Recharacterization: The Debate

Impact on the Lender

Recharacterization can impact a lender in two primary ways.

First, recharacterization arises in the context of claims objections where the objector argues that a lender's claim should be disallowed because it actually represents an equity contribution. In this situation, recharacterization is used to reduce the overall amount of allowed claims in a bankruptcy case by transforming claims into equity interests (which are often extinguished without compensation), thereby increasing the distribution percentage for holders of allowed claims.

Second, recharacterization can give rise to avoidance litigation ' specifically, preference and fraudulent transfer actions ' which could result, not only in claim disallowance, but also a judgment in favor of the bankruptcy estate against the purported lender. This occurs when a bankruptcy court determines that the purported “debt” actually constitutes an equity interest and thus the purported “repayments” of the “debt” are rendered constructively fraudulent transfers. Traditionally, recharacterization has only been employed against insider claims. Yet, as more fully discussed below, recent cases make clear that non-insider claims may also be subject to recharacterization.

Background

In the past, bankruptcy courts struggled to distinguish recharacterization claims from equitable subordination claims. An action for equitable subordination does not challenge the existence or validity of the underlying debt. “Rather, it challenges granting the debt the priority to which it is entitled under applicable law because of the creditor's inequitable conduct.” Insilco Techs., 480 F.3d at 217 (internal citations omitted). Equitable subordination arises under Bankruptcy Code ' 510, but the Bankruptcy Code does not expressly provide for recharacterization claims. In addition, equitable subordination is remedial in nature, requires a showing of misconduct, and is only employed to the extent necessary to undo the inequitable conduct. See In re Airadigm Comm., Inc., 616 F.3d 642, 658 (7th Cir. 2010). In contrast, recharacterization focuses on the underlying substance of the disputed transaction without regard to misconduct. Id.

The recharacterization inquiry is one that attempts to determine the true nature of a transaction. Where little money is available for distribution, both recharacterization and equitable subordination can have the same practical effect of preventing a creditor's recovery. However, recharacterization can also give rise to liability in the form of avoidance of purported pre-bankruptcy debt repayments. As the debate over the viability of recharacterization has waned, perhaps unsurprisingly, so has confusion surrounding equitable subordination.

Source of Law for Recharacterization of Claims

Despite almost uniform recognition of a bankruptcy court's power to recharacterize claims, a new debate among the circuit courts has emerged. The divide centers on when and how bankruptcy courts should engage in recharacterization. As previously mentioned, there is no provision in the Bankruptcy Code that expressly grants authority to the bankruptcy court to recharacterize debt. Two divergent theories underpinning the basis for recharacterizatio have arisen.

The Equitable Power Circuits

The Third, Fourth, Sixth and Tenth Circuits agree that bankruptcy courts have the power to recharacterize claims pursuant to their general equitable powers under Bankruptcy Code ' 105(a). These courts find that the power to recharacterize claims is “grounded” in a bankruptcy court's power to prevent substance from giving way to form. See In re SubMicron, 432 F.3d at 454 (quoting Pepper v. Litton, 308 U.S. 295, 305 (1939)). Thus, the recharacterization inquiry focuses on the substance of the transaction at issue, rather than the label attached to it.

Although various multi-factor tests have emerged, the circuits employing equitable power theories (Equitable Power Circuits) generally seek to determine “whether the parties called an instrument one thing when in fact they intended it as something else.” SubMicron, 432 F.3d at 456. Thus, the overarching inquiry is often whether the parties intended a loan to be a disguised equity contribution. In re Fedders North America, Inc., 405 B.R. 527, 554 (Bankr. D. Del. 2009) (citing SubMicron, 432 F.3d at 455-56).

The multi-factor tests from the Equitable Power Circuits use factors such as: 1) the names given to the instruments, if any, evidencing indebtedness; 2) the presence or absence of a fixed maturity date and repayment schedule; 3) the presence or absence of interest payments; 4) the source of repayments; 5) the adequacy or inadequacy of capitalization; 6) the identity of interest between the creditor and the stockholder; 7) the presence or absence of security for the loans; 8) the ability of the debtor to obtain outside financing; 9) the extent to which the advances were subordinated to the claims of other creditors; 10) the extent to which the advances were used to acquire capital assets; 11) the presence or absence of a sinking fund; 12) the presence or absence of voting rights; and 13) other considerations, such as a lack of corporate formalities. See AutoStyle, 269 F.3d at 749-50; In re Friedman's Inc., 452 B.R. 512, 519 (Bankr. D. Del. 2011) (collecting the multiple multi-factor tests).

The State Law Circuits

The two most recent circuit court decisions on recharacterization arise in the Fifth and Ninth Circuits. Both disagreed with the Equitable Power Circuits and held that Bankruptcy Code ' 105(a) does not authorize recharacterization. Though the Fifth and Ninth Circuits agree that bankruptcy courts have the authority to recharacterize debt to equity, they find the power arises solely under applicable state law.

The Fifth Circuit in Lothian Oil held that a bankruptcy court's authority to allow and disallow a claim under Bankruptcy Code ' 502 provides authority to recharacterize a claim that asserts a debt contrary to state law, but which should give the purported claimant some rights vis-'-vis the debtor. See Lothian Oil, 650 F.3d at 543 (citing Dornier Aviation, 453 F.3d at 232). Importantly, Lothian Oil, citing the Supreme Court's decision in Butner v. United States, 440 U.S. 48 (1979), concluded that recharacterization inquiries under ' 502 will depend on state law. Thus, according to the State Law Circuits, the basic test used to determine whether a claim will be recharacterized as an equity interest is whether the applicable state law would disallow the claim based on the theory of recharacterization.

The Ninth Circuit's decision in Fitness Holdings involved litigation over alleged constructively fraudulent transfers. Fitness Holdings showed disapproval of the Equitable Power Circuits' decisions, stating that “courts may not rely on [section] 105(a) and federal common law rules 'of their own creation' to determine whether recharacterization is warranted.” See Fitness Holdings, 714 F.3d at 1149. Rather, Fitness Holdings looked to whether state law provided the putative claimant a debt claim or equity interest. Id.

State Law Alters the Contours of Recharacterization

Comparing the dictionary definition of recharacterization and the recent Lothian Oil decision shows that reliance on state law as the source of law for recharacterization claims can expand the scope of those claims in new ways. On the one hand, Black's Law Dictionary defines “recharacterization” as “a court's determination that an insider's loan to an entity in liquidation ' should be treated as a capital contribution, not as a loan, thereby entitling the insider to only part of the liquidation proceeds payable after all the business's debts have been discharged.” Black's Law Dictionary (9th ed. 2009).

However, in Lothian Oil, the Fifth Circuit concluded “that recharacterization extends beyond insiders and is part of the bankruptcy courts' authority to allow and disallow claims under” Bankruptcy Code ' 502. Lothian Oil, 650 F.3d at 542. In Lothian Oil, the Fifth Circuit looked to the relevant state law [Texas] and did not find that state law distinguished between mischaracterized insider and non-insider claims. Id. at 544. Recharacterizing a non-insider's debt runs contrary to the more established grain of the Equitable Power Circuits. Yet, recharacterization of non-insider claims may become more common as bankruptcy courts rely on state law.

Lenders that find themselves in the Fifth and Ninth Circuits should closely examine applicable state law to determine the risks posed by a potential recharacterization claim. For example, in In re Gulf Fleet Holdings, Inc., 491 B.R. 747 (Bankr. W.D. La 2013), the bankruptcy court rejected the Trustee's recharacterization claim to the extent that it was based on the court's equitable powers under ' 105 and instead looked to state law. Id. at 773. The bankruptcy court held that while a recharacterization claim could be asserted under governing Louisiana state law based on a legal theory known as a “simulation” ' or “contract which by mutual agreement ' does not express the true intent of the parties” ' the plaintiff failed to allege the necessary elements to support such a claim. As a practical problem, without local counsel or extensive research, a lender may be wholly unaware of potential recharacterization claims.

In the few circuits that have not addressed recharacterization, the logic and policy underpinning the Lothian Oil decision may be gaining traction. For example, one oral ruling from a bankruptcy court in the Northern District of Illinois relied on Lothian Oil in stating that ' 105 does not constitute an independent basis to recharacterize a claim that would otherwise be allowable under ' 502. The court determined that state law governed and requested briefing regarding whether Illinois state law recognized recharacterization. In re Agri-Best Holdings, LLC, No. 12 A 01378, (Bankr. N.D. Ill. March 27, 2013) (Dkt. No. 33). As of the date of publication, this litigation was ongoing.

Nevertheless, many bankruptcy courts still employ the Equitable Power Circuits' analysis. For example, the bankruptcy court in In re Shubh Hotels Pittsburgh, LLC, 476 B.R. 181 (Bankr. W.D. Pa. 2012), recharacterized debt to equity based on the Third Circuit's equitable power framework. In Shubh Hotels, the bankruptcy court held that a claimant's unsecured claim was properly characterized as an equity contribution. The court based its decision on the objector's proffered evidence, including: 1) the testimony from the chief operating officer of the purported claimant that the advances were recorded on the debtor's books as equity; 2) the debtor's balance sheet prepared just seven days prior to the debtor's petition date did not reflect that any money was owed to the purported claimant; 3) the debtor's bankruptcy schedules signed under penalty of perjury did not reflect that any money was owed to the purported claimant; and 4) an expert report concluded that the transactions between the purported claimant and the debtor were appropriately accounted for as equity transactions.

Implications and Conclusions

Clearly, any financial transaction between an insider and a debtor is subject to heightened inspection in bankruptcy. In the Third, Fourth, Sixth, and Tenth Circuits where courts rely on equitable powers under ' 105 for recharacterization, it is critical for a lender to satisfy as many of the factors discussed above as possible. At a minimum, a lender should comply with corporate formalities and execute a valid and binding note.

It is also recommended that lenders avoid obtaining rights traditionally linked to equity interest holders, such as voting rights. Recent case law makes clear that reliance on state law has broadened the scope of recharacterization claims beyond just transactions involving insiders. In the Fifth and Ninth Circuits, and before any other court employing state law, lenders must recognize that non-insiders who engaged in financial transactions with debtors may also face newly cast recharacterization-like claims. Texas appears to be one such jurisdiction. See Lothian Oil, 650 F.3d 539.

Therefore, lenders should assess the likelihood of recharacterization claim on a circuit-by-circuit and state-by-state basis going forward in order to fully understand all of the risks of providing debt financing to financially troubled borrowers.

James B. Sowka is an attorney at Seyfarth Shaw LLP in the firm's Chicago office, where he concentrates his practice on bankruptcy law, creditor rights, and commercial and real estate litigation. Steven Schwartz is a bankruptcy attorney and LL.M. candidate at St. John's University.

In recent years, bankruptcy courts have come closer to reaching a consensus regarding their ability to recharacterize debt into equity. Yet, beneath this consensus lies a deepening divide that lenders should be aware of. Recharacterization challenges “the assertion of a debt against the bankruptcy estate on the ground that the 'loaned' capital was actually an equity investment.” In re Insilco Techs., Inc., 480 F.3d 212, 217 (3d Cir. 2007) (internal citations omitted).

Historically, courts were divided as to whether bankruptcy courts had the power to recharacterize purported debt as equity. That debate has essentially ended and the general consensus is that bankruptcy courts can recharacterize purported debt as equity.

Most recently, on April 30, 2013, the Ninth Circuit, in In re Fitness Holdings Int'l, Inc., overruled a prior opinion from the Ninth Circuit Bankruptcy Appellate Panel, holding that bankruptcy courts do in fact possess the power to recharacterize claims. See In re Fitness Holdings Int'l, Inc., No. 11-56677, 2013 WL 1800000 (9th Cir. April 30, 2013). In addition to the Ninth Circuit, the Third, Fourth, Fifth, Sixth, and Tenth Circuits have all recognized a bankruptcy court's ability to recharacterize claims. See In re Lothian Oil, Inc., 650 F.3d 539 (5th Cir. 2011); In re SubMicron Sys., 432 F.3d 448 (3d Cir. 2006); In re Dornier Aviation, 453 F.3d 225 (4th Cir. 2006); In re Hedged-Investments Assocs. Inc., 380 F.3d 1292 (10th Cir. 2004); In re AutoStyle Plastics, Inc., 269 F.3d 726 (6th Cir. 2001).

Impact on the Lender

Recharacterization can impact a lender in two primary ways.

First, recharacterization arises in the context of claims objections where the objector argues that a lender's claim should be disallowed because it actually represents an equity contribution. In this situation, recharacterization is used to reduce the overall amount of allowed claims in a bankruptcy case by transforming claims into equity interests (which are often extinguished without compensation), thereby increasing the distribution percentage for holders of allowed claims.

Second, recharacterization can give rise to avoidance litigation ' specifically, preference and fraudulent transfer actions ' which could result, not only in claim disallowance, but also a judgment in favor of the bankruptcy estate against the purported lender. This occurs when a bankruptcy court determines that the purported “debt” actually constitutes an equity interest and thus the purported “repayments” of the “debt” are rendered constructively fraudulent transfers. Traditionally, recharacterization has only been employed against insider claims. Yet, as more fully discussed below, recent cases make clear that non-insider claims may also be subject to recharacterization.

Background

In the past, bankruptcy courts struggled to distinguish recharacterization claims from equitable subordination claims. An action for equitable subordination does not challenge the existence or validity of the underlying debt. “Rather, it challenges granting the debt the priority to which it is entitled under applicable law because of the creditor's inequitable conduct.” Insilco Techs., 480 F.3d at 217 (internal citations omitted). Equitable subordination arises under Bankruptcy Code ' 510, but the Bankruptcy Code does not expressly provide for recharacterization claims. In addition, equitable subordination is remedial in nature, requires a showing of misconduct, and is only employed to the extent necessary to undo the inequitable conduct. See In re Airadigm Comm., Inc., 616 F.3d 642, 658 (7th Cir. 2010). In contrast, recharacterization focuses on the underlying substance of the disputed transaction without regard to misconduct. Id.

The recharacterization inquiry is one that attempts to determine the true nature of a transaction. Where little money is available for distribution, both recharacterization and equitable subordination can have the same practical effect of preventing a creditor's recovery. However, recharacterization can also give rise to liability in the form of avoidance of purported pre-bankruptcy debt repayments. As the debate over the viability of recharacterization has waned, perhaps unsurprisingly, so has confusion surrounding equitable subordination.

Source of Law for Recharacterization of Claims

Despite almost uniform recognition of a bankruptcy court's power to recharacterize claims, a new debate among the circuit courts has emerged. The divide centers on when and how bankruptcy courts should engage in recharacterization. As previously mentioned, there is no provision in the Bankruptcy Code that expressly grants authority to the bankruptcy court to recharacterize debt. Two divergent theories underpinning the basis for recharacterizatio have arisen.

The Equitable Power Circuits

The Third, Fourth, Sixth and Tenth Circuits agree that bankruptcy courts have the power to recharacterize claims pursuant to their general equitable powers under Bankruptcy Code ' 105(a). These courts find that the power to recharacterize claims is “grounded” in a bankruptcy court's power to prevent substance from giving way to form. See In re SubMicron , 432 F.3d at 454 (quoting Pepper v. Litton , 308 U.S. 295, 305 (1939)). Thus, the recharacterization inquiry focuses on the substance of the transaction at issue, rather than the label attached to it.

Although various multi-factor tests have emerged, the circuits employing equitable power theories (Equitable Power Circuits) generally seek to determine “whether the parties called an instrument one thing when in fact they intended it as something else.” SubMicron, 432 F.3d at 456. Thus, the overarching inquiry is often whether the parties intended a loan to be a disguised equity contribution. In re Fedders North America, Inc., 405 B.R. 527, 554 (Bankr. D. Del. 2009) (citing SubMicron, 432 F.3d at 455-56).

The multi-factor tests from the Equitable Power Circuits use factors such as: 1) the names given to the instruments, if any, evidencing indebtedness; 2) the presence or absence of a fixed maturity date and repayment schedule; 3) the presence or absence of interest payments; 4) the source of repayments; 5) the adequacy or inadequacy of capitalization; 6) the identity of interest between the creditor and the stockholder; 7) the presence or absence of security for the loans; 8) the ability of the debtor to obtain outside financing; 9) the extent to which the advances were subordinated to the claims of other creditors; 10) the extent to which the advances were used to acquire capital assets; 11) the presence or absence of a sinking fund; 12) the presence or absence of voting rights; and 13) other considerations, such as a lack of corporate formalities. See AutoStyle, 269 F.3d at 749-50; In re Friedman's Inc., 452 B.R. 512, 519 (Bankr. D. Del. 2011) (collecting the multiple multi-factor tests).

The State Law Circuits

The two most recent circuit court decisions on recharacterization arise in the Fifth and Ninth Circuits. Both disagreed with the Equitable Power Circuits and held that Bankruptcy Code ' 105(a) does not authorize recharacterization. Though the Fifth and Ninth Circuits agree that bankruptcy courts have the authority to recharacterize debt to equity, they find the power arises solely under applicable state law.

The Fifth Circuit in Lothian Oil held that a bankruptcy court's authority to allow and disallow a claim under Bankruptcy Code ' 502 provides authority to recharacterize a claim that asserts a debt contrary to state law, but which should give the purported claimant some rights vis-'-vis the debtor. See Lothian Oil, 650 F.3d at 543 (citing Dornier Aviation, 453 F.3d at 232). Importantly, Lothian Oil , citing the Supreme Court's decision in Butner v. United States , 440 U.S. 48 (1979), concluded that recharacterization inquiries under ' 502 will depend on state law. Thus, according to the State Law Circuits, the basic test used to determine whether a claim will be recharacterized as an equity interest is whether the applicable state law would disallow the claim based on the theory of recharacterization.

The Ninth Circuit's decision in Fitness Holdings involved litigation over alleged constructively fraudulent transfers. Fitness Holdings showed disapproval of the Equitable Power Circuits' decisions, stating that “courts may not rely on [section] 105(a) and federal common law rules 'of their own creation' to determine whether recharacterization is warranted.” See Fitness Holdings, 714 F.3d at 1149. Rather, Fitness Holdings looked to whether state law provided the putative claimant a debt claim or equity interest. Id.

State Law Alters the Contours of Recharacterization

Comparing the dictionary definition of recharacterization and the recent Lothian Oil decision shows that reliance on state law as the source of law for recharacterization claims can expand the scope of those claims in new ways. On the one hand, Black's Law Dictionary defines “recharacterization” as “a court's determination that an insider's loan to an entity in liquidation ' should be treated as a capital contribution, not as a loan, thereby entitling the insider to only part of the liquidation proceeds payable after all the business's debts have been discharged.” Black's Law Dictionary (9th ed. 2009).

However, in Lothian Oil, the Fifth Circuit concluded “that recharacterization extends beyond insiders and is part of the bankruptcy courts' authority to allow and disallow claims under” Bankruptcy Code ' 502. Lothian Oil, 650 F.3d at 542. In Lothian Oil, the Fifth Circuit looked to the relevant state law [Texas] and did not find that state law distinguished between mischaracterized insider and non-insider claims. Id. at 544. Recharacterizing a non-insider's debt runs contrary to the more established grain of the Equitable Power Circuits. Yet, recharacterization of non-insider claims may become more common as bankruptcy courts rely on state law.

Lenders that find themselves in the Fifth and Ninth Circuits should closely examine applicable state law to determine the risks posed by a potential recharacterization claim. For example, in In re Gulf Fleet Holdings, Inc., 491 B.R. 747 (Bankr. W.D. La 2013), the bankruptcy court rejected the Trustee's recharacterization claim to the extent that it was based on the court's equitable powers under ' 105 and instead looked to state law. Id. at 773. The bankruptcy court held that while a recharacterization claim could be asserted under governing Louisiana state law based on a legal theory known as a “simulation” ' or “contract which by mutual agreement ' does not express the true intent of the parties” ' the plaintiff failed to allege the necessary elements to support such a claim. As a practical problem, without local counsel or extensive research, a lender may be wholly unaware of potential recharacterization claims.

In the few circuits that have not addressed recharacterization, the logic and policy underpinning the Lothian Oil decision may be gaining traction. For example, one oral ruling from a bankruptcy court in the Northern District of Illinois relied on Lothian Oil in stating that ' 105 does not constitute an independent basis to recharacterize a claim that would otherwise be allowable under ' 502. The court determined that state law governed and requested briefing regarding whether Illinois state law recognized recharacterization. In re Agri-Best Holdings, LLC, No. 12 A 01378, (Bankr. N.D. Ill. March 27, 2013) (Dkt. No. 33). As of the date of publication, this litigation was ongoing.

Nevertheless, many bankruptcy courts still employ the Equitable Power Circuits' analysis. For example, the bankruptcy court in In re Shubh Hotels Pittsburgh, LLC, 476 B.R. 181 (Bankr. W.D. Pa. 2012), recharacterized debt to equity based on the Third Circuit's equitable power framework. In Shubh Hotels, the bankruptcy court held that a claimant's unsecured claim was properly characterized as an equity contribution. The court based its decision on the objector's proffered evidence, including: 1) the testimony from the chief operating officer of the purported claimant that the advances were recorded on the debtor's books as equity; 2) the debtor's balance sheet prepared just seven days prior to the debtor's petition date did not reflect that any money was owed to the purported claimant; 3) the debtor's bankruptcy schedules signed under penalty of perjury did not reflect that any money was owed to the purported claimant; and 4) an expert report concluded that the transactions between the purported claimant and the debtor were appropriately accounted for as equity transactions.

Implications and Conclusions

Clearly, any financial transaction between an insider and a debtor is subject to heightened inspection in bankruptcy. In the Third, Fourth, Sixth, and Tenth Circuits where courts rely on equitable powers under ' 105 for recharacterization, it is critical for a lender to satisfy as many of the factors discussed above as possible. At a minimum, a lender should comply with corporate formalities and execute a valid and binding note.

It is also recommended that lenders avoid obtaining rights traditionally linked to equity interest holders, such as voting rights. Recent case law makes clear that reliance on state law has broadened the scope of recharacterization claims beyond just transactions involving insiders. In the Fifth and Ninth Circuits, and before any other court employing state law, lenders must recognize that non-insiders who engaged in financial transactions with debtors may also face newly cast recharacterization-like claims. Texas appears to be one such jurisdiction. See Lothian Oil, 650 F.3d 539.

Therefore, lenders should assess the likelihood of recharacterization claim on a circuit-by-circuit and state-by-state basis going forward in order to fully understand all of the risks of providing debt financing to financially troubled borrowers.

James B. Sowka is an attorney at Seyfarth Shaw LLP in the firm's Chicago office, where he concentrates his practice on bankruptcy law, creditor rights, and commercial and real estate litigation. Steven Schwartz is a bankruptcy attorney and LL.M. candidate at St. John's University.