Recharacterization is a judicial doctrine originating in the case law of most state courts. Its main tenet is that “a spade should be called a spade”; that is, if an extension of credit has more of the characteristics of equity than of debt, it should be treated like equity even if it was denominated as debt. Thus, a loan that looks more like an equity investment will not be permitted to share in distributions to creditors, but will be classed as equity and paid (or not paid) in the same manner as equity.
While the doctrine of recharacterization was developed by state common law, it found its way into bankruptcy law through one of two different theories. The majority of courts sitting in bankruptcy cases have held that § 105 of the Bankruptcy Code provided the court with the power to recharacterize a loan as equity.[1] Other courts have held that the power to recharacterize a claim based on an alleged loan as equity is codified in § 502(b) of the Bankruptcy Code, which provides, in relevant part, that a bankruptcy court “shall allow such claim, except to the extent that ... such claim is unenforceable ... under any agreement or applicable law.”[2] Regardless of whether the inherent power to recharacterize is based on § 105 or § 502, courts look at many different factors when deciding whether to recharacterize a claim.
Because recharacterization has its genesis in state law, the lack of uniformity in the principles to be applied can be confusing. A recent case from the Dallas Division of the U.S. Bankruptcy Court for the Northern District of Texas contains an excellent discussion of the approaches of the various courts to the issue of recharacterization of a claim. In Equipment Equity,[3] Bankruptcy Judge Stacey Jernigan accurately summarized the law by stating:
The doctrine of re-characterization, as it has evolved across United States jurisdictions, unfortunately imposes inconsistent and, arguably, sometimes irrational results (particularly for insiders or other nontraditional lenders of last resort) who provide financial support to a business in financial distress.[4]
The Fourth and Sixth Circuits have approved the use of the following factors in determining whether to recharacterize debt as an equity contribution: (1) the names given to the instruments, if any, evidencing the indebtedness; (2) the presence or absence of a fixed maturity date and schedule of payments; (3) the presence or absence of a fixed rate of interest and 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 security, if any, for the advances; (8) the corporation’s ability to obtain financing from outside lending institutions; (9) the extent to which the advances were subordinated to the claims of outside creditors; (10) the extent to which the advances were used to acquire capital assets; and (11) the presence or absence of a sinking fund to provide repayments.[5]
The Tenth Circuit in Sender v. The Bronze Group Ltd. (In re Hedged–Invs. Assocs. Inc.)[6] applied a 13-factor test in affirming the decisions of the courts below to recharacterize a debt claim to equity. This test contains many of the same 11 factors as those applied by the Fourth and Sixth Circuits, but it relies on tax law cases in other circuits for its 13-factor test.[7]
The Third Circuit in Cohen v. KB Mezzanine Fund II LP (In re SubMicron Sys. Corp.)[8] has adopted a slightly different approach.
In defining the re-characterization inquiry, courts have adopted a variety of multi-factor tests borrowed from non-bankruptcy caselaw. While these tests undoubtedly include pertinent factors, they devolve to an overarching inquiry: the characterization as debt or equity is a court’s attempt to discern whether the parties called an instrument one thing when in fact they intended it as something else. That intent may be inferred from what the parties say in their contracts, from what they do through their actions, and from the economic reality of the surrounding circumstances. Answers lie in facts that confer context case-by-case.
No mechanistic scorecard suffices. And none should, for Kabuki outcomes elude difficult fact patterns.[9]
The Fifth Circuit, while generally approving of the many-factor tests adopted in the Third, Fourth, Sixth and Tenth Circuits, has also added a requirement that the courts look at applicable state law. In Grossman v. Lothian Oil Inc. (In re Lothian Oil Inc.),[10] the Fifth Circuit stated, “We conclude that re-characterization extends beyond insiders and is part of the bankruptcy courts’ authority to allow and disallow claims under 11 U.S.C. § 502.”[11] Reasoning from § 502 and the power to allow a claim under applicable principles of state law, the Fifth Circuit held that state law is the source of a bankruptcy court’s power to recharacterize a debt into equity and that the relevant inquiry is therefore (1) what state law governs a particular claim, and (2) what does state law provide? While the decision in Lothian Oil may seem on the surface to be different from those of the other circuit courts of appeals, most state courts that have addressed the issue of recharacterization have looked to the multi-factor approach of the tax law decisions.
The Eleventh Circuit Court of Appeals in Estes v. N & D Properties Inc.[12] has adopted an alternative two-pronged test. In In re N & D Properties Inc. partial equitable subordination of debt held by an insider creditor was ordered under § 510 and applicable precedent as to unpaid consumer creditors. The decision focuses on debts owed to consumers for deposits on furniture purchases where the insider creditor allowed the debtor to continue to take 100 percent deposits after furniture vendors had refused all future shipping, a fact that the insider creditor knew. Nevertheless, the Eleventh Circuit also considered the argument of the trustee for re-characterization of other debt held by the insider creditor. In denying recharacterization, the court stated:
[S]hareholder loans may be deemed capital contributions in one of two circumstances: where the trustee proves initial under-capitalization or where the trustee proves that the loans were made when no other disinterested lender would have extended credit.”[13]
The two-prong test announced in N & D Properties Inc. appears to have been followed only by a few lower courts in the Eleventh Circuit. It is clearly a minority position and, if widely adopted, would have the incongruous effect of discouraging insiders from making any loans at a time when the business needs insider loans the most.
[1] Roth Steel Tube Co. v. Comm’r of Internal Revenue, 800 F.2d 625, 630 (6th Cir. 1986); Bayer Corp. v. MascoTech Inc. (In re AutoStyle Plastics Inc.), 269 F.3d 726, 747–53 (6th Cir. 2001); Sender v. The Bronze Group Ltd. (In re Hedged–Invs. Assocs. Inc.), 380 F.3d 1292, 1298 (10th Cir. 2004); Cohen v. KB Mezzanine Fund II LP (In re SubMicron Sys. Corp.), 432 F.3d 448, 455 n.8 (3d Cir. 2006); and Fairchild Dornier GMBH v. Official Comm. of Unsecured Creditors (In re Official Comm. of Unsecured Creditors for Dornier Aviation (N. Am.) Inc.), 453 F.3d 225, 233–34 (4th Cir. 2006).
[2] Fed. Commc’ns Comm’n v. Airadigm Commc’ns Inc., et al. (In re Airadigm Commc'ns Inc.), 616 F.3d 642, 658 (7th Cir. 2010); Grossman v. Lothian Oil Inc. (In re Lothian Oil Inc.), 650 F.3d 539, 542-44 (5th Cir. 2011); In re Equipment Equity Holdings Inc., 491 B.R. 792, 852 (Bankr. N.D. Tex. 2013); Official Comm. of Unsecured Creditors v. Hancock Park Capital II L.P. (In re Fitness Holdings Int’l Inc.), 714 F.3d 1141, 1148-49 (9th Cir. 2013).
[3] Equipment Equity, supra note 2.
[4] Id. at 848 (footnote omitted).
[5] AutoStyle Plastics, supra note 1 at 749-50; Dornier Aviation, supra note 1 at 233-34.
[6] 380 F.3d 1292 (10th Cir. 2004).
[7] The 13 factors are: (1) the names given to the certificates evidencing the indebtedness; (2) the presence or absence of a fixed maturity date; (3) the source of payments; (4) the right to enforce payment of principal and interest; (5) participation in management flowing as a result; (6) the status of the contribution in relation to regular corporate creditors; (7) the intent of the parties; (8) “thin” or adequate capitalization; (9) identity of interest between the creditor and stockholder; (10) source of interest payments; (11) the ability of the corporation to obtain loans from outside lending institutions; (12) the extent to which the advance was used to acquire capital assets; and (13) the failure of the debtor to repay on the due date or to seek a postponement. Id. at 1298.
[8] 432 F.3d 448 (3d Cir. 2006).
[9] Id. at 455-56.
[10] 650 F.3d 539 (5th Cir. 2011).
[11] Id. at 542.
[12] 799 F.2d 726 (11th Cir. 1986).
[13] Id. at 733.