The ABI Journal has published several articles on the topic of recharacterization in the past two years: "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; "Is It a Capital Contribution or a Loan: Update—Recent Cases Discussing Recharacterization of Debt to Equity," published in the May 2003 issue; and "Recharacterization from Debt to Equity: Lenders Beware,"³ published in the November 2003 issue. Furthermore, ABI also sponsored a panel presentation on these issues at ABI's Annual Spring Meeting in Washington, D.C., on April 12, 2003,⁴ which produced a well-attended, and very lively, debate on the issues in this area.

A body of case law is slowly being established in this area. Additionally, there is also a knowledge base fueled by cases that are not reported, but are experienced by many in their practice on a regular basis. In light of the evolving information in this area, and in response to many of the concerns raised at the Annual Spring Meeting, this article seeks to provide some practical tips to bankruptcy practitioners faced with bringing or defending such causes of action.

Views from the Bar

The large audience gathered at the Annual Spring Meeting made it clear: Bankruptcy lawyers are not pleased about this developing area in which bankruptcy courts have overreaching power to recast a debt obligation to one of equity with little or no hope of repayment. Many comments were made about the efforts of those structuring the transactions and the perceived lack of certainty as to the future of many transactions. Further, it became very apparent from the intense nature of the discussions that without a requirement of some sort of bad faith or bad act on the part of the "lender," bankruptcy practitioners were not supportive of the most recent developments in the case law.

At the time of the meeting, there was still an open question as to whether bankruptcy courts even had the power to hear such claims, given Judge Barliant's comments in Outboard Motors.⁵ However, since that time, the district court overruled the U.S. Bankruptcy Court for the Northern District of Illinois, and later determined that recharacterization claims reinforce the priority provisions of the Code, rather than circumvent them.⁶ Accordingly, the discussions that took place among the panelists and the audience concerning whether bankruptcy judges could even enter into this area are moot (although, someone may file a formal challenge in another circuit, which could yield a different result).

Accordingly, at this writing, it seems clear that bankruptcy courts recognize recharacterization as a distinct cause of action; it is settled, for now at least, that bankruptcy courts do have the authority to hear recharacterization cases; and there have been two additional factors added to the now, commonly accepted
AutoStyle Plastics⁷ analysis for determining whether a claim should be recharacterized as one in equity.

Review of Factors Used to Analyze Recharacterization Claims

The AutoStyle court adopted the 11 factors from the Roth Steel Tube tax case⁸ and stated that 11 factors should be used in analyzing whether an obligation should be recast from debt to equity. The 11 factors cited by the AutoStyle court were:

1. the names given to the instruments, if any, evidencing the indebtedness;
2. the presence or absence of a fixed maturity date and scheduled payments;
3. the presence or absence of a fixed rate of interest and interest payments;
4. the source of the repayment;
5. the adequacy or inadequacy of capitalization;
6. the identity of interest between the creditor and the stockholder;
7. the security, if any, for advances;
8. the corporation's ability to obtain financing from outside lending institutions;
9. the extent to which the advances were subordinated to the claims of 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.⁹
    Two additional factors were added by the district court in Outboard Marine, which were adopted from the Hyperion Enterprises¹⁰ case:
12. the ratio of shareholder loans to capital; and
13. the amount or degree of shareholder control.

All courts that have used the AutoStyle factors agree that no one factor is controlling, and the cases are determined on a case-by-case basis.¹¹ The evolution of factors to aid in the analysis of recharacterization claims is consistent with the development in common law as to the definition of conduct that triggers equitable subordination.¹²

Some Unreported Developments

From personal experience, as well as discussions with many at the Annual Spring Meeting and the comments made to the panel from the audience, it is clear that there are many allegations concerning recharacterization that are not ever brought to official litigation. Further, even if the claims for recharacterization are filed, they are rarely litigated to conclusion, and even more rarely do they result in reported written decisions. Settlement seems to be the most likely result of most recharacterization claims due to the time involved in litigating such a case to conclusion. Practically speaking, claims for recharacterization are frequently raised at the beginning of a bankruptcy case and are often settled early on at the time of cash collateral or debtor-in-possession (DIP) financing negotiations. Further, many creditors' committees that raise these issues do so more as a point of leverage rather than a declaration of war to litigate the case to completion.

Additionally, it has also become clear that practitioners are using recharacterization with more and more inventiveness. For example, recharacterization issues have been raised in the context of securitization transactions, letters of credit, and in the provision and payment of guarantees. Recharacterization issues have also been raised in a type of bad-faith lending context; the argument is that to the extent that there is a point in a lending relationship where the lender knew or should have known that there was no way the borrower could repay the obligations, then from that point on, the obligations should be converted to an equitable contribution—one in which the lender is inferred to have supposedly shared in the risk of the future of the business (query: doesn't the lender always share the risk of the future business?). Another area for possible use is where an insider makes a "loan" that is clearly insufficient to meet the anticipated needs of the company. Again, there are no reported decisions in these types of cases at this time, but it does show the creative use in which this doctrine is being used, as well as the increased frequency with which it is being raised both formally in litigation and informally in negotiations, plan discussions and case management.

Practical Tips

1. Procedural Aspects of Bringing a Recharacterization Action? Of course, an allegation of recharacterization, for purposes of negotiation, can be raised at any time in a case. However, after appropriate analysis, if a party seeks to commence an action with the bankruptcy court, since the Bankruptcy Code does not expressly provide for a cause of action recognizing recharacterization (unlike §510(c) of the Code, which provides an express cause of action for equitable subordination), the first obstacle is a procedural one. A claim for equitable subordination must be brought by an adversary proceeding and generally may be initiated only by a trustee or DIP, unless a bankruptcy court authorizes another party to initiate such a proceeding.¹³ No such guidelines exist for recharacterization actions, but there are several different ways actions are being brought or it appears they can be brought.

Since §502 of the Code deems proofs of claims or interests to be allowed unless an objection is filed, if a claim has already been filed in a case, then an objection can be filed including a counterclaim raising the recharacterization issues that will convert the objection to an adversary proceeding pursuant to Federal Bankruptcy Rules of Procedure 3007 and 7001.¹⁴ If no claim has been filed, however, it is unclear whether a separate adversary proceeding can be commenced solely on the basis of the exercise of power under §105 of the Code to recharacterize the claim. Many such cases have been filed, and the procedural propriety has not been expressly challenged to date, but it is not certain that such a challenge could be upheld. Another suggestion is for an adversary to be commenced seeking a claims allowance determination under §502(f) of the Code and Federal Rule of Bankruptcy Procedure 7001. Cases have also been filed using §510(c) to seek equitable subordination, or, in the alternative, recharacterization. However, given the established understanding in bankruptcy courts that recharacterization and equitable subordination are separate and distinct causes of action, it is not clear whether a §510(c) action is the appropriate course to follow, either. Practically speaking, when preparing a "kitchen-sink" pleading against a lender, many pleadings will seek a determination for recharacterization (where the entire obligation is recharacterized and subordinated) or, in the alternative, equitable subordination, where the claim is subordinated to the extent of the harm only. There are many other possibilities as well—for example, in the Outboard Marine case, the lender filed an action seeking to compel payment, and recharacterization was raised as a counterclaim. Another thought is whether recharacterization can be used at the plan stage in a §1122(a) classification context.¹⁵

To date, there is no decision reported on a procedural challenge to these issues other than the overall propriety of the bankruptcy courts to hear the issues at all. However, it seems that there is much room for ingenuity when considering how to accomplish the recharacterization of an obligation from debt to equity, and thought must be given as to how best to proceed, given the facts of the particular case.

2. Who Can Bring a Claim for Recharacterization? When bringing an action for equitable subordination under §510 of the Bankruptcy Code, standing is an important issue. Generally, an action may be initiated only by a trustee or DIP, unless a bankruptcy court authorizes another party to initiate such a proceeding.¹⁶ Creditors' committees generally have an implied qualified right to initiate, with bankruptcy court approval, proceedings in the name of the trustee or DIP only when they unjustifiably fail to bring suit.¹⁷ There is one important exception to this general rule. When a trustee or DIP has not objected to a claim, or has no reason to object to a claim, a creditor may maintain a cause of action with the consent of the court under §510(c) of the Bankruptcy Code where the sole purpose of the action is to subordinate the claim to the objectant's claim.¹⁸ Since there is no express cause of action under the Bankruptcy Code for recharacterization, the question seems open as to who has proper standing to bring such actions. There are no reported cases in this area of standing to bring recharacterization actions. Practically speaking, in cases I have personally been involved with, creditors' committees are the ones raising the issues and bringing the actions, and there have been no challenges that I have seen to their standing to do so. Perhaps the bankruptcy courts will adopt the same analysis for standing as in equitable subordination cases, but arguments can be made that it should not involve the same analysis because standing decisions in equitable subordination cases rest on the express cause of action provided under the Bankruptcy Code, and the cause of action in an equitable subordination case is based on the conduct of a legitimate creditor, not the nature of the transaction. Consequently, in determining whether to bring a recharacterization action, consideration must be given to whether standing exists to bring such an action. There is also room for the possibility that a single creditor may have standing based on the exception to the general rule adopted in equitable subordination cases. Of course, a fine line must be walked in bringing a suit for the purposes of exerting pressure on settlement negotiations and taking advantage of the bankruptcy court's jurisdiction.

3. Should a Claim for Recharacterization Be Brought? In analyzing whether to bring an action for recharacterization, first and foremost, remember that recharacterization and equitable subordination are two distinct causes of action and should not be confused; equitable subordination is remedial and not only requires the showing of some bad faith or bad act on the part of the lender, but more importantly, it results only in the subordination of the claim to the extent of the harm. Equitable subordination turns on whether a legitimate creditor with a legitimate claim engaged in some sort of inequitable conduct that would warrant a subordination to offset the damage suffered. Alternatively, recharacterization results in the entire obligation being recast from a debt obligation to one of equity, and the entire obligation is, therefore, at the back of the priority line with very little chance, if any, of repayment. Remember, recharacterization is about whether there ever was a debt obligation in the first place.

Also, be mindful that no one factor is determinative, and all should be viewed in light of the transaction, or transactions, as a whole. For example, just because you have an insider transaction, without more, insider status does not necessarily warrant the recharacterization of the obligation to one of an equitable contribution. In fact, although insider status warrants closer scrutiny, it is but one factor to be balanced and does not mandate a lesser standard to satisfy as in equitable subordination cases.¹⁹ Another interesting difference is that all the requisite elements for equitable subordination must be satisfied.²⁰ In recharacterization cases, there are no set elements that must be satisfied, but there is an overall balancing of the factors to discern whether the obligation has the indicia of debt and was an arm's-length transaction. Accordingly, in some ways it may be easier to be successful in a recharacterization action.

Discovery is an important part of understanding the transaction as a whole and can be a very long and expensive process in these cases.²¹ Although important in any analysis, a good understanding of the facts is essential to conduct a complete analysis as to whether the litigation truly has merit vs. the expenditure of estate resources to fund a virtual hunting expedition just because one factor may be present.

4. How to Defend a Recharacterization Action. If your client is one against which a recharacterization action has been brought or alleged, the first step is to get a complete understanding of the facts involved as soon as possible. The easiest way to assess the likelihood of success of any recharacterization action is to parse through each of the factors one by one as they relate to the facts. After reviewing the factors in light of the facts, as well as the intent of the parties, the factors must be balanced in light of the totality of the circumstances. As in any litigation analysis, it is likely that some factors will be more supportive of a successful defense than others. Nonetheless, given the big picture, what does the overall likelihood of success look like?

In the defense of an action for equitable subordination under §510 of the Bankruptcy Code, demonstrating that the lender was not an insider allows the defendant to gain an advantage.²² In recharacterization cases, insider status is merely a factor to be balanced, and although when an insider is involved it requires a greater level of scrutiny, no separate standards or burdens of proof with respect to insiders have been developed to date in the reported cases on these issues.²³ Also in defense of an equitable subordination action, standing is an important issue and can be raised as a means of challenging the cause of action.²⁴ However, since there is no express cause of action under the Bankruptcy Code for recharacterization, the question seems open as to who has proper standing to bring such actions. Perhaps the bankruptcy courts will adopt the same analysis, but an argument can be made that it should not based on the fact that the standing decisions in equitable subordination cases rest on the express cause of action provided under the Bankruptcy Code. As a defendant, therefore, check to see who is raising the action—for example, the creditors' committee—and an argument, even for negotiation purposes, can be made that the action cannot be brought. Finally, a defense that can be raised in equitable subordination cases is that all of the elements that are required have not been satisfied; due to the balancing approach of the factors in recharacterization cases, this defense must be altered, but may be done in an effective way to downplay the "balancing" of various factors.

The down side to these cases is that there are not many reported decisions, and the cases are incredibly factual in nature. Consequently, it is very difficult to predict with certainty what the outcome may be. Moreover, given that the bankruptcy court is a court of equity, be mindful of the overlay of the total balancing approach the bankruptcy court will bring to bear depending on the facts of the case. It is very important to keep an experienced bankruptcy lawyer involved in the case and not totally hand the case off to litigators who can tend to focus on one particular fact or factor and lose sight of the big picture in the bankruptcy court and the balancing nature of the cases. The up side to these cases is that there are very few reported decisions, and the cases are incredibly factually dependent, which makes it easy to get up to speed quickly and create a unique defense based on the facts of the case.

Generally, when engaging in settlement discussions, be mindful of the cost of a defense, which is almost totally dependent on the facts that could involve extensive discovery, numerous depositions and voluminous document production, including electronic communications. Additionally, you will find that in many cases, the testimony is so self-serving it may not be given much weight.

Conclusion

While the common law applicable to recharacterization actions continues to evolve, for now the bankruptcy courts seem to have settled the questions as to whether recharacterization exists as a distinct cause of action and whether bankruptcy courts do have the authority to hear recharacterization cases. Further, the recognized factors from AutoStyle Plastics,²⁵ as supplemented by Outboard Marine,²⁶ do provide a roadmap by which to navigate an analysis of a recharacterization claim. Bankruptcy practitioners must be careful about the procedural posture of the case and in conducting the appropriate analysis of whether to bring a claim for recharacterization or how to successfully defend such a claim efficiently and economically.

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Footnotes

¹ Ms. Brighton would like to thank Hon. Judith K. Fitzgerald, Chief Judge of the Western District of Pennsylvania in Pittsburgh, and Nancy A. Ross CPA of High-Ridge Partners in Chicago for their comments and their shared participation on the panel at the Annual Spring Meeting discussing these issues. Return to article

² Ms. Brighton is special counsel for Kennedy Covington in their Charlotte, N.C., office in the Business Law/Debt Finance Group, where she practices primarily in the area of bankruptcy workouts and secured lending. She is a contributing editor of the ABI Journal and is certified in business bankruptcy by the American Board of Certification. Return to article

³ Authors: James Sprayregen, Jonathan Friedland and James R. Mayer. Return to article

⁴ "Recharacterization of Debt: Now You See It—Now You Don't! What Happened to Equitable Subordination?" panel presentation, ABI Annual Spring Meeting, Washington, D.C., April 12, 2003—panelists: Hon. Judith K. Fitzgerald, Nancy Ross, CPA and Jo Ann J. Brighton. Return to article

⁵ In re Outboard Marine Corp., Case No. 00 B 37405 (N.D. Ill. Jan. 14, 2002, at 33) (Barliant, J.). Return to article

⁶ In re Outboard Marine Corp., 2003 U.S. Dist. 12564, *2-3 (E.D. Ill. July 21, 2003). Return to article

⁷ In re AutoStyle Plastics Inc., 269 F.3d 726 (6th Cir. 2001), and In re Outboard Marine, 2003 U.S. Dist. 12564 at *6. Return to article

⁸ Roth Steel Tube Co. v. Commissioner of Internal Revenue Serv., 800 F.2d 625, 630 (6th Cir. 1986). Some courts have taken issue with the idea that tax factors cannot be applied in bankruptcy cases because the considerations for recharacterization of debt to equity in a tax case are distinct from the considerations in a bankruptcy case where the context is different. The district court in Outboard Marine stated that no one has identified what those different policy considerations are, let alone why those differences should preclude a bankruptcy court that is determining whether recharacterization is appropriate from relying on the factors that tax courts employ in conducting the same type of analyses. 2003 U.S. Dist. 12564 at *5. Return to article

⁹ Auto Style, 269 F.3d at 749-50, citing Roth Steel, 800 F.2d at 630. Return to article

¹⁰ In re Hyperion Enterprises, 158 B.R. 555 (D. R.I. 1993). Return to article

¹¹ AutoStyle Plastics, 269 F.3d at 750, citing Roth Steel, 800 F.2d at 630. See, also, Outboard Marine, 2003 U.S. Dist. 12564, at *6. Return to article

¹² See 11 U.S.C. §510(c), which allows for an action to equitably subordinate a claim, but does not define conduct that would warrant the remedy. See, also, In the Matter of U.S. Abatement Corp., 39 F.3d 556, 560 (5th Cir. 1994). Return to article

¹³ See In re 9281 Shore Road Owners Corp., 187 B.R. 837, 852 (Bankr. E.D.N.Y. 1995). Return to article

¹⁴ An interesting point to think about, perhaps, is this: If there is a disagreement about the nature of the transaction, does §502 even apply at all? Return to article

¹⁵ Query whether it would be a true "recharacterization" action at that point, or merely one of reclassification. Return to article

¹⁶ See Fed. Bankr. P. 7001(8); In re Danbury Square Assoc., 153 B.R. 657 (Bankr. S.D.N.Y. 1995); In re 9281 Shore Road Owners Corp., 187 B.R. 837, 852 (Bankr. E.D.N.Y. 1995). Return to article

¹⁷ In re Mayo, 112 B.R. 607, 651 (Bankr. D. Vt. 1990), citing In re STN Enterp. Inc., 779 F.2d 901, 904 (2d Cir. 1985). Return to article

¹⁸ Mayo, 112 B.R. at 651. Return to article

¹⁹ There are different analyses and requirements for proof for insiders vs. non-insiders in equitable subordination cases; generally, the standard applied to insiders is merely one of simple unfairness, while non-insiders are held to an "egregious" and "severely unfair" standard. See, e.g., In the Matter of Mobile Steel, 563 F.2d, 692, 699 n. 10 (5th Cir. 1977); U.S. v. Noland, 517 U.S. 535, 539 (1996). Return to article

²⁰ The First Circuit has established that the following elements are necessary to equitably subordinate a claim. The trustee or DIP must show that (1) the claimants have engaged in some type of inequitable conduct, (2) the misconduct must have resulted in injury to creditors or conferred an unfair advantage on the claimant and (3) equitable subordination of the claim must not be inconsistent with the provisions of the Bankruptcy Code. Hyperion, 158 B.R. at 562. Return to article

²¹ See, e.g., In re Vanguard Airlines Inc., 298 B.R. 626 (Bankr. W.D. Miss. 2003) (court recognized need for discovery before proceeding with a claim for recharacterization where "colorable" claim existed). Return to article

²² There are different analyses and requirements for proof for insiders vs. non-insiders in equitable subordination cases; generally, the standard applied to insiders is one of simple unfairness, while non-insiders are held to an "egregious" and "severely unfair" standard. See, e.g., In the Matter of Mobile Steel, 563 F.2d, 692, 699 n. 10 (5th Cir. 1977); U.S. v. Noland, 517 U.S. 535, 539 (1996). Return to article

²³ See, e.g., In re AutoStyle Plastics Inc., 269 F.3d 726 (6th Cir. 2001), and In re Outboard Marine, 2003 U.S. Dist. 12564 at *6. Return to article

²⁴ A claim for equitable subordination must be brought by an adversary proceeding, and generally may be initiated only by a trustee or DIP, unless a bankruptcy court authorizes another party to initiate such a proceeding. See Fed. Bankr. P. 7001(8); In re Danbury Square Assoc., 153 B.R. 657 (Bankr. S.D.N.Y. 1995); In re 9281 Shore Road Owners Corp., 187 B.R. 837, 852 (Bankr. E.D.N.Y. 1995). Return to article

²⁵ In re AutoStyle Plastics Inc., 269 F.3d 726 (6th Cir. 2001), and In re Outboard Marine, 2003 U.S. Dist. 12564 at *6. Return to article

²⁶ 2003 U.S. Dist 12564 at *6. Return to article