The recently concluded Athens Olympics provided devotees of international sport more than their share of compelling stories. One of those stories featured American gymnast Paul Hamm and his bid for a medal in the "all-around" men's gymnastics competition—a medley of routines on vault, high bar, pommel horse, parallel bars, floor exercise and rings. In first place after three routines, Hamm let fly a vault that even I, if properly motivated and medicated, would be able to match: a flailing aerial conniption that landed Hamm on his back, off the mat and in a heap inches away from startled judges, who promptly gave Hamm a score that should have doomed his competition. It didn't. Hamm's routines on parallel bars and high bar—coupled with a stunning string of missteps by other gymnasts—propelled Hamm to the gold medal. Hamm had performed what one observer called "a hideous tumble" and got away with it.

Elsewhere, an investment fund called The Bronze Group Ltd. performed what one observer called "a financial somersault" and got away with it. Beginning in 1986, Bronze Group lent nearly $2 million to an entity called Hedged-Investments Associates Inc. (HIA), a Ponzi scheme that got its start in the 1970s and managed to stave off its inevitable collapse until 1990.¹ Bronze Group's "financial somersault" is described in the Tenth Circuit's decision in Hedged-Investments Assocs. II LP v. Bronze Group Ltd. (In re Hedged-Investments Assocs.).² Most of the Bronze Group's individual participants, before forming Bronze Group, had been partners in an entity called BGL Associates and had contracted with an asset-trading company managed by James Donahue (the "visionary" behind HIA) to establish a stock trading account separate from the HIA partnerships. After discovering that Donahue had commingled their $900,000 with HIA funds, BGL demanded a return of its money. With HIA being what it was and Donahue being who he was, there was no way to return the $900,000. So BGL dissolved, and Donahue cut bad checks to the former BGL partners for the funds. Simultaneously, the former BGL partners "contributed" the checks for $900,000 to the newly formed Bronze Group, which then immediately loaned the $900,000 to HIA under a promissory note, security agreement and a UCC-1 financing statement identifying certain of HIA's trading accounts as collateral. No money actually changed hands, but the lending relationship had changed dramatically.

What made Bronze Group's loan to HIA all the more unconventional—and what would raise the ire of HIA's investors years later—was that the loan documents provided for "a flexible interest rate, with a minimum rate of 15 percent per annum for the life of the loan, plus additional interest to match the rate of any greater HIA earnings, minus a fee of 4 percent per annum."³ In other words, the "loan's payment terms were nearly identical to the profit payments Donahue had promised to HIA's limited partners /equity investors in the mid-1980s."⁴

HIA entered bankruptcy owing Bronze Group about $1.83 million (there were many subsequent advances). The panel trustee tried to convince the bankruptcy court that the most equitable way to distribute the estate's $11 million (against almost $200 million in investor interests) was to distribute a pro rata share of the estate to each interest-holder based on the amount of each holder's principal invested in HIA. Bronze Group objected, arguing that its lender status accorded it priority over the equity investors and that it should be paid in full before any investors received any distribution. The panel trustee and the investors tried two different approaches in an effort to lump Bronze Group in with HIA's equity investors. First, the panel trustee asked the bankruptcy court to recharacterize Bronze Group's loan as an equity contribution. The panel trustee argued that Bronze Group negotiated the same terms as those promised to equity investors and did so under circumstances where Bronze Group knew or should have known (based on the BGL debacle) that HIA was, at best, undercapitalized. Second, he asked the bankruptcy court to equitably subordinate Bronze Group's claim to the level of equity-holders.⁵

The bankruptcy court declined to recharacterize Bronze Group's loan as equity, but did equitably subordinate the debt to the same priority as HIA's equity investors, requiring Bronze Group to share pro rata with the investors. The district court agreed that the loan should not be recharacterized, but reversed the bankruptcy court's equitable subordination ruling and granted Bronze Group a judgment for the loan principal and all interest that accrued before bankruptcy.⁶ Understandably dissatisfied with having their $11 million estate depleted by $2 million in Bronze Group's favor, the investors appealed to the Tenth Circuit, asking the court to reverse the lower courts' refusal to recharacterize the loan and to reinstate the bankruptcy court's equitable subordination ruling.

The Tenth Circuit affirmed all aspects of the district court's ruling, refusing both to recharacterize the loan and to equitably subordinate Bronze Group's loan claim. Perhaps because it sensed that the bankruptcy court and the investors lacked a complete understanding of recharacterization and equitable subordination, the Tenth Circuit described each remedy separately, drawing an important distinction between them. A recharacterization "ignore[s] the label attached to the transaction at issue and instead recognizes its true substance...as a capital contribution."⁷ Equitable subordination "looks not to the substance of the transaction, but to the behavior of the parties involved. The funds in question are still considered outstanding corporate debt, but the courts seek to remedy some inequity or unfairness perpetrated against the bankruptcy entity's other creditors or investors by postponing the subordinated creditor's right to repayment until others' claims have been satisfied."⁸

In determining whether a loan is to be recharacterized as what the court called "camouflaged equity," the court settled on a list of 13 criteria originally proposed in a 1984 decision from the Eleventh Circuit: (1) the names given to the transaction documents, (2) presence or absence of a fixed maturity date, (3) the source of payments, (4) the right to enforce payment of principal and interest, (5) participation in management resulting from the transaction, (6) the status of the contribution in relation to regular corporate creditors, (7) the parties' intents, (8) adequacy of capitalization, (9) identity of interest between creditor and stockholder, (10) the source of interest payments, (11) the borrower's ability to obtain outside loans, (12) whether the borrower uses the advance to acquire capital assets and (13) the borrower's failure to repay on the due date or seek a forbearance.⁹ The Tenth Circuit acknowledged that the relative significance of the various criteria would vary from case to case, but stressed that placing too much emphasis on undercapitalization would create undesirable disincentives for shareholders and other insiders of a struggling enterprise "to keep a flagging business afloat."¹⁰ The court acknowledged that the Bronze Group loan's lack of maturity date, HIA's payment of interest out of its pooled investment account and HIA's "thin" capitalization all militated in favor of recharacterization. But based strictly on the bankruptcy court's findings of fact, the Tenth Circuit agreed with both lower courts that Bronze Group's loan should not be recharacterized.

What followed that portion of the ruling (a full explanation of the equitable subordination doctrine), while instructive, seems largely unnecessary. Despite spending several pages describing the criteria by which courts consider requests to equitably subordinate a creditor's claim, the Tenth Circuit's opinion seems to miss an important piece of its own analysis: that equitable subordination under Bankruptcy Code §510(c) would do nothing for the HIA investors because Bankruptcy Code §510(c) does not permit a debt to be equitably subordinated to or below the level of equity.¹¹ A claim can only be subordinated to another claim, not to an equity interest. Therefore, it is impossible to do precisely what the Tenth Circuit suggested earlier in its opinion—to "remedy some inequity or unfairness perpetrated against...investors"—by subordinating the debt to those investors' equity interests. The investors would gain essentially nothing by the court's equitably subordinating Bronze Group's debt. The best the investors could hope for is that Bronze Group's debt would be subordinated to the $18,000 in trade debt. Even so, that subordinated debt would still be of a higher priority than the first dollar of an investor's equity interest, and the investors would get nothing from the estate until Bronze Group's claim was paid in full.

The Tenth Circuit's rehearsal of equitable subordination law is, nonetheless, informative. The court reiterated established criteria for equitable subordination: "(1) 'inequitable conduct' on the part of the claimant sought to be subordinated, (2) injury to the other creditors of the bankrupt or unfair advantage for the claimant resulting from the claimant's conduct and (3) consistency with the provisions of the Bankruptcy Code." The Tenth Circuit noted also that it places "special emphasis on the inequitable conduct prong."¹²

Inequitable conduct, as the Tenth Circuit notes, can include three types of misconduct: "(1) fraud, illegality and breach of fiduciary duties, (2) undercapitalization or (3) claimant's use of the debtor as a mere instrumentality or alter ego."¹³ The bankruptcy court seems not to have applied any of these guidelines to Bronze Group, instead basing its equitable subordination ruling on Bronze Group's "failure to conduct reasonable due diligence before advancing the loan to HIA and on the similarities between the Bronze Group loan's earnings structure and the promised returns for the limited partnerships."¹⁴ The Tenth Circuit regarded those findings as insufficient for equitable subordination purposes. "Failure to conduct due diligence was certainly bad business practice, and the loan's terms might indeed be questionable, but these facts do not amount to blatant fraud or other illegality at the expense of HIA's other creditors."¹⁵

Interestingly, the Tenth Circuit noted that HIA's undercapitalization did not rise to the level of gross misconduct because "Bronze Group's managers were unaware of HIA's financial straits until the entire scheme collapsed in 1990." Did the Tenth Circuit unwittingly imply a disincentive to perform due diligence? Under that reasoning, the less a lender knows about how or to what extent a borrower is capitalized, the less likely undercapitalization will come back to haunt the lender later.

Ultimately, Bronze Group's "financial somersault"—like Paul Hamm's ungainly vault—was far from perfect and fraught with problems, but it was good enough to win. Getting paid in full from a Ponzi scheme is no mean feat, and Bronze Group's success in overcoming efforts to recharacterize and equitably subordinate its debt may say more about those remedies' narrow scope and exacting requirements than it says about Bronze Group's bona fides.

Footnotes

¹ The ensuing bankruptcy case has been something of a full-employment act for the courts. Since its start in 1990, the case began as a voluntary chapter 11 and converted to chapter 7 eight days later—and it has generated no fewer than eight appeals to the Tenth Circuit Court of Appeals. That the bankruptcy persists in more or less full swing after 14 years is remarkable, even for a Ponzi scheme case. Return to article

² 2004 U.S. App. LEXIS 18164 (10th Cir. Aug. 26, 2004). Return to article

³ Id. at *3. Return to article

⁴ Id. at *3-4. Return to article

⁵ Id. at *6. Return to article

⁶ Id. at *7. Return to article

⁷ Id. at *8. Return to article

⁸ Id. Return to article

⁹ Stinett's Pontiac Serv. Inc. v. Comm'r of Internal Revenue, 730 F.2d 634, 638 (11th Cir. 1984). Return to article

¹⁰ 2004 U.S. App. LEXIS 18164 at *13 n.1. Return to article

¹¹ Bankruptcy Code §510(c) provides that "under principles of equitable subordination," a court may "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...." Return to article

¹² 2004 U.S. App. LEXIS 18164 at *17. Return to article

¹³ Id. at *20 (quoting Fabricators Inc. v. Technical Fabricators Inc. (In re Fabricators)), 926 F.2d 1458, 1467 (5th Cir. 1991). Return to article

¹⁴ 2004 U.S. App. LEXIS 18164 at *22. Return to article

¹⁵ Id. at *22-23. Return to article