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.

In re Atlanticrancher Inc.—U.S. Bankruptcy Court for the District of Massachusetts

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.² 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.³ 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."⁴

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.⁵ 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."⁶ 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."⁷

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

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.⁸ 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."⁹ 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.¹⁰ 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.¹¹ 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."¹² 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.¹³

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

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.¹⁴ 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.¹⁵ 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."¹⁶ 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.¹⁷ 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.¹⁸

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

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.¹⁹ 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.²⁰ 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.²¹ 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.²² 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.²³ 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.'"²⁴ 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."²⁵

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

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.²⁶ 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."²⁷ 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 cases²⁸ and seems to be squarely settled by Autostyle Plastics²⁹ and its progeny. It should be interesting to see if these types of arguments will begin to be raised once again.

Conclusion

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.³⁰ Accordingly, it will be interesting to watch this area of case law develop and further updates are sure to follow.

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Footnotes

¹ 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. Return to article

² In re Atlanticrancher Inc., 279 B.R. 411 (Bankr. D. Mass. 2002). Return to article

³ 279 B.R. at 436. Return to article

⁴ 279 B.R. at 437. Return to article

⁵ 279 B.R. at 437. Return to article

⁶ 279 B.R. at 437, citing Kids Creek Partners, 212 B.R. 898, 932 (Bankr. N.D. Ill. 1997). Return to article

⁷ 279 B.R. at 438 citing Diasonics Inc. v. Ingallo, 121 B.R. 626, 630 (Bankr. N.D. Fla. 1990). Return to article

⁸ In re Phase-I Molecular Toxicology, 287 B.R. 571 (D. N.M. 2002). Return to article

⁹ Phase-1, 287 B.R. at 577, quoting Auto Style Plastics, 269 F.3d at 751. Return to article

¹⁰ Phase-1, 287 B.R. at 578 (citations omitted, emphasis added). Return to article

¹¹ 287 B.R. at 578, quoting Hyperion Enterp. Inc., 158 B.R. 555 (D. R.I. 1993) (rejecting argument that undercapitalization justifies recharacterization of debt in favor of using multi-factor approach). Return to article

¹² Phase-I, 287 B.R. at 578. Return to article

¹³ Phase-I, 287 B.R. at 578. Return to article

¹⁴ In re Internet Navigator Inc., 289 B.R. 133 (Bankr. N.D. Iowa 2003). Return to article

¹⁵ 289 B.R. at 137. Return to article

¹⁶ Id. (other citations omitted). Return to article

¹⁷ 289 B.R. at 137. Return to article

¹⁸ Id. Return to article

¹⁹ In re Submicron Systems Corp., Adversary No. A-00-484, unpublished opinion (Bankr. D. Del. March 10, 2003). Return to article

²⁰ Opinion at ¶58, page 34. Return to article

²¹ Opinion at ¶22, page 23. Return to article

²² Opinion at ¶¶32-33, page 23. Return to article

²³ Opinion at ¶32, page 26. Return to article

²⁴ Opinion at ¶¶28-30, pages 24-25. In re Octagon Roofing, 157 B.R. 852, 858 (N.D. Ill. 1993). Return to article

²⁵ Opinion at ¶22, page 23. Return to article

²⁶ In 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), citing In re Outboard Marine Corp. Oral Opinion (Bankr. N.D. Ill. Jan. 14, 2002). Return to article

²⁷ Outboard Motors at 34. Return to article

²⁸ See, e.g., Pacific Express Inc., 69 B.R. 112, 115 (9th Cir. B.A.P. 1986); In re Pine Tree Partners Ltd., 87 B.R. 481, 491 (Bankr. N.D. Ohio 1988); In 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) (requiring inequitable conduct for recharacterization; however, this case was decided before Autostyle and was also viewing recharacterization in the context of equitable subordination). Return to article

²⁹ 269 F.3d 726 (6th Cir. 2001). Return to article

³⁰ 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. Return to article