Capital Contribution or a Loan A Practical Guide to Analyzing Recharacterization Claims (or When Is Equitable Subordination the Appropriate Analysis)

Journal Issue

Jun 2002

Column Name

Journal HTML Content

It is well established that the bankruptcy court, as a court of equity, may "look
through form to substance" in determining the true nature of a transaction relating
to the rights of parties against a bankruptcy estate. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Omne Partners II, 67
B.R. 793 (Bankr. D. N.H. 1986)</a>.

The Bankruptcy Code does not expressly provide for the re-characterization of debt
to equity. However, bankruptcy courts can consider whether to recharacterize a claim
of debt as equity. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re AutoStyle Plastics Inc., 269 F.3d 726 (6th
Cir. 2001)</a>. Bankruptcy courts that have applied a recharacterization analysis have
stated that their power to do so stems from the authority vested in the bankruptcy
courts to use their equitable powers to test the validity of debt. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
Plastics, 269 F.3d at 747.2</a> The source of the court's general equitable
powers is in §105 of the Code, which states that bankruptcy judges have authority
to "issue any order, process or judgment that is necessary or appropriate to carry
out the provisions of the Code." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §105(a)</a>.<a href="#3" name="3a">3</a> There is a line
of cases where courts have determined that bankruptcy courts do not have any authority
to recharacterize a claim based principally on the fact that there is no specific
provision of the Code that allows courts to recharacterize claims. See, e.g.,

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Express Inc., 69 B.R. 112, 115 (9th Cir. B.A.P.
1986)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Pine Tree Partners Ltd., 87 B.R. 481, 491 (Bankr.
N.D. Ohio 1988)</a> (following In re Pacific Express). However, almost all
other courts have disagreed with this line of cases. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Herby's Foods, 2
F.3d at 133</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Midtown Product Terminal Inc., 599 F.2d 389,
393 (10th Cir. 1979)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Hyperion Enterprises, 158 B.R. at
561-62</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Inc. v. Ingalls, 121 B.R. 626, 630 (Bankr.
N.D. Fla. 1990)</a>.

The effect of the bankruptcy court's recharacterization of a claim from debt to
equity may be similar to the court's subordination of a claim through equitable
subordination in that in both cases, the claim is subordinated below that of other
creditors. However, there are important differences between a court's analysis of
recharacterization and equitable subordination issues, and recharacterization is actually
a distinct cause of action.<a href="#4" name="4a">4</a> Not only do recharacterization and equitable
subordination serve different functions, but the extent to which a claim is subordinated
under each process may be different.<a href="#5" name="5a">5</a>

Recharacterization cases turn on whether a debt actually exists, not on whether the
claim should be equitably subordinated. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Plastics, 269 F.3d at 748</a>.<a href="#6" name="6a">6</a>
In a recharacterization analysis, if the court determines that the advance of money
is equity and not debt, the claim is recharacterized, and the effect is subordination
of the claim as a proprietary interest because the corporation repays capital
contributions only after satisfying all other obligations of the corporation. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
Plastics, 269 F.3d at 748</a>.<a href="#7" name="7a">7</a> In an equitable subordination analysis, the
court is reviewing whether a legitimate creditor engaged in inequitable conduct, in
which case the remedy is subordination of the creditors' claim to that of another
creditor only to the extent necessary to offset injury or damage suffered by the
creditor and his favored equitable doctrine, may be affected. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Plastics,

269 F.3d at 747</a>.<a href="#8" name="8a">8</a>

If a claim is recharacterized, and therefore the advance is not a claim to begin
with and the creditor is not a legitimate one, then equitable subordination never comes
into play. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Georgetown Building Assoc., 240 B.R. 124, 137
(Bankr. D. D.C. 1999)</a>. Indeed, where shareholders have substituted debt
for adequate risk capital, their claims are appropriately recast as equity regardless
of satisfaction of the requirements of equitable subordination. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Hyperion
Enterp., 158 B.R. 555, 561 (D. R.I. 1993)</a>. Some of the
confusion between the doctrines is caused by the fact that undercapitalization is a
factor in an equitable subordination analysis and often is a factor in a
recharacterization analysis leading some courts to equitably subordinate claims that other
courts would recharacterize as equity contributions. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re AutoStyle Plastics, 269
F.3d 726 at 748</a>.<a href="#9" name="9a">9</a>

<h3>Recharacterization of Debt to Equity</h3>

Courts generally focus on several different criteria to determine if they should
characterize a claim as a loan or equity transaction. Recharacterization of loans as
contributions to capital is suggested when the contributors are not only shareholders,
but insiders or fiduciaries as well.<a href="#10" name="10a">10</a> The court's primary consideration appears to
be whether the transaction reflects the characteristics of an arm's length negotiation.
Courts are more likely to characterize a transaction made at arm's length as a loan
and will use a variety of factors to determine whether claimant made the transaction
at arm's length.<a href="#11" name="11a">11</a>

Factors for courts to consider generally fall into three critical groups: (1)
the formality of the alleged loan agreement, (2) the financial situation of the
company when the creditor made the purported loan and (3) the relationship between
the creditor and the debtor.<a href="#12" name="12a">12</a> Generally, courts measure the formality of the
alleged loan by how specific and complete the parties made the agreement.<a href="#13" name="13a">13</a> One court
has stated that the ultimate issue is whether the transaction had the substance and
character of an equity transaction or of a loan.<a href="#14" name="14a">14</a> Courts generally weigh the
relevant factors as a group so that no single factor will result in recharacterization
of an advance. The many different factors employed to determine if courts should treat
an alleged loan as a capital contribution make it difficult for both lenders and
corporate borrowers to predict how the court will view individual transactions.<a href="#15" name="15a">15</a>

<h3>The Roth Steel Factors</h3>

In evaluating the general categories stated above, bankruptcy courts generally look
to 11 factors, commonly referred to as the Roth Steel Factors, when analyzing
whether debt should be recharacterized as equity.<a href="#16" name="16a">16</a> No one factor is controlling or
decisive.<a href="#17" name="17a">17</a> The factors must be construed within the particular circumstances of each
case.<a href="#18" name="18a">18</a> The factors are the:

<ol>
<li>names given to the instruments, if any, evidencing the indebtedness;

</li><li>presence or absence of a fixed maturity date and schedule of payments;

</li><li>presence or absence of a fixed rate of interest and interest payments;

</li><li>source of repayment;

</li><li>adequacy or inadequacy of capitalization;

</li><li>identity of interests between the creditor and stockholders;

</li><li>security, if any, for the advances;

</li><li>corporation's ability to obtain financing from outside lending institutions;

</li><li>extent to which the advances were subordinated to the claims of outside
creditors;

</li><li>extent to which the advances were used to acquire capital assets; and

</li><li>presence or absence of a sinking fund to provide repayment.<a href="#19" name="19a">19</a>
</li></ol>

1. The Names Given to the Instruments. The absence of notes or other instruments
of indebtedness is a strong indication that the advances were capital contributions and
not loans. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Plastics, 269 F.3d at 750</a>.<a href="#20" name="20a">20</a> Additionally, courts
will examine the names given to the documents and whether or not the labels accurately
reflect the nature of the document and the substance of the transaction. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;

2. The Presence or Absence of a Fixed Maturity Date and Schedule of Payments.
The absence of a fixed maturity date and a fixed obligation to repay is an indication
that the advances were capital contributions and not loans. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Plastics, 269
F.3d at 750</a>. The bankruptcy court in AutoStyle Plastics noted that the absence
of a set schedule of repayment of principal weighs in favor of equity, but is not
dispositive. However, the district court noted that the participation agreements used
demand notes as well as a fixed interest rate and regular interest payments, which
the district court believed was indicative of a loan. Moreover, the district court
stated that a rigid application of a rule that the lack of a fixed maturity date and
fixed payment schedule is indicative of equity "would create a per se rule that use
of a demand note by an insider would always be indicative of an equity contribution
rather than a loan."<a href="#21" name="21a">21</a> The appellate court agreed with the district court, and
therefore concluded that the use of the demand note with a fixed rate of interest and
interest payment is more indicative of debt than equity. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Plastics, 269
F.3d at 750</a>.

3. The Presence or Absence of a Fixed Rate of Interest and Interest Payments.
The absence of a fixed rate of interest and interest payments is a strong indication
that the advance is for capital contributions rather than loans. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Plastics,
269 F.3d at 750</a>.<a href="#22" name="22a">22</a> In the AutoStyle Plastics case, the defendants provided
for interest, but subsequently agreed to defer interest payments. At best, the court
determined that an argument can be made that this factor cuts both ways since the
deferral of interest payments indicates the possibility that during the course of the
transaction the lender never expected to get repaid and converted it back to equity.
However, the court stated that it does not change the fact that initially at least,
there was a fixed rate of interest and interest payments indicating that the transaction
was originally intended to be debt and not equity.<a href="#23" name="23a">23</a> Moreover, the deferral of
interest payments does not by itself mean that the parties converted a debt transaction
to equity, since the defendants still expected to be repaid. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Plastics,

269 F.3d at 750</a>.

4. The Source of Repayment. 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="#24" name="24a">24</a> However, if various measures are taken to provide security for
performance of the obligations, the repayment becomes less dependent on the success of
the venture. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…. Lighting Co. v. Bokum Resources Corp., 40 B.R. 274,
297 (Bankr. D. N.M. 1983)</a>.<a href="#25" name="25a">25</a>

5. The Adequacy or Inadequacy of Capitalization. Thin or inadequate
capitalization is strong evidence that the advances are capital contributions rather than
loans.<a href="#26" name="26a">26</a> The undercapitalization analysis is particularly relevant when "a corporation
is started by the shareholders with a minimal amount of capital who then make a large
loan of money to the newly formed corporation. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Cold Harbor, 204 B.R.
904, 917 (Bankr. E.D. Va. 1997)</a>. The district court in AutoStyle
Plastics concluded that undercapitalization was adequate because the company had operated
for more than 20 years before the loans at issue were made. However, the appellate
court agreed that capitalization is not only assessed at initial capitalization. The
appellate court determined, as did the court in Roth Steel, that a court must look
at the capitalization at the time the transfer was made. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Plastics, 269
F.3d at 751</a>.<a href="#27" name="27a">27</a> Certain courts have determined that when a debt is incurred
when the debtor is undercapitalized and the prospect for repayment is poor, such
advances are a capital contribution and not a loan. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Transystems Inc., 569
F.2d 1364, 1369-71 (5th Cir. 1978)</a>. However, the inquiry
concerning undercapitalization is highly factual and may vary substantially with the
industry, company, size of the debt, accounting methods employed and like factors.

See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…. v. Colorado Invesco Inc., 902 F. Supp. 1339 (D. Colo.
1995)</a>. Additionally, some other conduct must also be found for undercapitalization
to constitute a basis for recharacterizing debt to equity lest insiders and others shy
away from lending to a corporation in financial distress or a venture at higher than
usual risk. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Creek, 212 B.R. at 931</a>.<a href="#28" name="28a">28</a>

6. The Identity of Interest Between the Creditor and the Stockholder. If
stockholders make advances in proportion to their respective stock ownership, an equity
contribution is indicated. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Plastics, 269 F.3d at 751</a>. On the other
hand, a sharply disproportionate ratio between a stockholder's percentage interest in
stock and in debt is indicative of a bona fide debt. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; "Where there is an exact
correlation between the ownership interest in the equity holders and their proportionate
share of the alleged loan...this evidence standing alone is almost...overwhelming."

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Harbor,</a><a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 204 B.R. at 919</a>.

7. The Security for the Advances. The absence of security for an advance is a
strong indication that the advance is for capital contributions rather than loans.
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Plastics, 269 F.3d at 751</a>.<a href="#29" name="29a">29</a> The fact that a lender incurred the
cost and invested the time to collateralize and perfect the advance makes the advance
look more like a loan than equity.

8. The Corporation's Ability to Obtain Outside Financing. When there is no
evidence of the availability of other outside financing, the fact that no reasonable
creditor would have acted in the same manner is strong evidence that advances were
capital contributions rather than loans. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Plastics, 269 F.3d at 751</a>.
However, a per se application of this factor alone would prevent any shareholder or
insider from ever loaning money to a company experiencing distress. Accordingly, this
factor must be viewed broadly and in the factual context in which it is being
applied. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Roofing, 157 B.R. at 858</a>.

9. The Extent to Which Advances Were Subordinated to Claims of Outside
Creditors. Subordination of advances to claims of all other creditors indicates that
the loans were capital contributions and not loans. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Plastics, 269 F.3d
at 751</a>.<a href="#30" name="30a">30</a>

10. The Extent to Which Advances Were Used 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 bona fide indebtedness. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Plastics,
269 F.3d at 752</a>.<a href="#31" name="31a">31</a> It should be noted, however, that at least one court
found it persuasive that a debtor needed working capital—specifically, "necessary
turnaround cash" to provide for payroll and other current expenses—and that the company
was on the verge of closing down or filing a chapter 11 petition.<a href="#32" name="32a">32</a> That court
determined that such a dire need of cash was persuasive in finding that the obligation
was a contribution to capital. However, the Transystems court clearly stated: "This
court does not hold that the above circumstances preclude the possibility that [the]
advance was a loan. However, taken in conjunction with the fact that there were no
indicia of a loan presented [to the court], beyond the labels affixed to the documents
themselves...[the shareholder's] intent was to provide a contribution to capital."

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 569 F.2d at 1369</a>.

11. The Presence or Absence of a Sinking Fund to Provide Repayments. The
failure to establish a sinking fund for repayment is evidence that the advances were
capital contributions rather than loans. The AutoStyle Plastics court noted that if the
loans are secured by liens, it obviates any need for a sinking fund. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.3d
at 752</a>.<a href="#33" name="33a">33</a>

<h3>Other Factors to Be Considered</h3>

Additionally, the intent of the parties will probably be examined by the court.
Some courts have expressly stated that the "intent of the advancing party must be
examined." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Inc., 569 F.2d at 1366</a>.<a href="#34" name="34a">34</a> See, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
Partners, 67 B.R. at 794</a> (the court found support for the position that the
intent of the parties must be closely examined when analyzing whether sale leaseback
transactions should be recharacterized). Further, the court must investigate the
manner in which the circumstances, under which the advance was consummated in order
to determine whether the bona fides of indebtedness, had been established.
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 569 F.2d at 1366</a>.

There are also a couple of additional factors that have been looked at by bankruptcy
courts in analyzing whether debt should be recharacterized as equity, including the degree
of shareholder control and how the obligation was treated in the business records. See
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 158 B.R. at 561</a>.<a href="#35" name="35a">35</a>

Finally, in a bankruptcy case, each claimant has the ultimate burden to prove the
validity of its claims. Practically, the noteholders have the burden of establishing
that the bridge loan was valid and was, in fact, a loan.<a href="#36" name="36a">36</a>

<h3>Equitable Subordination</h3>

A second stage of the analysis must also be included concerning the standards for
equitable subordination of the noteholders' claims. Should the bridge loan not satisfy
the requirements for recharacterization of debt to equity, all or part of the bridge
loan may be subject to a claim for equitable subordination to the claims of unsecured
creditors (or possibly the claims of shareholders who did not participate in the bridge
loan). Section 510(c) of the Code grants a bankruptcy judge the power to
equitably subordinate the claim of a creditor whose conduct has caused injury to other
parties or has afforded a creditor an unfair advantage over other creditors.<a href="#37" name="37a">37</a> While
§510(c) does not define the conduct that triggers equitable subordination, courts
have developed established common law in this area. Equitable subordination is
remedial, not penal, and should be used sparingly. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… the Matter of U.S.
Abatement Corp., 39 F.3d 556, 560 (5th Cir. 1994)</a>. The doctrine
of equitable subordination should not be used punitively to take away anything to which
a creditor is justly entitled as a result of the liquidation of the debtor's assets,
and bestow it upon others who have no right to it. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Cumberland Farms Inc.,
81 B.R. 678, 681 (Bankr. D. Mass. 1995)</a>. It should also be
noted that an equitable subordination complaint, even if successful, may not result in
total subordination. The claim will only be subordinated to the extent necessary to
offset the unfair advantage or harm which the creditors suffered on account of the
inequitable conduct.<a href="#38" name="38a">38</a> However, if conduct is so egregious that it affects the
validity of the claim under applicable law, the debtor can ask the court to disallow
it in full as part of the claims avoidance process. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… the Matter of Mobile Steel,

563 F.2d, 692, 699 n. 10 (5th Cir. 1977)</a>.

The First Circuit has established that the following elements are necessary to
equitably subordinate a claim. The trustee/ DIP must show that:

<ol>
<li>The claimants have engaged in some type of inequitable conduct;

</li><li>The misconduct must have resulted in injury to creditors or conferred an unfair
advantage on the claimant; and

</li><li>Equitable subordination of the claim must not be inconsistent with the
provisions of the Bankruptcy Code.
</li></ol>

While the general three-prong test appears to be quite broad, courts have largely
confined equitable subordination of claims to three general paradigms: (1) when a
fiduciary of the debtor misuses his position to the disadvantage of other creditors;
(2) when a third party controls the debtor to the disadvantage of other creditors;
and (3) when a third party actually defrauds other creditors.<a href="#40" name="40a">40</a>

<h3>Insider Status and Its Effect on Equitable Subordination</h3>

Initially, it should be stated that a claim arising from the dealings between a
debtor and an insider is to be rigorously scrutinized by the courts. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 158
B.R. at 562</a>.<a href="#41" name="41a">41</a> However, the mere fact of an insider relationship is
insufficient to warrant subordination. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 158 B.R. at 562</a>. "The reason
that transactions of insiders will be closely studied is because such parties usually
have greater opportunity for such inequitable conduct, not because the relationship itself
is somehow grounds for subordination."<a href="#42" name="42a">42</a> Such claims are not automatically subordinated
because insiders are the persons most interested in restoring and reviving the debtor,
and such bona fide effort should be viewed with approval.<a href="#43" name="43a">43</a>

Section 101(31) defines the term "insider." If the debtor is a corporation,
the term insider includes "(1) an officer or director of the debtor; (2) a
person in control of the debtor; (3) a partnership in which the debtor is a
general partner; (4) a general partner of the debtor; or (5) a relative of the
general partner, director, officer or person in control of the debtor." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
U.S.C. §101(31)</a>. Mere stock ownership, with nothing more, does not constitute
an insider relationship to the debtor. A lender can also be an insider if it
generally acted as a joint venturer or prospective partner with the debtor rather than
as an arm's-length creditor. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Am Corp. v. Delta Air Lines Inc., 175
B.R. 438, 500 (S.D.N.Y. 1994)</a>.

Insider status goes only to determining the standard under which the creditor's
conduct is reviewed. Insider status alone is insufficient and cannot provide a
sufficient basis for subordination. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Astroline Communic. Co. L.P., 226
B.R. 324, 329 (Bankr. D. Conn. 1998)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Beverages Int'l.
Ltd., 50 B.R. 273, 281 (Bankr. D. Mass. 1985)</a>. Where a creditor
is a non-insider, the trustee must show that the creditor's conduct was "egregious
and severely unfair in relation to other creditors." Hyperion, 158 at B.R.
562. In the context of insiders, the standard is one of simple unfairness. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;

Furthermore, the burden of proof shifts in insider transactions. Once the trustee has
met its initial burden of going forward with factual evidence to overcome the validity
of the claimant's proof of claim, the burden shifts to the claimant/insider to
demonstrate its good faith and the fairness of its conduct. In order to shift the
burden, the trustee must provide a "substantial factual basis to support its allegation
of impropriety."<a href="#44" name="44a">44</a>

<h3>Inequitable Conduct</h3>

The initial requirement is that the claimant must have engaged in an equitable
conduct; an inequitable result is not enough on its own. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…. v. Noland,
517 U.S. 535, 539 (1996)</a>.<a href="#45" name="45a">45</a> Courts have divided the varieties of
inequitable conduct into three broad categories: (1) fraud, illegality or breach of
fiduciary duties; (2) under-capitalization; or (3) control of the debtor through
use of the debtor as the creditor's alter ego or instrumentality.<a href="#46" name="46a">46</a>

Additionally, certain courts have granted requests for equitable subordination, even
though the party whose claim is being subordinated has not engaged in any inequitable
conduct. This procedure has been described as "no fault" equitable subordination. Many
of the recent decisions have focused on the issue of tax penalties and priority to
be accorded such penalties. However, in 1996, the U.S. Supreme Court rendered
two important decisions in this area. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…. v. Noland, 517 U.S. at 535</a>,
and <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…. v. Reorganized CF&I Fabricators of Utah Inc., 518 U.S. 213
(1996)</a>. Those two decisions essentially eliminated the imposition of subordination
in the absence of inequitable conduct. The only area in which courts continue to
recognize subordination absent inequitable conduct concerns stock redemption claims. The
inequitable conduct prong is generally the most difficult to apply.<a href="#47" name="47a">47</a> The inequitable
conduct and the claim at issue do not need to be related to warrant subordination.
The inequitable conduct may arise out of any unfair act by the cre

Journal Authors

Jo Ann J. Brighton

Journal Date

Saturday, June 1, 2002 - 12:00

Bankruptcy Rule

2002