When Is Your "Debt" Claim Not A Debt Claim?

Traditionally, bankruptcy law honored the basic axiom that debt should be paid before equity. As corollaries:

• secured debt would be paid from its collateral with any surplus available to unsecured debt,
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• unsecured debt would share ratably in unencumbered assets, subject to the following exceptions:
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  • legislatively imposed priority claims would be paid before general claims;
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  • contractual subordinations would be recognized;
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  • insiders of a debtor who abused their position to their advantage could have their claims "equitably" subordinated to the extent necessary to right the wrong; and
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  • claims arising from equity investments in a debtor could be subordinated to creditors' claims.

Recent cases have spawned a new corollary which "recharacterizes" debt as equity in certain circumstances. While the courts apply an array of tests, recharacterized debt typically involves advances by insiders to a company which is in distress and which has no access to outside, arm's-length sources of financing.

Although no specific provision of the Bankruptcy Code expressly confers power to recharacterize debt as equity, bankruptcy courts across the nation have rationalized that their power to recharacterize a claim of debt to equity stems from the authority vested in the bankruptcy courts to use their equitable powers to test the validity of claims.1 According to at least one court, "recharacterization of debt as equity involves a factual determination as to whether or not the asserted debt is in fact debt or instead is an equity contribution disguised as debt."2 If unsecured debt is recharacterized, a claim that would have been pari passu with other general unsecured creditors would become a claim junior to all other creditors.

Although recharacterization is often lumped together with equitable subordination, it is important to note that a court does not need to find inequitable conduct on the part of the claimant to recharacterize the debt to equity. The policy underlying recharacterization of debt to equity is to prevent a shareholder from shifting the risk of owning equity to the company's creditors.3

While most bankruptcy courts did not question their authority to recharacterize claims, a few "hold-out" courts did, finding that although the Bankruptcy Code supports a court's ability to determine the amount and the allowance or disallowance of claims, recharacterization of debts to equity under the court's equitable powers would result improperly in inconsistent standards under the Bankruptcy Code for the subordination of debts.4 This summer, one of the few bankruptcy courts that held that an action for recharacterization of claims could not be recognized was reversed.5 Now it is almost universally accepted that bankruptcy courts have authority to recharacterize a claim of a creditor as an equity interest in bankruptcy.6

In trying to determine whether debt should be recharacterized, courts analyze a variety of factors. The analysis attempts to determine whether the transaction created a debt or equity relationship from the outset.7 The following factors (or substantially similar lists of factors) are often used in determining whether a claim will be treated as debt or equity:

• Names given to instruments, if any, evidencing the debt;
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• Presence or absence of a fixed maturity date and amortization schedule;
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• Presence or absence of a fixed rate of interest and interest payments;
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• Source of repayments;
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• Adequacy or inadequacy of capitalization;
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• Identity of interest between the creditor and stockholder;
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• Security, if any, obtained for the advances;
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• Corporation's ability to obtain financing from outside lending institutions;
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• Extent to which the advances were subordinated to the claims of outside creditors;
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• Extent to which the advances were used to acquire capital assets; and
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• Presence or absence of a sinking fund to provide repayments.8

In a recent case, the United States Bankruptcy Court for the District of Delaware declined to recharacterize debt where a creditor advanced funds evidenced by notes secured by a second property lien.9 In connection with the notes, the creditor received a seat on the board of directors of the debtor. For several months, the debtor paid interest in cash on the notes. Additional notes were issued in exchange for further advances. Subsequently, the debtor received additional funding from the creditor although no additional notes were issued for these funds. Funding was used primarily to satisfy critical working capital needs. Based on the record, the court made the following findings favoring characterization as debt: (i) the name given to the funding was debt; (ii) the intent of the parties was to create debt; (iii) the fundings had a fixed maturity date and interest rate.

Rejecting the plaintiff's request for recharacterization, the court held that insolvency of the debtor, undercapitalization, inability to pay cash interest and the fact that no disinterested third-party lender other than the defendants would lend money were not dispositive that the fundings were equity infusions.

In addition, the court was not persuaded by the plaintiff's argument that seats on the board favored recharacterization. The court explained that it was not unusual for lenders to have designees on a company's board to keep a close eye on the company's financial situation to protect their investments. While several factors slightly favored recharacterization, such as the absence of a sinking fund and the questionable adequacy of capitalization or collateral, the court determined that the majority of factors weighed toward characterization as debt.

Conversely, in 2002, the United States Bankruptcy Court for the District of Massachusetts, found recharacterization appropriate where four factors weighed in favor of recharacterizing "loans" as capital contributions. Specifically, the court found (i) inadequate capitalization at the time of transfer, (ii) a high degree of control of the debtor by the "lender," including significant involvement in the debtor's daily operations, (iii) no availability of similar loans from outside lenders and (iv) that defendant made no effort to collect (as an attempt to exercise his rights as a secured creditor would have put the company out of business).10

Although no one factor is controlling or decisive,11 the general rule appears to be that the more the transaction seems like an arm's-length deal, the more likely the transaction is a loan and not an equity contribution.

Unfortunately, in a distressed situation the parties most likely to advance additional funds are those that already have a vested interest in the company. However, given the inherent risk of such an investment, the insider will often insist that such investment be made as a loan rather than a capital contribution. The current case law and factors used to determine the "true nature" of a transaction may create a disincentive for such additional funds to be advanced to the company.

For further information about the courts' ability to recharacterize debt to equity, please contact:

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Endnotes
[1] See e.g., Citicorp Real Estate, Inc. v. PWA, Inc. (In re Georgetown Bldg. Assocs L.P.), 240 B.R. 124, 137 (Bankr. DDC 1999).
[2] In re Outboard Marine Corp., 2003 U.S. Dist LEXIS 1256413.
[3] See e.g., Committee of Unsecured Creditors v Logue (In re Logue Mechanical Contracting Corp.), 106 B.R. 436, 438 (Bankr. W.D. Pa. 1989).
[4] In re Pacific Exp., Inc, 69 B.R. 112, 115 (B.A.P. 9th Cir. 1986).
[5] In re Outboard Marine Corp. 2003 US Dist LEXIS 12564 (N.D. Ill. July 21, 2003).
[6] See e.g., Cohen v KB Mezzanine Fund II, L.P. (In re Sumicron Sys. Corp.), 291 B.R. 314, 322 (D. Del 2003); Aquino v Black, et al (In re Atlantic Rancher, Inc.), 279 B.R. 411, 433 (Bankr. D. Mass. 2002).
[7] In re Cold Harbor Assocs., L.P, 204 B.R. 904, 915 (Bankr. E.D. Va. 1997).
[8] In re Autostyle Plastics, Inc., 269 F.3d 726 (6th Cir. 2001).
[9] In re Submicron Systems Corporation, 291 B.R. 314 (Bankr. D. Del. 2003).
[10] Aquino v. Black (In re Atlantic Rancher, Inc.), 279 B.R. 411 (Bankr. D. Mass 2002).
[11] Roth Steel Tube Co. v Commissioner of Internal Revenue, 800 F.2d 625, 630 (6th Cir. 1986).