Digging Deep into the Tenth Circuit’s Alternate Fuels Decision

In June 2015, the Tenth Circuit Court of Appeals decided In re Alternate Fuels Inc.,[1] clarifying its position on debt-equity recharacterization in light of two Supreme Court decisions and further entrenching a circuit split on recharacterization analysis. This article provides an in-depth discussion of the case, as well as some thoughts on the implications for recharacterization analysis going forward.

Case Summary

Alternate Fuels Inc. (AFI) was a corporation that had engaged in surface coal mining operations. In 1996, after AFI filed its first bankruptcy petition and stopped all mining operations, John Warmack assumed control of AFI and formed a new company, Cimarron, to handle AFI’s remaining mining work. Cimarron completed the mining work in 1999, leaving AFI responsible for fulfilling reclamation obligations under Missouri law. At this time, William and M. Earlene Jenkins (collectively referred to by the court as “Mr. Jenkins”) purchased Warmack’s interest in AFI. Mr. Jenkins purchased AFI to fulfill the company’s reclamation obligations and obtain the release of 24 certificates of deposit pledged to secure reclamation bonds that AFI had provided to the state. Mr. Jenkins believed that, through his political connections, he could fulfill AFI’s reclamation obligations for less than the value of the certificates of deposit and could thus make a profit upon the release of the certificates after AFI’s obligations were fulfilled. Notably, although AFI executed several promissory notes to Mr. Jenkins over the course of his ownership, Mr. Jenkins testified that the released certificates of deposit were his only anticipated source of payment and that he did not expect AFI to repay the promissory notes from its own funds. Indeed, as AFI had virtually no income during this time, it would have been nearly impossible for AFI to have used its own funds to repay the notes.

In 2002, AFI filed a lawsuit against state officials alleging tortious interference with completion of the reclamation process. During this time, AFI’s reclamation efforts ceased. AFI also executed another promissory note to Jenkins, who continued to fund the company during this time, assigning him $3 million of its potential recovery from the lawsuit. AFI subsequently won the lawsuit and filed for bankruptcy to determine the priority of payment for the proceeds.

Legal Analysis

The Tenth Circuit held that recharacterization of Mr. Jenkins’s loans was inappropriate in this case. In reaching this holding, the Tenth Circuit relied on a test articulated in a previous case, Hedged-Investments,[2] and confirmed that a court’s authority to recharacterize arose from § 105(a) of the Bankruptcy Code and the general equitable powers that the section conferred on the court.

Mr. Jenkins had argued that two Supreme Court decisions, Travelers[3] and Law,[4] required the court to use § 502(b) rather than § 105(a) for recharacterization analysis; however, the majority quickly dismissed these arguments. According to the court, neither Travelers nor Law dealt directly with recharacterization, and the court warned that to interpret these cases to do so would conflate disallowance of a claim under § 502(b) with recharacterization under § 105(a). Indeed, the majority drew a firm line between these sections and their purposes, stressing that disallowance of a claim under § 502(b) required an inquiry into a claim’s enforceability, while recharacterization under § 105(a) was an inquiry into “the true nature of a transaction underlying a claim.”[5] Thus, § 502(b) is a threshold determination for allowance of a claim, and even once this test is met, a court must still inquire into the claim’s proper priority.

Having confirmed that it would continue to use § 105(a) to determine debt-equity recharacterization, the court next applied the 13-factor Hedged-Investments test to conclude that recharacterization was not appropriate. In its analysis, the court determined, among other things, that there was nothing inherently improper about Mr. Jenkins’s arrangement with AFI; that the promissory notes could be characterized as instruments of indebtedness; and that Mr. Jenkins did not increase his participation in AFI’s management as a result of the advances he had made to the company. Finally, although AFI was undercapitalized, the court warned that placing too much emphasis on this factor would deter business owners from trying to rescue failing companies.

In contrast, the dissenting judge would have affirmed the bankruptcy court’s decision to recharacterize the loans as equity. Although the dissent agreed with the majority that the Hedged-Investments test was appropriate, the dissent believed that the majority was incorrect in its weighing of the factors. In particular, the dissent believed that the majority’s concern about the undercapitalization factor’s possible deterrent effect on business owners was misplaced in this particular case, as Mr. Jenkins was not trying to rescue a failing company at all, but rather sought only to benefit from the company’s reclamation obligations.

Looking Ahead

Courts remain divided over the correct Bankruptcy Code provision to apply in a recharacterization analysis. The Tenth Circuit’s decision in Alternate Fuels places it in opposition to the Fifth and Ninth Circuits, both of which have held that a § 502(b) analysis is the proper mechanism for making a determination as to recharacterization.[6] Under a § 502(b) analysis, recharacterization is only appropriate where applicable state law would treat the interest as equity.

The Tenth Circuit’s multi-factor test allows for a flexible approach to determining whether recharacterization is appropriate in any given circumstance, as the test takes into account the transaction’s economic terms and all of the surrounding circumstances. As with any multi-factor test, however, the Tenth Circuit’s approach may result in unpredictability. For example, courts following this approach may struggle with how to weigh the 13 factors, particularly in a close case. Indeed, the majority and dissent’s differing approaches illustrate that different judges disagree over the significance of particular factors.

The Tenth Circuit’s decision, though reaching a different result from the Fifth and Ninth Circuits, accords with decisions from the Third, Fourth and Sixth Circuits.[7] Thus, many believe that the time is ripe for the Supreme Court to take up the issue of the proper test for recharacterization. In the meantime, those advising parties working with struggling companies should continue to be mindful of the specific details of their transactions and the jurisdiction in which they are working.