Recharacterization of Debt to Equity in Bankruptcy Proceedings: A Split in the Circuits

Courts have held that bankruptcy courts have the authority to recharacterize debt to equity if the circumstances warrant such treatment. However, circuit courts are divided as to which provision of the Bankruptcy Code provides such authority. The majority looks to the court’s equitable powers. The minority holds that the ability must be grounded in the allowance of claims pursuant to state law.

The Majority Approach: Authority to Recharacterization Pursuant to General Equitable Powers

The majority approach, adopted by the Third, Fourth, Sixth and Tenth Circuits, holds that a court’s power to grant such a remedy rests in the court’s equitable powers granted by Code § 105(a).[1] Courts adopting the majority approach utilize multi-factor balancing tests patterned on federal tax law cases.[2]

In In re AutoStyle Plastics, the Sixth Circuit articulated an 11-factor test that included (1) the names given to the instruments, if any, evidencing the indebtedness; (2) the presence or absence of a fixed maturity date and schedule of payments; (3) the presence or absence of a fixed rate of interest and interest payments; (4) the source of repayments; (5) the adequacy or inadequacy of capitalization; (6) the identity of interest between the creditor and the shareholder; (7) the security, if any, for the advances; (8) the corporation’s ability to obtain financing from outside lending institutions; (9) the extent to which the advances were subordinated to outside creditors; (10) the extent to which the advances were used to acquire capital assets; and (11) the presence or absence of a sinking fund to provide repayments.[3] While the number of factors utilized by the circuits varies, the factors considered are similar or identical.[4]

The underlying inquiry is to discern the intent of the parties at the time of the transaction[5] and ensure that “substance will not give way to form.”[6] While courts utilize the factors to guide their analysis, a “mechanistic scorecard” approach is inappropriate.[7] The factors must be considered within the particular circumstances of each case, and no one factor is dispositive.[8]

Minority Approach: Authority to Recharacterize Pursuant to Code § 502(b)

The Fifth and Ninth Circuits have rejected reliance on Code § 105(a) and instead rely on § 502(b), finding that courts may only recharacterize debt as equity where applicable state law would treat the asserted interest as equity.[9] Courts adopting the minority approach have held that “recharacterization ... is part of the bankruptcy courts’ authority to allow and disallow claims under 11 U.S.C. § 502,” which looks to “applicable” state law to determine whether a claim is allowable.[10]

In In re Lothian Oil, the Fifth Circuit applied Texas law to determine whether recharacterization of debt to equity was appropriate.[11] The Fifth Circuit noted that Texas courts have imported a multi-factor test from federal tax law to distinguish between debt and equity.[12] Accordingly, while the Fifth Circuit grounded its authority to recharacterize debt in state law, it found the state and federal approaches to be essentially the same.[13]

In In re Fitness Holdings Int’l, the Ninth Circuit followed the Fifth Circuit’s lead and determined that bankruptcy courts had the authority to recharacterize debt to equity pursuant to Code § 502(b).[14] The Ninth Circuit held that the bankruptcy courts must evaluate whether the claim would be recharacterized as equity pursuant to the applicable (California) state law.[15] Unfortunately, the Ninth Circuit failed to identify applicable California precedent.[16]

As the law of recharacterization of debt to equity is a legal concept rooted primarily in federal tax law,[17] state law on the issue is sparse.[18] Therefore, the inquiry in circuits that follow this approach is likely to first determine whether applicable state law exists. If not, one needs to decide whether the state courts would recognize the doctrine, and if so, would apply a multi-factor test similar to those developed in federal tax practice.[19]

Conclusion

Thus far, every circuit court to address the issue has concluded that bankruptcy courts can examine the substance of a transaction to characterize a claim as equity. Whether based on the court’s inherent equitable power or allowance under state law, the conclusion in a particular instance may be the same. However, the minority approach does not address how bankruptcy courts are to address even the most obvious examples of equity disguised as debt if a particular state does not recognize recharacterization. Without state precedent to follow, whether, and on what conditions, recharacterization exists in circuits that follow the minority approach remains an open question.