Is It a Capital Contribution or a Loan Update Recent Cases Discussing Recharacterization of Debt to Equity

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May 2003

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Since the writing of
"Is It a Capital Contribution or a Loan? A Practical Guide to Analyzing
Recharacterization Claims (or, When is Equitable Subordination the Appropriate
Analysis?)," published in the June 2002 issue of the ABI Journal, several courts have issued opinions relative to the
topic. The purpose of this article is to provide an update with respect to the
recent decisions that have been issued by the courts in this area.

<h3>In re Atlanticrancher Inc.—U.S. Bankruptcy Court for the District of Massachusetts</h3>

In July 2002, the U.S. Bankruptcy Court for the District
of Massachusetts ruled on an adversary proceeding brought by a chapter 7
trustee to recharacterize a creditor's claims as equity, or in the
alternative, for equitable subordination of those claims. The court was
persuaded that the advance made to the undercapitalized debtor, which was
unable to secure financing from another source, was an equity investment
despite being cast as a loan transaction because, among other things, the terms
and conditions of the "loan" gave the creditor who made the advance
control of the operation of the debtor.<a href="#2" name="2a">2</a> The length of the opinion of the court
(26 pages) and the court's discussion of the extensive testimony
highlight the incredible factually dependent nature of cases concerning claims
for recharacterization of debt to equity. Some other facts that the court also
found persuasive were the sophistication of the lender and the integrated set
of loan documents, which essentially compelled the debtor to treat the lender
as if he were a substantial owner of the company rather than simply a lender.<a href="#3" name="3a">3</a>
The court determined that evidence supported that the lender was also extremely
involved in the daily operations of the debtor. Further, in the court's
view, "undercapitalization was by far the single most important cause of
the debtor's financial failure."<a href="#4" name="4a">4</a>

Interestingly,
in the Atlanticrancher case, the note
and related agreements were properly documented with maturity dates and
interest rates used for working capital, and treated as debt on the
debtor's books. However, despite the proper documentation, the lender
never made any effort to collect on the promissory note or foreclose on its
collateral. In the court's view, the lender knew that any attempt to
exercise its rights as a secured creditor would have put the debtor out of
business, and thus, the lender did not treat the convertible promissory note
and the rights contained therein as a loan, but rather treated it as an
investment.<a href="#5" name="5a">5</a> In quoting Kids Creek Partners, the court stated that the "ultimate issue is
whether the transaction had the substance and character of an equity
contribution or loan."<a href="#6" name="6a">6</a> Finally, the court held that if a claim is
determined to be a capital contribution rather than a debt, equitable
subordination has no relevance and declined to conduct an analysis or make a
determination on the request to equitably subordinate the "loan."<a href="#7" name="7a">7</a>

<h3>In re Phase-I Molecular Toxicology—U.S. Bankruptcy Court for the District of New Mexico</h3>

In
November 2002, the U.S. Bankruptcy Court for the District of New Mexico
concluded that the transaction before it was a loan and not an equity
contribution.<a href="#8" name="8a">8</a> In Phase-I, the creditors
filed a complaint for equitable subordination of certain shareholders'
secured claims or recharacterization of the loans as capital contributions.
Each of two shareholders extended a $150,000 loan to the debtor, and each
obtained a security interest in all or substantially all of the debtor's
assets. The security interest was subsequently properly perfected. Prior to the
granting of the loans, the two shareholders and other entities had already
invested $10 million as stockholders of the debtor. When the request for the
loan was made, the debtor anticipated selling assets of a subsidiary and other
assets that would generate significant cash sometime in the fall. The court, in
determining that the transaction was a loan and not a contribution to capital,
was persuaded by (1) the title given to the instruments, specifically, "Senior
Secured Demand Bridge Note;" (2) the fact that the security agreements
were entered into at or near the time of the advances; (3) the fact that
significant assets were pledged for security of the notes; (4) the fact that
although the notes were payable on demand, and contained no fixed maturity
date, they did include an interest charge; and (5) the fact that the intended
repayment of the loan was anticipated to be received from the sale of assets
and was not completely dependent on the future success of the debtor's
business.

In
quoting Auto Style Plastics, the court
stated, "If the expectation of repayment depends solely on the success of
the borrower's business, the transaction has the appearance of a capital
contribution."<a href="#9" name="9a">9</a> The court also found it persuasive that the expenses for
the enforcement of the loan were included in the promissory notes and that
there was no evidence that the other existing shareholders made contributions
to the loan proportionate to their respective stock ownership. While the court
engaged in some discussion concerning the under-capitalization of the company
and the company's inability to obtain a similar loan from outside
sources, it did note that, for the purposes of recharacterizing an advance as a
capital contribution rather than a loan, the undercapitalization factor is the
initial capitalization, and not the capitalization at the time of the
transfer.<a href="#10" name="10a">10</a> The court then found that the initial capitalization of the debtor
was significant, and stated that whether the debtor was undercapitalized at the
time of the transfer is somewhat relevant, but it is not determinative.<a href="#11" name="11a">11</a>

Further, the court noted that while the fact that the debtor could not obtain a
loan from any other disinterested lender weighs in favor of treating the advance
as a capital contribution, that by itself does not "tip the
scale."<a href="#12" name="12a">12</a> The court finished its discussion in reviewing that there was
no evidence that the lenders were allowed to participate in the management of
the debtor flowing from the transaction, or that the advanced funds were used
to acquire capital assets. The court concluded that the transaction therefore
constituted a loan.<a href="#13" name="13a">13</a>

<h3>In re Internet Navigator Inc.—U.S. Bankruptcy Court for the Northern District of Iowa</h3>

In January 2003, the U.S. Bankruptcy Court for the Northern District of Iowa
refused to recharacterize a loan that a corporate debtor's principals had
provided to the debtor prior to the commencement of the chapter 11 case as a
contribution to capital.<a href="#14" name="14a">14</a> In Internet Navigator, the court reiterated that the factors in cases such as Autostyle
Plastics and In re Cold Harbor
Associates should be considered in light of
the circumstances surrounding each case with no one factor given controlling or
decisive weight.<a href="#15" name="15a">15</a> The court stated that "the ultimate issue then is
whether the transaction had the substance and character of an equity
contribution or of a loan."<a href="#16" name="16a">16</a> The court was persuaded that the intent of
the debtor and the claimants was that they be paid wages and repaid for
advances and expenses. The court looked to the minutes of the board, which
recognized the obligation as debt and which indicated an intent to issue
"warrants" that were ultimately avoided. The court was not troubled
that all the formalities were not followed in documenting the debts as it was a
small, closely held corporation. However, the court did note that the corporate
financial reports showed that the company categorized the debt as liabilities,
as opposed to equity, and that at least since the beginning of 1998, the minutes
of the meetings of the board showed the board had discussed documenting the
debt prior to that time.<a href="#17" name="17a">17</a> The court took note of the fact that the amount due
each claimant did not directly correspond with each party's interest in
the corporation, and that although the claimants were insiders, shareholders
and principals of the debtors, their claims were more like debt than capital
contribution.<a href="#18" name="18a">18</a>

<h3>In re Submicron Systems Corp.—U.S. Bankruptcy Court for the District of Delaware</h3>

In
March 2003, the U.S. Bankruptcy Court for the District of Delaware issued an
unpublished opinion in which it denied the request to recharacterize various
pre-petition funding as equitable contributions.<a href="#19" name="19a">19</a> In Submicron, the court stated that the trial testimony was
uncontradicted and that if the defendants had not made the 1999 funding to the
debtor, the company would have been forced to close down and liquidate, leaving
nothing for the unsecured creditors.<a href="#20" name="20a">20</a> In a lengthy (35-page) opinion, the
court concluded that the 1999 fundings were properly characterized as debt, and
that they would also be characterized as secured debt. The 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) by the
additional loans.<a href="#21" name="21a">21</a> The 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.<a href="#22" name="22a">22</a>

The 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 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 court's opinion, to
recharacterize the 1999 fundings as equity.<a href="#23" name="23a">23</a> The court also took note that (1)
the plaintiff had not proven that the defendants or their designees controlled
or dominated the debtor company in any way, and (2) while undercapitalization
lends itself for a court to be more skeptical of purported loans,
undercapitalization of a loan is insufficient to justify the subordination of
insider claims. The court quoted In re Octagon Roofing: "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.'"<a href="#24" name="24a">24</a>
The court also stated that "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."<a href="#25" name="25a">25</a>

<h3>In re Abtox (Ross v. H&Q Life Science Investors, H&Q Healthcare Investors)—U.S. Bankruptcy Court for the Northern District of Illinois</h3>

In
a very recent decision, the U.S. Bankruptcy Court for the Northern District of
Illinois determined that a cause of action for recharacterization should not be
recognized under the Code based on the reasoning of an oral opinion issued by
Judge Barlant in the same district.<a href="#26" name="26a">26</a> Judge Doyle incorporated Judge
Barlant's views that "there is nothing anywhere in the Bankruptcy
Code that authorizes converting a claim into an equity interest for any reason
whatsoever."<a href="#27" name="27a">27</a> Judge Barlant recognized that although §510(c) of the
Code recognizes the principle of equitable subordination, in that circuit there
must be a showing of inequitable conduct that he found was not required in the
so-called claims for recharacterization and, therefore, distinguished the
ability of the court to entertain such claims. Judge Barlant also noted that
§105 can never be read to authorize a result that directly violates
another section of the Code such as §726. Finally, Judge Barlant concluded
that although he was aware that there was authority for equitable
recharacterization of a claim as equity, including in his district and a recent
appeals court decision, he did not believe there was any such remedy in
bankruptcy. Judge Doyle, by incorporation of Judge Barlant's oral opinion,
is resurrecting the debate that arose early in these cases<a href="#28" name="28a">28</a> and seems to be
squarely settled by Autostyle Plastics<a href="#29" name="29a">29</a>
and its progeny. It should be interesting to see if these types of arguments
will begin to be raised once again.

<h3>Conclusion</h3>

Since
the writing of the original article in June 2002, some interesting case law has
developed. Although recharacterization of claims as equity is the "tool
de jour" in the creditors' committee toolbox of late, the
complexity of the opinions and the intense focus on the facts in each case make
it clear that these cases will not be viewed lightly by courts, and the relief
requested will not be granted easily. All of the cases originally reported in
the article, as well as the cases that have been decided since then, are
consistent in their emphasis that no one factor is decisive 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. It is interesting to note
that the Submicron case highlights the
reality that with respect to the test concerning undercapitalization, or the
debtor's inability to obtain similar financing elsewhere, only those with
the financial stake in the company would be willing to extend financing in times
of dire financial distress, and accordingly, undue weight should not be given
to those factors.

It
is clear that any recharacterization claim is incredibly factually dependent
and that discovery and testimony can be extensive and expensive. Accordingly, given
the recent developments in the case law, a claim for recharacterization as a
contribution to capital should not be brought without investigation and
sufficient facts to support the allegation by a preponderance of the evidence.
Finally, although not reported in decisions yet, I can report via first-hand
knowledge and anecdotally that there are many adversaries being filed, or being
threatened to be filed, using recharacterization even more creatively.
Recharacterization claims have sprung up with respect to the provision of
guarantees, letters of credit and in the context of securitization.<a href="#30" name="30a">30</a>
Accordingly, it will be interesting to watch this area of case law develop and
further updates are sure to follow.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Ms.
Brighton is a partner in Nixon Peabody LLP's Manchester, N.H., office in
the Bankruptcy Group, where she practices primarily in the area of bankruptcy,
workouts and secured lending. She is a contributing editor to the ABI
Journal and certified in business
bankruptcy by the American Board of Certification. <a href="#1a">Return to article</a>

<a name="2">2</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Atlanticrancher Inc., 279 B.R. 411 (Bankr.
D. Mass. 2002)</a>. <a href="#2a">Return to article</a>

<a name="3">3</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
B.R. at 436</a>. <a href="#3a">Return to article</a>

<a name="4">4</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
B.R. at 437</a>. <a href="#4a">Return to article</a>

<a name="5">5</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
B.R. at 437</a>. <a href="#5a">Return to article</a>

<a name="6">6</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
B.R. at 437</a>, citing <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
Creek Partners, 212 B.R. 898, 932 (Bankr. N.D.
Ill. 1997)</a>. <a href="#6a">Return to article</a>

<a name="7">7</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
B.R. at 438</a> citing <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
Inc. v. Ingallo, 121 B.R. 626, 630 (Bankr. N.D.
Fla. 1990)</a>. <a href="#7a">Return to article</a>

<a name="8">8</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Phase-I Molecular Toxicology, 287 B.R. 571
(D. N.M. 2002)</a>. <a href="#8a">Return to article</a>

<a name="9">9</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; 287 B.R. at 577</a>, quoting <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
Style Plastics, 269 F.3d at 751</a>. <a href="#9a">Return to article</a>

<a name="10">10</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; 287 B.R. at 578</a> (citations omitted,
emphasis added). <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=2…
B.R. at 578</a>, quoting <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
Enterp. Inc., 158 B.R. 555 (D. R.I. 1993)</a>
(rejecting argument that undercapitalization justifies recharacterization of
debt in favor of using multi-factor approach). <a href="#11a">Return to article</a>

<a name="12">12</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; 287 B.R. at 578</a>. <a href="#12a">Return to article</a>

<a name="13">13</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; 287 B.R. at 578</a>. <a href="#13a">Return to article</a>

<a name="14">14</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Internet Navigator Inc., 289 B.R. 133
(Bankr. N.D. Iowa 2003)</a>. <a href="#14a">Return to article</a>

<a name="15">15</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
B.R. at 137</a>. <a href="#15a">Return to article</a>

<a name="16">16</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; (other citations omitted). <a href="#16a">Return to article</a>

<a name="17">17</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
B.R. at 137</a>. <a href="#17a">Return to article</a>

<a name="18">18</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; <a href="#18a">Return to article</a>

<a name="19">19</a> In
re Submicron Systems Corp., Adversary No.
A-00-484, unpublished opinion (Bankr. D. Del. March 10, 2003). <a href="#19a">Return to article</a>

<a name="20">20</a> Opinion
at ¶58, page 34. <a href="#20a">Return to article</a>

<a name="21">21</a> Opinion
at ¶22, page 23. <a href="#21a">Return to article</a>

<a name="22">22</a> Opinion
at ¶¶32-33, page 23. <a href="#22a">Return to article</a>

<a name="23">23</a> Opinion
at ¶32, page 26. <a href="#23a">Return to article</a>

<a name="24">24</a> Opinion
at ¶¶28-30, pages 24-25. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Octagon Roofing, 157 B.R. 852, 858 (N.D.
Ill. 1993)</a>. <a href="#24a">Return to article</a>

<a name="25">25</a> Opinion
at ¶22, page 23. <a href="#25a">Return to article</a>

<a name="26">26</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=0…
re Abtox Inc. (Ross v. H & Q Life Science Investors, H&Q Healthcare
Investors), Adv. No. 00 A 00661 (Bankr. N.D.
Ill. March 5, 2003)</a>, citing In re Outboard Marine Corp. Oral Opinion (Bankr. N.D. Ill. Jan. 14, 2002). <a href="#26a">Return to article</a>

<a name="27">27</a> Outboard
Motors at 34. <a href="#27a">Return to article</a>

<a name="28">28</a> See,
e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=6…
Express Inc., 69 B.R. 112, 115 (9th Cir. B.A.P.
1986)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8…
re Pine Tree Partners Ltd., 87 B.R. 481, 491
(Bankr. N.D. Ohio 1988)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re. Zenith Elect. Corp., 241 B.R. 92, 107
(Bankr. D. Del. 1999), aff'd., Nordhoff Investments Inc. v. Zenith
Elect., 258 F.3d 180 (3d Cir. 2001)</a> (requiring inequitable conduct for recharacterization; however, this case was
decided before Autostyle and was also
viewing recharacterization in the context of equitable subordination). <a href="#28a">Return to article</a>

<a name="29">29</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
F.3d 726 (6th Cir. 2001)</a>. <a href="#29a">Return to article</a>

<a name="30">30</a> For
example, in the Williams Communications
bankruptcy case in the Southern District of New York, the Official Committee of
Unsecured Creditors reported that they are investigating whether the former
parents' debts should be subordinated or recharacterized as equity
because of the nature of the transactions and the actions of the company. See "From Debt to Equity," The
Daily Deal, July 31, 2002. <a href="#30a">Return to article</a>

Journal Authors

Jo Ann J. Brighton

Journal Date

Thursday, May 1, 2003 - 12:00

Bankruptcy Rule

2003