Debt-to-equity Recharacterization Is It More than Equitable Subordinations Evil Twin

Debt-to-equity Recharacterization Is It More than Equitable Subordinations Evil Twin

Journal Issue: 
Column Name: 
Journal Article: 
In the past couple of years, bankruptcy courts have issued several alarming opinions on lender liability. Cases such as Exite and Senior Living Properties demonstrate that bankruptcy courts will look past documentation to the background facts and conduct of the parties. In addition, although Congress codified the doctrine of equitable subordination many years ago, trustees, debtors and committees are not limiting themselves to §510(c)'s provisions.

Another doctrine affecting the extent and validity of a claim is not based on conduct at all. Instead, the doctrine of debt-to-equity recharacterization seeks to re-classify a claim to an interest based on several factors other than conduct. Though many courts and practitioners view the doctrine of debt-to-equity recharacterization as a variation of equitable subordination, it is a distinct legal theory. In fact, and what many do not realize, debt-to-equity recharacterization serves one of the basic tenets of the Bankruptcy Code: proper classification of a claim.

Equitable Subordination: Its Elements and Purpose

Pursuant to 11 U.S.C. §510(c), a court may, under principles of equitable subordination, (a) subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or part of another allowed interest; or (b) order that any lien securing such a subordinated claim be transferred to the estate. Section 510(c) recognizes the authority to review a claimant's conduct and determine the equity in allowing that claimant to share in a pro rata distribution in bankruptcy with other claimants of equal status. See DeNatale, Andrew and Abram, Prudence B., "The Doctrine of Equitable Subordination as Applied to Nonmanagement Creditors," 40 Bus. Law J. 417, 421 (1985).

To equitably subordinate a claim, (a) the claimant must have engaged in some kind of inequitable conduct, (b) the misconduct must have resulted in injury to the creditors of the debtor or conferred an unfair advantage on the claimant and (c) the subordination must not be inconsistent with the provisions of the Bankruptcy Code. See In re Mobile Steel Co., 563 F.2d 692, 699-700 (5th Cir. 1977); see, also, United States v. Noland, 517 U.S. 535, 539, 116 S.Ct. 1524, 134 L.Ed.2d 748 (1996).

If a claimant is not an insider, then evidence of more egregious conduct such as fraud, spoliation or overreaching is otherwise necessary. See Mobile Steel at 701; Fabricators Inc. v. Technical Fabricators Inc. (In re Fabricators Inc.), 926 F.2d 1458, 1465 (5th Cir. 1991). Indeed, the mere exercise of one's rights does not and cannot justify the equitable subordination of a claim without some additional, inequitable conduct. United States Abatement Corp. v. Mobil Exploration & Producing U.S. Inc. (In re United States Abatement Corp.), 39 F.3d 556 (5th Cir. 1994).

However, irrespective of the claimant's inequitable conduct, if no harm resulted, then subordination is not warranted. See Comstock v. Group of Inst. Investors, 335 U.S. 211, 229, 68 S.Ct. 1454, 92 L.Ed. 1911 (1948) (holding that a parent's domination over its bankrupt subsidiary did not justify equitable subordination if the parent did not use its power to its advantage or to the detriment of the subsidiary). In fact, equitable subordination is a remedial measure that seeks to cure the harm caused to other creditors, not to punish the claimant whose conduct caused the harm. As a remedial tool that focuses on the conduct of a particular claimant, equitable subordination varies greatly from the fact-specific examination of debt-to-equity recharacterization.

Debt-to-equity Recharacterization: Its Purpose and Elements

Debt-to-equity recharacterization focuses on specific facts and circumstances to support a finding that the alleged debt is actually an equity interest and the alleged loan was actually a capital contribution. Diasonics Inc. v. Ingalls, 121 B.R. 626, 629 (Bankr. N.D. Fla. 1990). Debt-to-equity recharacterization does not examine conduct or harm. See Id. In addition, the Bankruptcy Code does not address debt-to-equity recharacterization in §510(c).

Though not specifically addressing debt-to-equity recharacterization, such an analysis is central to the administration of a bankruptcy estate. See In re Cold Harbor Associates L.P., 204 B.R. 904, 915 (Bankr. E.D. Va. 1997). After all, the Bankruptcy Code clearly contemplates a different treatment of debt and equity, so it is essential to determine whether a claim is debt or equity. See Id.

In determining whether a claim is debt or equity, courts generally consider the following factors: (a) names given to the legal instruments, (b) presence or absence of a fixed maturity date and schedule of payments, (c) the presence or absence of a fixed rate of interest and interest payments, (d) the source of repayments, (e) the adequacy or inadequacy of capitalization, (f) the identity of interest between creditors and stockholders, (g) the security, if any, for the advances, (h) the corporation's ability to obtain financing from outside lending institutions, (i) the extent to which the advances were subordinated to the claims of outside creditors, (j) the extent to which the advances were used to acquire capital assets and (k) the presence or absence of a sinking fund to provide repayments. See Roth Steel Tube Co. v. Commissioner, 800 F.2d 625 (6th Cir. 1986); see, also, In re Autostyle Plastics Inc., 269 F.3d 726, 749-50 (6th Cir. 2001), and In re Cold Harbor, 204 B.R. at 915.

The most typical situation where debt-to-equity recharacterization arises is where shareholders, having already made capital contributions to a corporation, subsequently advance funds labeled a "loan." Some trustees have asserted that these subsequent advances are disguised capital contributions, akin to a synthetic lease, and should be treated as capital contributions instead of a loan. See Summit Coffee Co. v. Herby's Foods Inc., 2 F.3d 128, 133 (5th Cir. 1993).

Though some courts may use other factors, most courts overwhelmingly use three groups of considerations: (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. See Cold Harbor, 204 B.R. at 915 (holding that the primary concern is whether the transaction bears the earmarks of an arm's length bargain); see, also, Diasonic v. Ingalls, 121 B.R. at 629-32 (holding that when the putative claimant advanced funds to the debtor, no other disinterested lender would extend equivalent credit, which holding supported the recharacterization of debt to equity).

Certain courts, however, have held that a bankruptcy court has no authority to recharacterize debt to equity. See In re Pacific Express Inc., 69 B.R. 112, 115 (BAP 9th Cir. 1986); In re Pinetree Partners Ltd., 87 B.R. 481, 491 (Bankr. N.D. Ohio 1988). The Pacific Express court held that because the result achieved through debt-to-equity recharacterization was subordination, and such determinations were governed by express Code provisions—i.e., §510(c)—it would be inconsistent with the Code to allow such determinations to be made under different standards via the court's equitable powers. See Pacific Express, 69 B.R. at 115.

Conclusion

Despite the reasoning set forth in Pacific Express, the application of such reasoning could result in a perversion of the Code. Consider, for example, an equity interest-holder who files a monetary proof of claim instead of a proof of interest. If conduct is not in issue, then equitable subordination would not apply. If courts cannot recharacterize debt to equity, then the equity interest-holder has successfully transformed its equity into a claim, since no other procedure would serve to support a claim objection. Because such a result is absurd, debt-to-equity recharacterization must exist.

Another view of the difference between equitable subordination and debt-to-equity recharacterization is that equitable subordination principles apply only to true creditors, whereas courts reclassify equity contributions because corporations repay equity after satisfying other obligations. Diasonics, 121 B.R. at 630. The difference between the two doctrines may seem subtle at first glance, but proper application yields quite different results to varying circumstances.

Journal Date: 
Monday, November 1, 2004