[1]As courts continue to work out the finer points of the “plausibility” standard of pleading announced by the Supreme Court in Bell Atlantic Corporation v. Twombly[2] and further developed in Ashcroft v. Iqbal,[3] plaintiffs are well advised to be as specific as possible in alleging facts to support their claims.[4] A recent decision from a Minnesota bankruptcy court emphasizes that this is especially true when it comes to invoking the equitable doctrine of recharacterization as a means of converting debt to equity in a bankruptcy case.[5]
Prior to filing voluntary petitions under chapter 11, Duke and King Acquisition Corp. and its affiliated debtors collectively owned and operated more than 90 Burger King franchises throughout the Midwest and Florida.[6] Following a sale of substantially all of the debtors’ assets and confirmation of a liquidating plan, the liquidating trustee asserted claims against two separate groups of defendants, one consisting of individuals and entities affiliated with the debtors’ private-equity sponsor, and the other consisting of entities from which affiliates of the sponsor had purchased the bulk of the franchised Burger King restaurants in a 2006 transaction.[7]
The trustee’s complaint asserted various avoidance claims relating to the 2006 purchase transaction, as well as claims for money damages arising from alleged breaches of fiduciary duties relating to the way in which the sponsor had “constituted, capitalized, incorporated, and operated the Debtors for and after the purchase of the restaurant locations.”[8] The liquidating trustee also requested, “[a]s subsidiary relief,” that the court recharacterize the sponsor’s scheduled claims against the debtors’ estates as equity for purposes of their treatment in any further distributions in liquidation.[9]
Among other things, the court was singularly unimpressed by the trustee’s effort to invoke the remedy of recharacterization — a remedy that the court characterized as “extraordinary, judicially created, and potentially sweeping in its application” — by way of the following single sentence in the complaint: “In fairness and equity to the estate’s general unsecured creditors, the [sponsor’s] claim should be recharacterized as equity.”[10] Finding the trustee’s allegations with respect to the recharacterization claim to be “pitifully inadequate,” the court dismissed the relevant count of the complaint with prejudice, but not before devoting significant analysis to the state of the law with respect to recharacterization.
Noting the absence of any controlling authority in the Eighth Circuit, the court observed that at least three different standards have emerged in other circuits for “deem[ing] contributions by shareholders or other participants to have been equity investment rather than lending.”[11] The court then characterized those three standards as follows: (1) “[t]he Eleventh Circuit’s ‘objective’ test, [which] requires debt to insiders to be recharacterized as equity whenever the insider’s advance had been made at a time when no independent, disinterested lender would have extended credit to the debtor”;[12] (2) “[a] totality-of-the-circumstances test, considering multiple identified terms of the particular insider-debtor relationship and characteristics of the advances in question”;[13] and (3) “[a]n importation of the applicable state law standard for recharacterization of debt as equity, to the degree that it is [recognized under applicable state law].”[14]
The court next proceeded to consider the trustee’s allegations in light of these three standards, ultimately concluding that the trustee’s “sparse phrasing” in invoking recharacterization was consistent only with the “objective” standard applied by the Eleventh Circuit, under which “initial undercapitalization ... and corporate desperation at the time of the post-formation infusion ... would justify a judicial shoehorning down into the lower status of equity, taking the lending shareholder out of competition with third-party creditors of the company in the priority of claims.”[15] The court concluded, however, that this objective standard “simply is not the rule to apply.”[16] Instead, the court looked to the multi-factor, totality-of-the-circumstances approach, which it noted has been widely utilized by courts in the remainder of the circuits, regardless of “whether one goes with a federal generation or the incorporation of state law.”[17]
In reviewing the complaint in light of the totality-of-the-circumstances approach, the court found it to be devoid of factual allegations supporting the recharacterization claim. In particular, the court noted the trustee’s failure to allege “a bit of circumstance contemporaneous with the [sponsor’s] lending-in, that is consistent with an expectation on their part to not have a true creditor status.”[18] Accordingly, the court dismissed the trustee’s recharacterization claim without leave to amend.
This result should serve as an important warning to future litigants seeking the harsh remedy of recharacterization. By following a few basic steps, however, thoughtful practitioners can likely avoid dismissal of their recharacterization claims at the pleading stage. First, before drafting the complaint, take the time to fully research the applicable legal standard for recharacterization in your jurisdiction — including, if relevant, the law of any states that may potentially govern a recharacterization claim. Second, be sure that you can allege specific facts to plausibly suggest that the applicable standard is met. Third, and finally, link the relevant facts to the recharacterization claim so that it is impossible for the court to lose sight of them amidst the other general allegations of the complaint.
[1] The views expressed in this article are those of the author, and do not reflect the views of Jones Day or any of its clients.
[2] 550 U.S. 545 (2007).
[3] 556 U.S. 662 (2009).
[4] In Twombly, the court held that for a complaint to sufficiently state a claim, its “[f]actual allegations must be enough to raise a right to relief above the speculative level.” 550 U.S. at 555. The court further explained in Iqbal that “only a complaint that states a plausible claim for relief survives a motion to dismiss.” 556 U.S. at 679. Thus, “where the well-pleaded facts do not permit the court to infer more than the mere possibility of misconduct, the complaint has alleged — but it has not ‘show[n]’ — ‘that the pleader is entitled to relief.’” Id. (quoting Fed. R. Civ. P. 8(a)(2)).
[5] Kaye v. Nath Cos. (In re Duke and King Acquisition Corp.), 508 B.R. 107 (Bankr. D. Minn. 2014).
[6] Id. at 113.
[7] Id. at 113-14.
[8] Id. at 115.
[9] Id. at 114.
[10] Id. at 155 (quoting complaint).
[11] Id.
[12] Id. at 156 (citing In re N & D Props. Inc., 799 F.2d 726, 733 (11th Cir. 1986)). The court appears to interpret the Eleventh Circuit test as solely applicable to insiders and not to other lenders.
[13] Id. at 156-57 (citing Bayer Corp. v. MascoTech Inc. (In re Autostyle Plastics Inc.), 269 F.3d 726, 747-53 (6th Cir. 2001), and In re Official Comm. of Unsecured Creditors for Dornier Aviation (N. Am.) Inc., 453 F.3d 225, 233-34 (4th Cir. 2006)). The court’s reference to the “insider-debtor relationship” should not be read to imply that courts applying this test have limited the recharacterization doctrine to insider claims. See AutostylePlastics, 269 F.3d at 747-48 (holding that bankruptcy court had authority to recharacterize claims of non-insider loan participants under appropriate circumstances).
[14] Id. at 157 (citing In re Lothian Oil Inc., 650 F.3d 539, 542-43 (5th Cir. 2011)). The Ninth Circuit has also adopted this approach. See Official Comm. of Unsecured Creditors v. Hancock Park Capital II L.P. (In re Fitness Holdings Int’l Inc.), 714 F.3d 1141 (9th Cir. 2013).
[15] 508 B.R. at 158.
[16] Id.
[17] Id.
[18] Id.