Vaulting Past Recharacterization and Equitable Subordination

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Oct 2004

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The recently concluded
Athens Olympics provided devotees of international sport more than their
share of compelling stories. One of those stories featured American gymnast
Paul Hamm and his bid for a medal in the "all-around"
men's gymnastics competition—a medley of routines on vault,
high bar, pommel horse, parallel bars, floor exercise and rings. In first
place after three routines, Hamm let fly a vault that even I, if properly
motivated and medicated, would be able to match: a flailing aerial
conniption that landed Hamm on his back, off the mat and in a heap inches
away from startled judges, who promptly gave Hamm a score that should have
doomed his competition. It didn't. Hamm's routines on parallel
bars and high bar—coupled with a stunning string of missteps by other
gymnasts—propelled Hamm to the gold medal. Hamm had performed what
one observer called "a hideous tumble" and got away with it.

Elsewhere, an investment fund called The Bronze Group
Ltd. performed what one observer called "a financial
somersault" and got away with it. Beginning in 1986, Bronze Group
lent nearly $2 million to an entity called Hedged-Investments Associates
Inc. (HIA), a Ponzi scheme that got its start in the 1970s and managed to
stave off its inevitable collapse until 1990.<a href="#1" name="1a">1</a> Bronze Group's
"financial somersault" is described in the Tenth
Circuit's decision in Hedged-Investments
Assocs. II LP v. Bronze Group Ltd. (In re Hedged-Investments Assocs.).<a href="#2" name="2a">2</a> Most of the Bronze Group's individual
participants, before forming Bronze Group, had been partners in an entity
called BGL Associates and had contracted with an asset-trading company
managed by James Donahue (the "visionary" behind HIA) to
establish a stock trading account separate from the HIA partnerships. After
discovering that Donahue had commingled their $900,000 with HIA funds, BGL
demanded a return of its money. With HIA being what it was and Donahue
being who he was, there was no way to return the $900,000. So BGL
dissolved, and Donahue cut bad checks to the former BGL partners for the
funds. Simultaneously, the former BGL partners "contributed"
the checks for $900,000 to the newly formed Bronze Group, which then
immediately loaned the $900,000 to HIA under a promissory note, security
agreement and a UCC-1 financing statement identifying certain of
HIA's trading accounts as collateral. No money actually changed
hands, but the lending relationship had changed dramatically.

What made Bronze Group's loan to HIA all the
more unconventional—and what would raise the ire of HIA's
investors years later—was that the loan documents provided for
"a flexible interest rate, with a minimum rate of 15 percent per
annum for the life of the loan, plus additional interest to match the rate
of any greater HIA earnings, minus a fee of 4 percent per annum."<a href="#3" name="3a">3</a> In
other words, the "loan's payment terms were nearly identical to
the profit payments Donahue had promised to HIA's limited partners
/equity investors in the mid-1980s."<a href="#4" name="4a">4</a>

HIA entered bankruptcy owing Bronze Group about $1.83
million (there were many subsequent advances). The panel trustee tried to
convince the bankruptcy court that the most equitable way to distribute the
estate's $11 million (against almost $200 million in investor
interests) was to distribute a pro rata share of the estate to each interest-holder based on the
amount of each holder's principal invested in HIA. Bronze Group
objected, arguing that its lender status accorded it priority over the
equity investors and that it should be paid in full before any investors
received any distribution. The panel trustee and the investors tried two
different approaches in an effort to lump Bronze Group in with HIA's
equity investors. First, the panel trustee asked the bankruptcy court to
recharacterize Bronze Group's loan as an equity contribution. The
panel trustee argued that Bronze Group negotiated the same terms as those
promised to equity investors and did so under circumstances where Bronze
Group knew or should have known (based on the BGL debacle) that HIA was, at
best, undercapitalized. Second, he asked the bankruptcy court to equitably
subordinate Bronze Group's claim to the level of equity-holders.<a href="#5" name="5a">5</a>

The bankruptcy court declined to recharacterize
Bronze Group's loan as equity, but did equitably subordinate the debt
to the same priority as HIA's equity investors, requiring Bronze
Group to share pro rata with the investors. The district court agreed that the loan should
not be recharacterized, but reversed the bankruptcy court's
equitable subordination ruling and granted Bronze Group a judgment for the
loan principal and all interest that accrued before bankruptcy.<a href="#6" name="6a">6</a> Understandably
dissatisfied with having their $11 million estate depleted by $2 million in
Bronze Group's favor, the investors appealed to the Tenth Circuit,
asking the court to reverse the lower courts' refusal to
recharacterize the loan and to reinstate the bankruptcy court's
equitable subordination ruling.

The Tenth Circuit affirmed all aspects of the
district court's ruling, refusing both to recharacterize the loan
and to equitably subordinate Bronze Group's loan claim. Perhaps
because it sensed that the bankruptcy court and the investors lacked a
complete understanding of recharacterization and equitable subordination,
the Tenth Circuit described each remedy separately, drawing an important
distinction between them. A recharacterization "ignore[s] the label
attached to the transaction at issue and instead recognizes its true
substance...as a capital contribution."<a href="#7" name="7a">7</a> Equitable subordination
"looks not to the substance of the transaction, but to the behavior
of the parties involved. The funds in question are still considered
outstanding corporate debt, but the courts seek to remedy some inequity or
unfairness perpetrated against the bankruptcy entity's other
creditors or investors by postponing the subordinated creditor's
right to repayment until others' claims have been satisfied."<a href="#8" name="8a">8</a>

In determining whether a loan is to be
recharacterized as what the court called "camouflaged equity,"
the court settled on a list of 13 criteria originally proposed in a 1984
decision from the Eleventh Circuit: (1) the names given to the transaction
documents, (2) 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 resulting from the transaction, (6) the
status of the contribution in relation to regular corporate creditors, (7)
the parties' intents, (8) adequacy of capitalization, (9) identity of
interest between creditor and stockholder, (10) the source of interest
payments, (11) the borrower's ability to obtain outside loans, (12)
whether the borrower uses the advance to acquire capital assets and (13)
the borrower's failure to repay on the due date or seek a
forbearance.<a href="#9" name="9a">9</a> The Tenth Circuit acknowledged that the relative significance
of the various criteria would vary from case to case, but stressed that
placing too much emphasis on undercapitalization would create undesirable
disincentives for shareholders and other insiders of a struggling
enterprise "to keep a flagging business afloat."<a href="#10" name="10a">10</a> The
court acknowledged that the Bronze Group loan's lack of maturity
date, HIA's payment of interest out of its pooled investment account
and HIA's "thin" capitalization all militated in favor of
recharacterization. But based strictly on the bankruptcy court's
findings of fact, the Tenth Circuit agreed with both lower courts that
Bronze Group's loan should not be recharacterized.

What followed that portion of the ruling (a full
explanation of the equitable subordination doctrine), while instructive,
seems largely unnecessary. Despite spending several pages describing the
criteria by which courts consider requests to equitably subordinate a
creditor's claim, the Tenth Circuit's opinion seems to miss an
important piece of its own analysis: that equitable subordination under
Bankruptcy Code §510(c) would do nothing for the HIA investors because
Bankruptcy Code §510(c) does not permit a
debt to be equitably subordinated to or below the level of equity.<a href="#11" name="11a">11</a> A claim can only be subordinated to another claim,
not to an equity interest. Therefore, it is impossible to do precisely what
the Tenth Circuit suggested earlier in its opinion—to "remedy
some inequity or unfairness perpetrated against...investors"—by
subordinating the debt to those investors' equity interests. The
investors would gain essentially nothing by the court's equitably
subordinating Bronze Group's debt. The best the investors could hope
for is that Bronze Group's debt would be subordinated to the $18,000
in trade debt. Even so, that subordinated debt would still be of a higher
priority than the first dollar of an investor's equity interest, and
the investors would get nothing from the estate until Bronze Group's
claim was paid in full.

The Tenth Circuit's rehearsal of equitable
subordination law is, nonetheless, informative. The court reiterated
established criteria for equitable subordination: "(1)
'inequitable conduct' on the part of the claimant sought to be
subordinated, (2) injury to the other creditors of the bankrupt or unfair
advantage for the claimant resulting from the claimant's conduct and
(3) consistency with the provisions of the Bankruptcy Code." The
Tenth Circuit noted also that it places "special emphasis on the
inequitable conduct prong."<a href="#12" name="12a">12</a>

Inequitable conduct, as the Tenth Circuit notes, can
include three types of misconduct: "(1) fraud, illegality and breach
of fiduciary duties, (2) undercapitalization or (3) claimant's use of
the debtor as a mere instrumentality or alter ego."<a href="#13" name="13a">13</a> The bankruptcy
court seems not to have applied any of these guidelines to Bronze Group,
instead basing its equitable subordination ruling on Bronze Group's
"failure to conduct reasonable due diligence before advancing the
loan to HIA and on the similarities between the Bronze Group loan's
earnings structure and the promised returns for the limited
partnerships."<a href="#14" name="14a">14</a> The Tenth Circuit regarded those findings as
insufficient for equitable subordination purposes. "Failure to
conduct due diligence was certainly bad business practice, and the
loan's terms might indeed be questionable, but these facts do not
amount to blatant fraud or other illegality at the expense of HIA's
other creditors."<a href="#15" name="15a">15</a>

Interestingly, the Tenth Circuit noted that
HIA's undercapitalization did not rise to the level of gross
misconduct because "Bronze Group's managers were unaware of
HIA's financial straits until the entire scheme collapsed in
1990." Did the Tenth Circuit unwittingly imply a disincentive to
perform due diligence? Under that reasoning, the less a lender knows about
how or to what extent a borrower is capitalized, the less likely
undercapitalization will come back to haunt the lender later.

Ultimately, Bronze Group's "financial
somersault"—like Paul Hamm's ungainly vault—was far
from perfect and fraught with problems, but it was good enough to win.
Getting paid in full from a Ponzi scheme is no mean feat, and Bronze
Group's success in overcoming efforts to recharacterize and
equitably subordinate its debt may say more about those remedies'
narrow scope and exacting requirements than it says about Bronze
Group's bona fides.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> The ensuing
bankruptcy case has been something of a full-employment act for the courts.
Since its start in 1990, the case began as a voluntary chapter 11 and
converted to chapter 7 eight days later—and it has generated no fewer
than eight appeals to the Tenth Circuit Court of Appeals. That the
bankruptcy persists in more or less full swing after 14 years is
remarkable, even for a Ponzi scheme case. <a href="#1a">Return to article</a>

<a name="2">2</a> 2004 U.S.
App. LEXIS 18164 (10th Cir. Aug. 26, 2004). <a href="#2a">Return to article</a>

<a name="3">3</a> Id. at *3. <a href="#3a">Return to article</a>

<a name="4">4</a> Id. at *3-4. <a href="#4a">Return to article</a>

<a name="5">5</a> Id. at *6. <a href="#5a">Return to article</a>

<a name="6">6</a> Id. at *7. <a href="#6a">Return to article</a>

<a name="7">7</a> Id. at *8. <a href="#7a">Return to article</a>

<a name="8">8</a> Id. <a href="#8a">Return to article</a>

<a name="9">9</a> Stinett's Pontiac Serv. Inc. v. Comm'r of
Internal Revenue, 730 F.2d 634, 638 (11th Cir.
1984). <a href="#9a">Return to article</a>

<a name="10">10</a> 2004 U.S.
App. LEXIS 18164 at *13 n.1. <a href="#10a">Return to article</a>

<a name="11">11</a> Bankruptcy
Code §510(c) provides that "under principles of equitable
subordination," a court may "subordinate for purposes of
distribution all or part of an allowed claim to all or part of another
allowed claim or all or part of an allowed interest to all or part of
another allowed interest...." <a href="#11a">Return to article</a>

<a name="12">12</a> 2004 U.S.
App. LEXIS 18164 at *17. <a href="#12a">Return to article</a>

<a name="13">13</a> Id. at *20 (quoting Fabricators Inc. v. Technical Fabricators Inc. (In re
Fabricators)), 926 F.2d 1458, 1467 (5th
Cir. 1991). <a href="#13a">Return to article</a>

<a name="14">14</a> 2004 U.S.
App. LEXIS 18164 at *22. <a href="#14a">Return to article</a>

<a name="15">15</a> Id. at *22-23. <a href="#15a">Return to article</a>

Journal Authors

Jordan A. Kroop

Journal Date

Friday, October 1, 2004 - 12:00

Bankruptcy Rule

2004