Aviation, 453 F.3d at 229-30. Nevertheless, utilizing a fact-specific, 11-part test, the Fourth Circuit affirmed the bankruptcy court's finding that, overall, the spare parts transactions were more consistent with a capital contribution. Dornier Aviation, 453 F.3d at 234. The Fourth Circuit noted that '[t]he [bankruptcy] court found particularly significant (1) GmbH's insider status, (2) 'the lack of a fixed maturity date' for the purported loans, (3) the fact that DANA would not be required to pay until it became profitable, (4) DANA's 'long history of unprofitability and the fact that its liabilities after the corporate restructuring far exceeded its assets,' and (5) GmbH's assumption of Dana's losses.' Id. Moreover, the Fourth Circuit found that evidence that GmbH regularly allowed several of its customers to defer payments (indicating that DANA was not receiving special treatment by virtue of its relationship to GmbH) was insufficient to 'undermine the bankruptcy court's finding that GmbH and DANA had a special relationship.' Id. at 236 (emphasis in original). Finally, the Fourth Circuit summarily dismissed GmbH's contention that a transfer of inventory (such as the spare parts transferred to DANA) could not constitute an equity investment. Id. In so holding, the Fourth Circuit became the first circuit court to authorize recharacterization of a claim from debt to equity where the underlying 'investment' was not made in cash.

The Practical Solution

GmbH's actions in Dornier Aviation were not so egregious as to make the outcome of the case obvious. Indeed, GmbH appeared to have taken reasonable steps to ensure the spare parts transactions would be respected by regularly invoicing DANA for the spare parts, providing stated payment deadlines and performing annual reconciliations of the amounts owed. Additionally, GmbH's 'investment' in DANA was not in cash, which is the traditional form of an equity investment. Based on these facts, GmbH's major failing ' like many inter-company transactions of a similar nature ' was in its collection efforts. In applying the 11-factor test, the Fourth Circuit relied on several factors directly relating to GmbH's failure to make any effort to collect sums from DANA (lack of a fixed maturity date, the fact that DANA would not be required to pay until it became profitable and GmbH's assumption of DANA's losses). Had GmbH collected or made good faith efforts to collect even a portion of the amount due from DANA over the years, the Fourth Circuit (and the district and bankruptcy courts before it) may not have been so eager to recharacterize the Spare Parts Claim.

The short-term harm that may have been caused by GmbH's efforts to collect all or a portion of its debt from DANA is seriously outweighed by the long-term benefit of such efforts. For example, although GmbH's collection efforts may have hastened DANA's bankruptcy filing, it is obvious that such efforts would not have been the sole cause of the filing. To the contrary, DANA's financial situation deteriorated, and DANA filed for bankruptcy, despite GmbH's deferral of DANA's debt. In collecting amounts from DANA, GmbH also may have been faced with a lawsuit for the return of payments under ” 547 and/or 548 of the Bankruptcy Code. Even if GmbH were to lose such a lawsuit, however, its claim under section 502(h) (which provides the tranferee of an avoided transfer, such as a preference, with a claim against the debtor's estate) would be allowed and likely would not be recharacterized as equity, placing GmbH in a better overall position than it found itself in Dornier Aviation.

Conclusion

The lesson to be learned for companies and the professionals who advise them is that carefully structured transactions, with written invoices, stated payment dates and careful and accurate ledgers of account, no longer will suffice to protect a parent corporation's position if its subsidiary files for bankruptcy. To the contrary, the oft-repeated mantra of bankruptcy judges and practitioners alike ' that form will not prevail over substance ' has found a new application in the form of recharacterization under ' 105(a) of the Bankruptcy Code. In practical terms, although a parent that promptly collects debts from its troubled subsidiary may find itself in the unfortunate position of a creditor of a bankrupt company, a parent that completely fails to collect debts from a troubled subsidiary may find itself relegated to the even more unenviable position of an equity investor in a bankrupt company. To avoid being relegated to this position, parent companies must promptly and consistently collect outstanding debts from their subsidiaries and affiliates.

Rebecca L. Booth is an associate in Morgan Lewis' Business and Finance Practice. Her practice focuses on corporate bankruptcy, restructuring and other insolvency related matters. Ms. Booth has been involved in the representation of debtors, lenders, formal and informal committees, and other significant parties in large bankruptcy cases.

In the recent case of In re Dornier Aviation (North America), Inc., 453 F.3d 225 (4th Cir. 2006) the United States Court of Appeals for the Fourth Circuit held that
' 105(a) of the Bankruptcy Code provides the bankruptcy court with authority to recharacterize a claim from debt to equity. In upholding the recharacterization of a parent's $84 million claim against its wholly owned subsidiary, the Fourth Circuit made clear that form will not prevail over substance in the context of inter-company transactions. The Fourth Circuit failed, however, to provide any guidance on how inter-company transactions might be structured to avoid recharacterization under ' 105(a). This article presents one obvious, albeit not often utilized, solution: Parent corporations should collect debts due and owing from their subsidiaries to avoid the possibility of being relegated to the unenviable position of an equity investor in the event of a bankruptcy proceeding.

The Case

Dornier Aviation (North Ameri-ca) (DANA) was a wholly owned indirect subsidiary of Fairchild Dornier GmbH (GmbH), a Ger-man aircraft manufacturer. Dor-nier Aviation, 453 F.3d at 229. GmbH and DANA had a close business relationship pursuant to which GmbH provided DANA with spare aircraft parts, which DANA either used to provide services to GmbH's customers, or resold for a profit. Id. GmbH invoiced DANA regularly for the spare parts it provided. Id. GmbH's invoices provided that payment was due within 30 days unless otherwise agreed by the parties. Id. at 230. The parties also performed annual reconciliations of amounts owed from DANA to GmbH as a result of outstanding invoices. Id.

Notwithstanding these formalities designed to ensure that 'spare parts transactions' between GmbH and DANA were treated as ordinary course, arms'-length business transactions, evidence adduced at trial established that: 1) DANA did not pay its invoices from GmbH within 30 days; 2) DANA and GmbH had an informal agreement whereby DANA would not be required to repay its debt to GmbH until DANA became profitable; and 3) GmbH treated DANA 'specially' because GmbH viewed DANA as a vehicle for expanding its business into North America. Dornier Aviation, 453 F.3d at 230. Moreover, an audit report prepared by GmbH's external auditors concluded that GmbH 'assumed' a significant amount of DANA's operating losses as a result of the companies' close corporate relationship, as well as DANA's 'financial dependency' on GmbH. Id.

GmbH filed a $146 million claim against DANA, which included $84 million in claims relating to spare aircraft parts provided to, but never paid for, by DANA (the 'Spare Parts Claim'). The Official Committee of Unsecured Creditors in DANA's Chapter 11 proceedings (the 'Committee') objected to, inter alia, the Spare Parts Claim, asserting that it should be equitably subordinated pursuant to ' 510(c) of the Bankruptcy Code or, alternatively, recharacterized as equity pursuant to
' 105(a) of the Bankruptcy Code. Id. The bankruptcy court rejected the Committee's equitable subordination argument, but found that the entirety of the Spare Parts Claim should be recharacterized as equity. Id. The United States District Court for the Eastern District of Virginia affirmed the bankruptcy court's decision and the case was appealed to the Fourth Circuit. On appeal, the Fourth Circuit affirmed the decisions of the bankruptcy court and the district court.

The Substantive Issues

GmbH argued that the Bankruptcy Code does not authorize recharacterization of debt to equity unless the claim at issue: 1) is disallowable under ' 502(b) of the Bankruptcy Code; or 2) can be equitably subordinated under ' 510(c) of the Bankruptcy Code. Reply Brief of Appellants at p. 13. GmbH asserted that Congress implemented policy decisions in the Bankruptcy Code by providing specific means by which a bankruptcy court could recharacterize a claim from debt to equity. Specifically, Congress provided that a bankruptcy court could disallow a claim under ' 502(b) of the Bankruptcy Code or, upon a showing of 'inequitable conduct,' equitably subordinate a claim under ' 510(c). Id. at 12-13. Accordingly, GmbH alleged that because no section of the Bankruptcy Code other than ” 502(b) and 510(c) specifically authorizes recharacterization of a claim, the bankruptcy court lacked authority to do so. Id. Indeed, GmbH asked the Fourth Circuit to 'end the confusion ' about where recharacterization fits in the Bankruptcy Code or what distinct purpose it serves by holding that bankruptcy courts lack the power to 'recharacterize' a debt claim as equity unless the claim is disallowable under 11 U.S.C. ' 502(b) or can be equitably subordinated under 11 U.S.C. ' 510(c).' Reply Brief of Appellants at p. 13.

In holding that recharacterization was well within the scope of the bankruptcy court's authority, the Fourth Circuit did indeed 'end the confusion' regarding the two issues presented by GmbH, ie, 1) what section of the Bankruptcy Code authorizes recharacterization in the absence of disallowance and equitable subordination; and 2) what purpose recharacterization serves, distinct from disallowance and equitable subordination.

Section 105(a) Authorizes Recharacterization

The Fourth Circuit addressed GmbH's first argument by holding that a bankruptcy court could utilize ' 105(a) of the Bankruptcy Code ' which authorizes a bankruptcy court to 'issue any order, process, or judgment that is necessary or appropriate to carry out the provision of' the Bankruptcy Code ' to recharacterize an allowed claim that is not eligible for equitable subordination. Dornier Aviation, 453 F.3d at 231. In making this holding, the Fourth Circuit opined that a bankruptcy court needed authority to recharacterize debt as equity under ' 105(a) in order to implement the priority scheme established by ' 726 of the Bankruptcy Code. Id. Absent this authority, the court explained, 'any equity investor could label its contribution a loan and guarantee itself a higher priority ' and a larger recovery ' should the debtor file for bankruptcy.' Id. By tying the authority to recharacterize a claim from debt to equity under ' 105(a) to the priority scheme established by ' 726 of the Bankruptcy Code, the Fourth Circuit circumvented the well established principle that a bankruptcy court may exercise its equitable power under ' 105(a) only as a means to fulfill some specific Bankruptcy Code provision. See, eg, In re SPM Mfg. Corp., 984 F.2d 1305, 1311 (1st Cir. 1993).

Recharacterization Serves a Different Purpose

The Fourth Circuit then swiftly disposed of GmbH's argument that recharacterization serves no purpose distinct from disallowance or equitable subordination. Dornier Avia-tion, 453 F.3d at 232. The Fourth Circuit first noted that, unlike recharacterization and equitable subordination, disallowance under ' 502(b) was 'appropriate when the claimant has no rights vis-'-vis the bankrupt ' ' Id. (emphasis in original). In contrast, 'when a bankruptcy court recharacterizes [or equitably subordinates] a claim, it necessarily recognizes the existence of a relationship between the debtor and the claimant ' ' Id. The Fourth Circuit next held that while a decision to equitably subordinate a claim rests on the bankruptcy court's assessment of a creditor's behavior, recharacterization rests on the bankruptcy court's assessment of the substance of the transaction. Id.

The Practical Problem

The Fourth Circuit's analysis and conclusions in Dornier Aviation present a practical problem for companies who may have business dealings with affiliates and subsidiaries.

GmbH took steps well beyond those employed in many similar inter-company transactions to ensure that the 'spare parts transactions' were ordinary course business dealings that would be honored in the event of a bankruptcy. GmbH regularly invoiced DANA for the spare parts, provided DANA with stated payment deadlines and performed annual reconciliations with DANA regarding amounts due for the spare parts. Dornier Aviation, 453 F.3d at 229-30. Nevertheless, utilizing a fact-specific, 11-part test, the Fourth Circuit affirmed the bankruptcy court's finding that, overall, the spare parts transactions were more consistent with a capital contribution. Dornier Aviation, 453 F.3d at 234. The Fourth Circuit noted that '[t]he [bankruptcy] court found particularly significant (1) GmbH's insider status, (2) 'the lack of a fixed maturity date' for the purported loans, (3) the fact that DANA would not be required to pay until it became profitable, (4) DANA's 'long history of unprofitability and the fact that its liabilities after the corporate restructuring far exceeded its assets,' and (5) GmbH's assumption of Dana's losses.' Id. Moreover, the Fourth Circuit found that evidence that GmbH regularly allowed several of its customers to defer payments (indicating that DANA was not receiving special treatment by virtue of its relationship to GmbH) was insufficient to 'undermine the bankruptcy court's finding that GmbH and DANA had a special relationship.' Id. at 236 (emphasis in original). Finally, the Fourth Circuit summarily dismissed GmbH's contention that a transfer of inventory (such as the spare parts transferred to DANA) could not constitute an equity investment. Id. In so holding, the Fourth Circuit became the first circuit court to authorize recharacterization of a claim from debt to equity where the underlying 'investment' was not made in cash.

The Practical Solution

GmbH's actions in Dornier Aviation were not so egregious as to make the outcome of the case obvious. Indeed, GmbH appeared to have taken reasonable steps to ensure the spare parts transactions would be respected by regularly invoicing DANA for the spare parts, providing stated payment deadlines and performing annual reconciliations of the amounts owed. Additionally, GmbH's 'investment' in DANA was not in cash, which is the traditional form of an equity investment. Based on these facts, GmbH's major failing ' like many inter-company transactions of a similar nature ' was in its collection efforts. In applying the 11-factor test, the Fourth Circuit relied on several factors directly relating to GmbH's failure to make any effort to collect sums from DANA (lack of a fixed maturity date, the fact that DANA would not be required to pay until it became profitable and GmbH's assumption of DANA's losses). Had GmbH collected or made good faith efforts to collect even a portion of the amount due from DANA over the years, the Fourth Circuit (and the district and bankruptcy courts before it) may not have been so eager to recharacterize the Spare Parts Claim.

The short-term harm that may have been caused by GmbH's efforts to collect all or a portion of its debt from DANA is seriously outweighed by the long-term benefit of such efforts. For example, although GmbH's collection efforts may have hastened DANA's bankruptcy filing, it is obvious that such efforts would not have been the sole cause of the filing. To the contrary, DANA's financial situation deteriorated, and DANA filed for bankruptcy, despite GmbH's deferral of DANA's debt. In collecting amounts from DANA, GmbH also may have been faced with a lawsuit for the return of payments under ” 547 and/or 548 of the Bankruptcy Code. Even if GmbH were to lose such a lawsuit, however, its claim under section 502(h) (which provides the tranferee of an avoided transfer, such as a preference, with a claim against the debtor's estate) would be allowed and likely would not be recharacterized as equity, placing GmbH in a better overall position than it found itself in Dornier Aviation.

Conclusion

The lesson to be learned for companies and the professionals who advise them is that carefully structured transactions, with written invoices, stated payment dates and careful and accurate ledgers of account, no longer will suffice to protect a parent corporation's position if its subsidiary files for bankruptcy. To the contrary, the oft-repeated mantra of bankruptcy judges and practitioners alike ' that form will not prevail over substance ' has found a new application in the form of recharacterization under ' 105(a) of the Bankruptcy Code. In practical terms, although a parent that promptly collects debts from its troubled subsidiary may find itself in the unfortunate position of a creditor of a bankrupt company, a parent that completely fails to collect debts from a troubled subsidiary may find itself relegated to the even more unenviable position of an equity investor in a bankrupt company. To avoid being relegated to this position, parent companies must promptly and consistently collect outstanding debts from their subsidiaries and affiliates.

Rebecca L. Booth is an associate in Morgan Lewis' Business and Finance Practice. Her practice focuses on corporate bankruptcy, restructuring and other insolvency related matters. Ms. Booth has been involved in the representation of debtors, lenders, formal and informal committees, and other significant parties in large bankruptcy cases.