Submicron Developments in Recharacterization Certainty and Finality or Further Confusion

Journal Issue

Apr 2006

Column Name

Feature

Citation

ABI Journal, Vol. XXV, No. 3, p. 28, April 2006

Bankruptcy Code

Topic Tags

Journal HTML Content

In a recent decision, the Third Circuit Court of Appeals (which included now
Supreme Court Justice Alito) issued the first appeals court decision on the
standard of appellate review for a recharacterization determination. Specifically,
the appeals court found that a recharacterization decision is one based in fact
that cannot be overturned on appeal unless the findings by the lower court are
clearly erroneous. Further, the court took great pains to distinguish equitable
subordination from recharacterization and specifically recognized recharacterization
as a cause of action that courts can address using the equitable powers granted
to bankruptcy courts under the Bankruptcy Code.
The appeals court also hammered home the concept that each recharacterization
determination is factually dependent, and no application of "magic factors"
can churn out an easy broad-based finding. Parenthetically, it should be noted
that the appeals court's decision also included a finding that a secured creditor
can bid the full amount of its claim, not just the economic value, even if the
collateral has no value at all and even if those claims are bid by an assignee
of the secured creditors as part of a pre-packaged plan.
By way of brief background, recharacterization is an action where a party requests
that a bankruptcy court disregard form over substance and "recharacterize"
a transaction that was structured as debt into an equitable contribution which,
by its nature, is behind the secured creditors in line for repayment. Recharacterization
is different from equitable subordination in that there is no misconduct required
and that it is not punitive in nature. Further, in equitable subordination the
obligation is only subordinated to the extent of the harm, but in recharacterization
the entire obligation is treated as junior to secured debt. Finally, while the
power to determine cases of equitable subordination is specifically provided
for under the Code pursuant to §510, bankruptcy courts have found the authority
to recharacterize transactions from debt to equity based on the equitable powers
contained in §105 of the Code. In cases that have been decided in the area
of recharacterization, courts have sought to enumerate a list of factors to
aid in the determination of whether an obligation was really intended to be
a debt or an equity transaction—regardless of what it is structured as
on its face. In another departure from the analysis that is conducted in the
context of equitable subordination, the factors used by courts in recharacterization
are for guidance only, and no one factor is controlling; each recharacterization
case is factually dependent.2 This article seeks to provide an update in the
evolving area of recharacterization. For an in-depth discussion of the evolution
of recharacterization and the case law to date, this author refers readers to
her prior writings.3
In re Submicron Systems Corp.: The Lower Court Ruling

In 1997, 1998 and 1999, Submicron funded its operations through a series of
notes that were issued in favor of several different lenders. By mid-1999, the
business of Submicron continued to decline and a determination was made to sell
the assets as soon as possible. Submicron negotiated with the lenders, and a
buyer was found. Submicron filed a pre-packaged bankruptcy petition that was
dependent upon the sale agreement with the buyer. The sale agreement provided
that a new entity (which was a limited-liability corporation) would be set up
to purchase the assets out of the bankruptcy and that the existing lenders would
contribute new capital to the new entity as well as assign their claims against
Submicron to the new buyer entity in exchange for equity in the new buyer entity.
The sales agreement further provided that the new buyer entity would then credit-bid
the full value of the lender's secured claims to purchase the assets of Submicron
at the §363 sale. The practical reality was that the unsecured creditors
would receive nothing.
In the bankruptcy case, the creditors' committee raised four objections to
the §363 sale: (1) the notes were executed in 1999 (just prior to the financial
downturn of Submicron and within months of the bankruptcy petition); (2) if
not recharacterized, the 1999 notes should be treated as unsecured debt; (3)
the new entity should not be allowed to credit bid the secured lender's claims
to the full amount of the secured debt since the assets were fully encumbered
and, for all intents and purposes, had no value; and (4) seeking equitable subordination
of certain of the lender's claims was warranted. The bankruptcy court dismissed
the creditors' committee's objections.
In 2003, the U.S. District Court in Delaware issued an opinion in which it
affirmed the court's denial of the creditors' committee's request to recharacterize
the various pre-petition fundings as equitable contributions.4 In its decision,
the district court noted that the trial testimony was uncontradicted in that
if the defendants had not made the 1999 funding to the debtor, Submicron would
have been forced to close down and liquidate, leaving nothing for the unsecured
creditors.5 In a lengthy opinion, the district court concluded that the 1999
fundings were properly characterized as debt, and that they would be treated
as secured debt. The district court was persuaded that the parties intended
the 1999 fundings to be secured debt, and stated that the defendants were protecting
their past investments (secured debt) through the additional loans.6 The district
court noted that while several factors leaned slightly toward equity, such as
the absence of a sinking fund, the inadequacy of capitalization and collateral,
the majority of the other factors weighed toward characterization as debt.7
The district court concluded that the plaintiff failed to show that under the
debtor's financially distressed circumstances the defendant's 1999 fundings
were irrational, improper or equity infusions disguised as debt.
Interestingly, the district court was not troubled that some of the defendant's
1999 fundings had notes while others did not, since the record was clear that
the debtor's accounting department had made numerous mistakes and errors when
generating notes. The fact that the notes were generated for some fundings and
not for others was not sufficient in and of itself, in the district court's
opinion, to recharacterize the 1999 fundings as equity.8 The district
court also took note that (1) the committee had not proven that the defendants
or their designees controlled or dominated Submicron in any way, (2) while undercapitalization
lends itself for a court to be more skeptical of purported loans, under-capitalization
of a loan is insufficient to justify the subordination of insider claims, and
(3) the lender's participation on the board did not, in and of itself, provide
support for equity characterization.9 The district court quoted In
re Octagon Roofing and stated: "This is because 'any other analysis
would discourage loans from insiders to companies facing financial difficulty,
and that would be unfortunate because it is the shareholders who are most likely
to have the motivation to salvage a floundering company.'"10 The district
court also stated: "When a company is in distress, the only parties motivated
to put new money in are those that already have a financial stake; this is the
action of any reasonable lender under the circumstances at bar."11

Submicron: Third Circuit Court of Appeals Decision 
Recharacterization. The Third Circuit Court of Appeals reviewed the
district court ruling and affirmed the district court's determination that the
infusion of funds in 1999 should not be recharacterized as an equity investment.12
The appeals court spent a great deal of time in its opinion explaining recharacterization
and differentiating it from equitable subordination. Further, the appeals court
explicitly stated that there can be no "Kabuki"-like outcome based
on the application of some "mechanistic scorecard" of factors.13 While
the opinion of the appeals court provides a summary of the factors used by other
courts to aid in the evaluation of whether an obligation should be recharacterized
as equity, the appeals court was clear that the outcome is overwhelmingly driven
by the facts in each case. "Which course a court discerns is typically
a common-sense conclusion that the party infusing funds does so as a banker
(the party expects to be repaid with interest no matter what the borrower's
fortunes; therefore, the funds are debt) or as an investor (the funds infused
are repaid based on the borrower's fortunes; hence, they are equity). Form is
no doubt a factor, but in the end it is no more than an indicator of what the
parties actually intended and acted on."14
With the appeals court's emphasis on the factually dependent nature of recharacterization
decisions, it predictably determined that the district court's findings were
findings of fact and could not be overturned unless clearly erroneous.15
While the appeals court noted that there was no direct precedent on whether
a recharacterization conclusion was a finding of fact or law, it found guidance
from cases that were decided in the context of recharacterizing obligations
for tax purposes. The appeals court's use of tax recharacterization cases by
analogy was a logical leap and identical in analysis to the use of the Roth
Steel factors, which were employed by the AutoStyle Plastics court
in the early recharacterization cases.16 Ultimately, the appeals court reviewed
the findings of the district court and determined that its findings were not
clearly erroneous and could not be overturned.

Credit Bidding. The appeals court also affirmed a finding by the district
court that the new buyer entity could credit-bid the face value of its claim
(which had been assigned to it by the lenders as part of a pre-negotiated plan)
and not only the economic value. The appeals court noted that it was well-settled
under §363(k) that creditors can bid the full face value of their secured
claims.17 An argument had been raised that because the claimant was not partially
undersecured but fully undersecured (because the collateral was found to have
no economic value), the established law under §363(k) did not apply. The
appeals court found that nothing about the logic of allowing credit bids up
to the full face value of the collateral changes if the collateral has no actual
value.18 The appeals court concluded that the logical conclusion must be that
a full credit bid must be allowed because §363 was designed to avoid the
complexities and inefficiencies of valuing collateral altogether by substituting
the theoretically preferable mechanism of a free-market sale to set the price.19
Further, the appeals court could find nothing in the language of §363(k)
that limited a lender's ability to credit-bid its claim to the economic value
of the claim.
Conclusion
The Submicron decision by the appeals court reiterates that no one factor
is determinative in assessing recharacterization claims, and that all the facts
must be viewed in light of the circumstances surrounding each case with no one
factor given controlling or decisive weight. Further, the appeals court decision
in Submicron provides the first precedent for the appropriate standard
to be applied on appeal for recharacterization decisions. While many recharacterization
disputes are likely to be settled by the parties because of the time and expense
involved in litigating such a factually intense cause of action, those cases
that are not settled generally involve large sums of money and provide the incentive
to appeal the ruling of a lower court. Perhaps the Third Circuit's determination
that recharacterization cases are not likely to be overturned on appeal, unless
the findings of the lower court were clearly erroneous, will provide some greater
finality to recharacterization decisions as well as a disincentive to pursue
an appeal.

Finally, the court's discussion of credit-bidding is thought-provoking and
sure to create further controversies concerning the applicability of §506
to §363 sales as well as the strategic use of credit-bidding in §363
sales in the future. Given the discussion of the purposes of §506 and §363,
the appeals court decision can arguably be cited to support any argument to
be made that §506 does not apply to asset sales under §363. Moreover,
perhaps the committee pursued the wrong objections in attacking the sale. Perhaps
the pre-packaged plan and the assignment of claims by the lenders with the full
intent to allow the credit-bidding of its claims amounted to a sub rosa plan.
Perhaps an argument could have been made that the "arrangement" between
the lenders and the new buyer entity concerning the credit-bidding of its secured
claims chilled the bidding process in some way or amounted to collusion in the
sale process. While the focus was on the amount of the credit bid allowed by
the assignee of the lenders' claims, it seems the focus should have been on
the behind-the-scenes dealings between the parties that placed the buyer in
the position to credit-bid the claims in the first place. While it can be argued
that the unsecured creditors would not have received anything in a liquidation
anyway, it appears they were the ones that were outwitted and outplayed in this
case.
<blockquote> </blockquote>

<hr>
<h3>Footnotes</h3>

1 The author would like to thank Jonathan P. Friedland of Kirkland & Ellis
in Chicago for his insight, comments and collaboration on this article. Further,
the author would like to thank her colleague J. Michael Booe for his continued
role as a sounding board and for his input and ideas. 
2 See, e.g., In re AutoStyle Plastics Inc., 269 F.3d 726
(6th Cir. 2001).

3 Brighton, Jo Ann J., "Is It a Capital Contribution or a Loan?,"
ABI Journal, Vol. XXI, No. 5, June 2002, p. 1; Brighton, Jo Ann J., "Is
It a Capital Contribution or a Loan? Update: Recharacterization—Practical
Pointers in an Evolving Arena," ABI Journal, Vol. XXII, No. 10,
December/January 2004, p. 18; Sprayregen, James H.M., Friedland, Jonathan P.,
and Mayer, James R., "Recharacterization from Debt to Equity: Lenders Beware,"
ABI Journal, Vol. XXI, No. 9, November 2003; Sprayregen, James H.M.,
Friedland, Jonathan P., Brighton, Jo Ann J., and Bianca, Salvatore F., "Recharacterization
of Debt to Equity: An Overview, Update and Practical Guide Using an Evolving
Doctrine," 2004 Annual Survey of Bankruptcy Law, Thomson West. 
4 In re Submicron Systems Corp., 291 B.R. 314 (D. Del. 2003). 
5 Id. at 329.

6 Id. at 324-25.
 7 Id. at 326. 
8 Id. 
9 Id. at 325-26.

10 Id. at 325; In re Octagon Roofing, 157 B.R. 852, 858 (N.D.
Ill. 1993). 
11 Id. at 324-25. 
12 432 F.3d 438 (3rd Cir. 2006). 
13 432 F.3d at 456. 
14 Id.

15 Id. at 457. 
16 The Roth Steel factors were formulated in the context of a tax court
case. Roth Steel Tube Co. v. Commissioner of Internal Revenue Service,
800 F.2d 625 (6th Cir. 1986). The AutoStyle Plastics court determined
that the Roth Steel factors provided a general framework for assessing
recharacterization of tax claims and that it was also appropriate in the bankruptcy
context in determining whether to recharacterize debt to equity. 269 F.3d at
750.

17 Id. at 459-60. 
18 Id. 
19 Id.

Journal Authors

Jo Ann J. Brighton

Journal Date

Saturday, April 1, 2006 - 12:00

Bankruptcy Rule

2006

none