Recharacterization from Debt to Equity Lenders Beware

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Nov 2003

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One of the world's largest boat manufacturers was struggling to stay afloat.<a href="#3" name="3a">3</a> In the fall of 2000, Outboard Marine
Corp. (OMC) and its lenders completed the tenth amendment to their loan and security agreement, creating an
additional $45 million tranche of debt (Tranche B). Quantum Industrial Partners LDC, which over the course of two
years had become the direct or beneficial owner of nearly 100 percent of OMC stock, immediately purchased a 100
percent participation interest in Tranche B. Quantum agreed with lead lender Bank of America that Tranche B would
be subordinated to the $105 million Tranche A loan. Quantum also handed over to Bank of America all of its legal
rights against OMC.

Two months later, OMC filed for chapter 11 protection, and Bank of America brought an action to collect on all the
secured loans. In his counterclaim, trustee Alex D. Moglia asked the bankruptcy court to use its equitable powers to
decree that the Tranche B loan, allegedly owed to Quantum, did not give rise to a right to payment because it was
not a loan at all, but merely an equity security.

<h3>Beyond Courts' Authority?</h3>

The bankruptcy court declined the invitation to recharacterize the debt, however, observing from the bench
that:

<blockquote>
[T]here is no basis in bankruptcy law to recharacterize a debt as equity. That bizarre concept arose from a serious
misreading of a few tax cases... Somehow, those very reasonable cases got read into the bankruptcy context into
some sort of equitable doctrine... In my opinion, no bankruptcy court has the power to do any such thing under the
Bankruptcy Code.
</blockquote>

In re Outboard Marine Corp., Case No. 00 B 37405 (N.D. Ill., Jan. 14, 2002, at 33) (Barliant, J.).

Judge Barliant's view is in conflict with that of most courts that have considered the issue.<a href="#4" name="4a">4</a> Yet Judge Barliant and
other opponents of debt recharacterization point out that while §105(a) of the Bankruptcy Code grants bankruptcy
courts broad authority to "issue any order, process or judgment," such authority may only be exercised "to carry out
the provisions of this title." The Bankruptcy Code, they argue, already contains a specific provision governing
equitable subordination (§510), permitting the court to subordinate the claim of a creditor who has acted inequitably
to offset injury to other creditors. Because Congress, in §510, provided a remedy strikingly similar to
recharacterization, the principle of expressio unius est exclusio alterius suggests that Congress did not intend to
permit the recharacterization of debt into equity. In other words, the use of recharacterization to craft an additional
remedy where the elements of equitable subordination, the Code-provided remedy, are not present, constitutes an
unauthorized exercise of a bankruptcy court's authority.

Moreover, bankruptcy courts' equitable power does not extend to changing the fundamentals of bankruptcy law
regarding the validity of creditors' entitlements or the priority scheme established by §726. See In re Outboard
Marine at 34; citing <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…. v. Noland, 116 S. Ct. 1524 (1996)</a> (a bankruptcy court's equitable power does not extend
to reordering the priority scheme devised by Congress); <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… v. Ill. Dep't. Rev., 120 S. Ct. 1951 (2000)</a>

(bankruptcy courts are not authorized to make wholesale substitution of underlying law controlling creditors'
entitlements pursuant to equitable power); <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… Factors Inc. v. Kmart Corp., 291 B.R. 818, 823 (N.D. Ill.
2003)</a> ("we cannot ignore the Bankruptcy Code's statutory scheme of priority in favor of 'equity'").

<h3>Determining the Natureof a Transaction</h3>

On appeal, the district court reversed, making the case in favor of recharacterization.<a href="#5" name="5a">5</a> First, while
recharacterization and equitable subordination may have, in practice, similar effects on a debt, the two
remedies are theoretically distinct:

<blockquote>
The recharacterization of a debt as equity involves a factual determination as to whether or not the asserted debt is
in fact debt or is in fact an equity contribution disguised as a debt. Equitable subordination, on the other hand, is an
equitable remedy applied against a legitimate creditor who has acted inequitably.<a href="#6" name="6a">6</a>

</blockquote>

Viewed in this light, recharacterization arguably reinforces, rather than interferes with, the priority scheme. The
"substance over form" analysis could prevent insiders and other parties from improperly availing themselves of the
benefits of ownership without shouldering the attendant risks. In addition, according to the district court, no
disharmony necessarily exists between recharacterization and equitable subordination, because equitable
subordination, by definition, only becomes relevant if the court determines that the advance in question was not an
equity contribution.

Thus, the district court remanded the case to the bankruptcy court, ordering it to exercise its authority to determine
whether the facts justified recharacterization. In making this determination, the bankruptcy court was urged to
consider 13 factors as it engaged in the Zen-like task of "assess[ing] the true nature of [the] transaction."<a href="#7" name="7a">7</a>

<h3>Factors in Recharacterization Analysis</h3>

The factors are:
<ol>
<li>the name given the instrument that evidences the indebtedness (the issuance of a stock certificate indicates an
equity contribution, whereas the issuance of a bond, debenture or note is indicative of a bona fide indebtedness);

</li><li>the presence or absence of a fixed maturity date (the presence of a fixed maturity date indicates a fixed
obligation to repay, a characteristic of a debt obligation);

</li><li>the expected source of the repayments (if repayment is dependent on corporate earnings, the transaction has
the appearance of a capital contribution);

</li><li>the right to enforce payment of the principal and interest (if there is a definite obligation to repay the advance,
this would be an indicator of a loan);

</li><li>participation in management flowing as a result of the transaction (if the contributors were granted increased
voting power or participation in the debtor's affairs by virtue of the advance, this would be an indication of a
capital contribution);

</li><li>the status of the contribution in relation to regular corporate creditors (subordination of advances to claims of
all other creditors indicates that the advances are capital contributions and not loans);

</li><li>the intent of the parties (intent to create either a debt or equity relationship);

</li><li>"thin" or inadequate capitalization (thin capitalization is very strong evidence of a capital contribution);

</li><li>identity of interest between creditor and stockholder (a sharply disproportionate ratio between a shareholder's
percentage interest in stock and debt is strongly indicative of a bona fide indebtedness);

</li><li>presence or absence of a fixed rate of interest and interest payments (lack of provisions for payment of
interest indicates that the money advanced was intended as a capital contribution);

</li><li>the ability of the corporation to obtain loans from outside lending institutions (if a corporation is able to
borrow funds from outside sources at the time the advance is made, the transaction has an appearance of a bona
fide indebtedness);

</li><li>the extent to which the corporation used the advance to acquire capital assets (use of advances to meet the
daily operating needs of the corporation, rather than to purchase capital assets, is indicative of a bona fide
indebtedness); and

</li><li>the failure of the debtor to repay on the due date or to seek postponement (repayment of the advance on the
due date indicates a bona fide indebtedness).<a href="#8" name="8a">8</a>
</li></ol>

The formula is an unscientific one, and no one factor is determinative. These factors are merely prisms through
which courts gaze to divine the true character of a transaction.

Eschewing this detailed, balanced and somewhat metaphysical analysis, some courts in the Eleventh Circuit have
adopted a surprisingly draconian approach.<a href="#9" name="9a">9</a> Those courts willingly convert debt into equity where the trustee can
show either (1) that the debtor was initially undercapitalized or (2) that the advance was made at a time when no
other disinterested lender would have extended credit. In either one of these scenarios, the purported lender will lose
its claim even if every other factor points to bona fide indebtedness.<a href="#10" name="10a">10</a> Moreover, courts may recharacterize debt
based on the "no other disinterested lender" situation even where banks are continuing to extend credit, but insisting
upon subordination of the insiders' loans.<a href="#11" name="11a">11</a>

<h3>One Less Lifeboat for Distressed Businesses</h3>

The recharacterization risk is in some ways far more menacing to a would-be lender than is the risk of equitable
subordination. Recharacterization, which requires no finding of inequitable conduct, will frequently result not in a
lower priority claim, but in a total loss for the would-be lender.

As would-be lenders tighten up their purse-strings in response to this risk, it is the troubled small- to medium-sized
companies who will feel the pinch. Indeed, the situation is not uncommon. Often, a company in financial distress
may find its best avenue for additional funds to be from insiders who already have a vested interest in the company.
However, while such parties may be willing to make additional investments in such companies, they also
understand the risks attendant with doing so. It is therefore common for such investments to be made as loans rather
than capital contributions.

In that sense, Judge Barliant's view may be more welcome to some distressed businesses and their constituents
because it facilitates (or at least does not impede) investment in financially troubled companies by those parties who
are their most logical and often only potential sources of capital. Companies and investors need predictability, and
the flow of business and finance depends on the law's respect for, and protection of, the players' reasonable
expectations.

On the other hand, one can also argue that corporate insiders should not have free reign to disguise their equity
investments to the detriment of legitimate lenders and trade creditors. Those who would enjoy the benefits of
ownership should not be permitted to use artifice to escape its inherent perils. That may be why a majority of courts
believe that, if used properly, the approach endorsed by the district court in In re OMC may be able to protect
against such abuses while upholding legitimate loan transactions.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> "Recharacterization" is a process by which a bankruptcy court:

<blockquote>
causes debt (or at least something the parties to the transaction characterized as debt) to be converted into equity.
Courts that believe they have the authority to recharacterize debt rely on their equitable power under §105 of the
Bankruptcy Code to look past the form of a transaction and instead consider a transaction's substance. The
recharacterization risk is in some ways far more dangerous to a would-be lender than is the risk of equitable
subordination, which is a remedy for inequitable conduct and involves determining whether a legitimate creditor's
claim should be subordinated to the extent necessary to offset injury to other creditors. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… re Autostyle Plastics Inc.,
269 F.3d 726 (6th Cir. 2001)</a>. Recharacterization, on the other hand, requires no finding of inequitable conduct. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…;
Moreover, equitable subordination results in a lower priority claim debt, whereas recharacterization converts a
creditor's claim to an equity interest.
</blockquote>

Sprayregen P.C., J., Friedland, J. and Carmel, M., "Recharacterization from Debt to Equity: Do Bankruptcy Courts
Have the Power?" The Bankruptcy Strategist, Vol. XIX, No. 5, March 2001; see, also, Sprayregen P.C., J. and
Friedland, J., "Doubledowning—Avoid Double Trouble: Structuring Alternatives for Additional Rounds in
Troubled Portfolio Companies," The Journal of Private Equity, Fall 2002. This article updates those two prior
articles. For further detail and additional case law, consult those articles. <a href="#1a">Return to article</a>

<a name="2">2</a> James H.M. Sprayregen and Jonathan Friedland are partners in the Chicago and New York offices of Kirkland &
Ellis LLP. James Mayer is an associate in the Chicago office. <a href="#2a">Return to article</a>

<a name="3">3</a> See In re Outboard Marine Corp., 2003 U.S. Dist. 12564, *2-3 (E.D. Ill. July 21, 2003). <a href="#3a">Return to article</a>

<a name="4">4</a> See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… re Autostyle Plastics Inc., 269 F.3d at 747-48 (6th Cir. 2001)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=7… re N&D Properties Inc., 799 F.2d
726, 730 (11th Cir. 1986)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… re Phase I Molecular Toxicology Inc., 287 B.R. 571, 576 (Bankr. D. N.M. 2002)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Kids Creek Partners L.P., 212 B.R. 898, 931 (Bankr. N.D. Ill. 1997)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… re Cold Harbor Assoc. L.P., 204 B.R.
904, 915 (Bankr. E.D. Va. 1997)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… Inc. v. Ingalls, 121 B.R. 626, 630 (Bankr. N.D. Fla. 1990)</a>. But, see

<a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=6… re Pacific Exp. Inc., 69 B.R. 112, 115 (B.A.P. 9th Cir. 1986)</a> (bankruptcy courts' recharacterization of debt to
equity improperly creates inconsistent standards for subordination of debts). <a href="#4a">Return to article</a>

<a name="5">5</a> See In re Outboard Marine Corp., 2003 U.S. Dist. at *16-17. <a href="#5a">Return to article</a>

<a name="6">6</a> In re Outboard Marine Corp. at *13. <a href="#6a">Return to article</a>

<a name="7">7</a> Id. at *16. <a href="#7a">Return to article</a>

<a name="8">8</a> See, generally, <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=4… of Mixon v. United States, 464 F.2d 394 (5th Cir. 1972)</a>; see, also, <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… Corp. v.
Hillsborough Holdings Corp., 176 B.R. 223, 248 (Bankr. M.D. Fla. 1994)</a> (considering the same factors as the

Mixon court); see, also, <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8… Steel Tube Co. v. Commissioner, 800 F.2d 625, 630-32 (6th Cir. 1986)</a> (considering
11 factors similar to the Mixon court to determine if advances were loans or capital contributions); <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… re Cold
Harbor Assocs. L.P., 204 B.R. 904, 915 (Bankr. E.D. Va. 1997)</a> (stating primary factor to consider in determining
whether advances were loans or capital contributions is whether the transaction bears earmark of an arm's length
bargain); <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… Inc. v. Ingalls, 121 B.R. 626, 632 (N.D. Fla. 1990)</a> (holding that insiders' advances were capital
contributions where the insider advanced its funds at a time when no other disinterested lender would have extended
credit equivalent to the amount advanced). <a href="#8a">Return to article</a>

<a name="9">9</a> See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… Inc. v. Ingalls, 121 B.R. at 631</a> (while some courts have "acknowledged that there were at least 11
separate determining factors [in recharacterization analysis, the Eleventh Circuit standard indicates that] shareholder
loans may be deemed capital contributions in one of two circumstances: where the trustee proves initial
undercapitalization or where the trustee proves that the loans were made when no other disinterested lender would
have extended credit.") (citing <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=7… re N&D Properties Inc., 799 F.2d 726 (11th Cir. 1986)</a>). <a href="#9a">Return to article</a>

<a name="10">10</a> This rule is not universally followed in the Eleventh Circuit. See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… Corp. v. Hillsborough Holdings Corp., 176 B.R. 223, 248 (M.D. Fla. 1994)</a> (applying 13-factor test). <a href="#10a">Return to article</a>

<a name="11">11</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…; 121 B.R. at 631-32</a>. <a href="#11a">Return to article</a>

Journal Authors

James H.M. Sprayregen

James R. Mayer

Jonathan P. Friedland

Journal Date

Saturday, November 1, 2003 - 12:00

Bankruptcy Rule

2003