Recharacterization of Debt to Equity: From ‘Kabuki outcomes’ to a Gestalt Approach
By John T. Morrier*
In bankruptcy cases, recharacterization of debt to equity is a cause of action which is brought to transform a debt claim to an equity interest. The obvious result of recharacterization is that the creditor’s claim, instead of sharing ratably with other creditors, is deemed to be a capital contribution, subordinated to claims of other creditors, and usually in the bankruptcy context, extinguished.
Five circuits now recognize the power of the bankruptcy court to recharacterize debt to equity, and thus the source of the bankruptcy courts’ power to order the remedy is well settled. Courts differ in their application of the doctrine, however. In determining whether to recharacterize debt to equity, the vast majority of courts have developed and applied multi-part tests, and have examined 7, 11, 13 or sometimes even 15 factors, which not only can be difficult, but make results unpredictable.
Two recent circuit cases have adopted a more direct approach to debt recharacterization. Focusing on a fact specific inquiry, as opposed to an analysis of various factors, these courts examine the purported lending relationship, not as a summation of the various parts, but as a unified whole. This article will discuss the implications of the two recent circuit court of appeals cases which have utilized the holistic approach– Cohen v. KB Mezzanine Fund et al. (In re SubMicron Systems Corp.) (“Submicron”) and Fairchild Dornier GmbH v. Official Committee of Unsecured Creditors (In re Dornier Aviation (North America), Inc.) (“Dornier”).
At the outset, recharacterization must be distinguished from two related, but distinct, bankruptcy remedies – claim disallowance (or allowance) under Bankruptcy Code Section 502(b) and equitable subordination under Bankruptcy Code Section 510(c). Disallowance under section 502(b) is only appropriate where there is “no basis in fact or law” for a valid claim against a debtor’s estate. Equitable subordination and recharacterization are both equitable remedies, designed “to ensure that substance will not give way to form, that technical considerations will not prevent substantial justice from being done.” In determining the applicability of equitable subordination, the focus is on the conduct of the creditor, and whether there was some inequitable conduct and harm which requires a remedy.
In contrast, the determination of debt recharacterization, focuses on the transaction, and specifically whether a debt even exists.
Recharacterization has emerged as a separate remedy, a distinct bankruptcy cause of action, despite criticism that it is not based in a particular statutory provision. The recharacterization analysis has its genesis in tax cases, where courts have faced the question of whether a particular financial arrangement among insiders should be considered debt or equity for tax purposes. The lead test in this arena comes from the Sixth Circuit case Roth Steel Tube Co. v. Comm’r of Internal Revenue. Roth Steel, which was adopted by the Sixth Circuit in the bankruptcy context, sets forth eleven factors for consideration:
- the names given to the instruments, if any, evidencing the indebtedness;
- the presence or absence of a fixed maturity date and schedule of payments;
- the presence or absence of a fixed interest rate and interest payments;
- the source of repayments;
- the adequacy of capitalization;
- the identity of interest between creditor and stockholder;
- the security, if any, for the advances;
- the corporation’s ability to obtain financing from outside lending institutions;
- the extent to which the advances were subordinated to the claims of outside creditors;
- the extent to which the advances were used to acquire capital assets; and
- the presence or absence of a sinking fund to provide repayments.
The Tenth and Eleventh Circuits have adopted a 13-factor test, largely overlapping with the 11 Roth Steel/Autostyle Plastics factors. And in the Ninth Circuit, the bankruptcy appellate panel has rejected recharacterization as a separate remedy.
Submicron, Dornier and the Gestalt approach
Lower courts have struggled to apply these multi-factor tests, and the cases include much discussion of which one or subset of the factors is most important. The two circuit courts which most recently considered the question, Submicron and Dornier, have refined the approach. Both courts in these cases evaluated the financial relationship at issue in a particular case as an integrated whole, and focused on the one question: did the parties intend there to be a loan or an equity investment?
In Submicron, the Third Circuit noted the various multi-factor tests, including a seven-factor test used by the district court in the determining the matter below, but found the factor-based approach lacking: “No mechanistic scorecard suffices. And none should, for Kabuki outcomes elude difficult fact patterns.” The court articulated an approach which considers the transaction as a whole, an “overarching inquiry:”
While these tests undoubtedly include pertinent factors, they devolve to an overarching inquiry: the characterization as debt or equity is a court’s attempt to discern whether the parties called an instrument one thing when in fact they intended it as something else.
In Submicron, the creditors committee challenged the use of purported secured debt as the basis for a credit bid in an asset sale under section 363. The district court applied a multi-factor test, and determined that the purported debt should not be recharacterized as equity. On appeal, the circuit court reviewed the facts which supported the lower court decision. Considering many of the dozen or so factors employed in prior circuit decisions, the court analyzed the purported lending relationship as a whole. In support of the conclusion that the instruments in question were debt, the court noted the following facts: the name given to the financing was debt, the instruments carried fixed maturity and interest, the debtor had booked the funding as debt on its books and in public filings with the SEC, and the security interest in the debtor’s assets was perfected. Facts tending to support recharacterization include the lender’s participation on the debtor’s board of directors, and the fact that notes were not issued for a particular tranche of the questioned funding. Further, both the district court and the circuit court noted that, as with the debtor, “when a corporation is undercapitalized, a court is more skeptical of purported loans made to it because they may in reality be infusions of capital,” however, “when existing lenders make loans to a distressed company, they are trying to protect their existing loans.” Accordingly, the court did not consider as determinative to a recharacterization analysis the question of whether an unrelated lender would have made the loans. Ultimately looking at the financing as a whole, the court found that these facts were insufficient to support recharacterization.
In Dornier, the Fourth Circuit not only upheld recharacterization as a remedy, it actually recharacterized the transaction to equity. Further, it applied an approach akin to the Submicron “overarching inquiry.” Dornier Aviation North America, the debtor, was a wholly-owned subsidiary of Fairchild Dornier, GMBH. The parent sold parts on credit to the subsidiary, which in turn, used the parts to provide warranty support to the parent’s customers in the North American market, or resold them to non-warranty customers. Standard invoices on net-30 terms were issued for each sale from parent to sub, however, the parties had an arrangement that the subsidiary did not have to repay the parent for non-warranty parts until it became profitable. Annually, the parent reconciled the account balance, and repeatedly deferred the sub’s obligation to repay the intercompany debt. Eventually, the subsidiary landed in bankruptcy court, and despite efforts to reorganize, proposed and confirmed a liquidating plan. The parent asserted a claim of approximately $146 million, including capital advances and the claim for the sale of spare parts. On a challenge by the official committee of unsecured creditors, the bankruptcy court recharacterized the majority of the parent’s claim, including the spare parts claim.
While the bankruptcy court discussed both the 11-factor test of Roth / AutoStyle Plastics and the 13-factor test of Hedged-Investments, and the district court discussed a 13-factor test applied by a Virginia bankruptcy court, the Fourth Circuit stated that “the substance of all of these multi-factor tests is identical.” Ultimately, the Fourth Circuit found five facts particularly significant in concluding that the transaction “on the whole was more consistent with a capital contribution:”
- the insider status of the parent and sub relationship;
- the lack of any fixed maturity date for the intercompany obligation;
- the agreement to defer repayment until the sub was profitable;
- the fact that the sub had long been unprofitable; and
- the parent’s assumption of the subsidiary’s operating losses.
Again, the entirety of the credit relationship was considered, as opposed to a listing of which of a dozen factors supported (or not) recharacterization.
The analysis employed by the courts in Submicron and Dornier reinforces the broadly accepted principle that recharacterization is a question of fact, not of law, and as such, a lower court’s determination of the issue cannot be overturned unless clearly erroneous. The Sixth and Ninth Circuits are in agreement. And while these courts followed a different approach from courts applying the multi-factor test, they do not entirely reject the traditional approach. The Submicron and Dornier courts distilled the inquiry to two basic questions: 1) Does the loan have the indicia of an arm’s length transaction? and, 2) What was the intention of the parties in creating the investment? Like courts applying the traditional approach, these decisions emphasize that a purported lending relationship involving insiders depends on the intent of the parties, that no one factor should mechanically decide the question, and that the facts which form the basis of the transaction are critical.