Bankruptcy, Debt Recharacterisation, and the Constitution: An Erie Relationship.

AuthorSchlagel, Cameron J.

    A circuit split has emerged on the issue of debt recharacterization in bankruptcy. Debt recharacterization is a judicially-created "equitable remedy" whereby a bankruptcy court reclassifies a purported debt--usually a loan from a corporate insider to the corporation--as a capital contribution. Recharacterization in bankruptcy has the practical effect of subordinating the recharacterized claim to the lowest rung in the Bankruptcy Code's (1) priority ladder. There is general agreement that a bankruptcy court has the power to recharacterize debt as equity in certain circumstances. (2) A split has arisen among circuit courts of appeal, however, with regard to the proper test for determining whether a claim should be recharacterized. (3) The circuit decisions generally fall into one of two categories: those which have adopted or developed a test under federal common law and those that look to state law tests.

    The majority of circuits--five of the seven circuits that have addressed the issue--have determined the recharacterization question by applying either one of two different federal tests: (1) a "per se" rule; (4) or (2) a multi-factor test. (5) Within the majority that subscribes to the federal law approach, most circuits have applied variations of the multi-factor test set forth by the Sixth Circuit in Fairchild Dornier GmbH v. Official Comm. of Unsecured Creditors (In re Dornier Aviation (AutoStyle Plastics). (6) Some circuits have modified the AutoStyle Plastics test; however, notwithstanding these modifications, the circuits generally agree on the rationale underlying the AutoStyle Plastics test, and the determinative effect it has on the claim at issue. (7)

    The Eleventh Circuit has taken a narrower approach. In Estes v. N & D Properties, Inc. (In re N & D Properties, Inc.,) (8) it identified only two circumstances in which recharacterization is appropriate. (9) "Shareholder loans may be deemed capital contributions in one of two circumstances: where the trustee proves initial under-capitalization or where the trustee proves that the loans were made when no other disinterested lender would have extended credit." This test has struggled to gain followers. Most commentators view it as a strict, "per se" rule that does not sufficiently account for the various complexities that are almost always present in cases where the "debt versus equity" characterization is at issue. (10)

    A distinct minority, comprised of only the Fifth Circuit and the Ninth Circuit, refer to state law to determine the issue of recharacterization. (11) Whereas the majority circuits find the source of authority to recharacterize debt in the bankruptcy court's general equitable powers under 11 U.S.C. [section] 105(a), the minority circuits have framed the issue of recharacterization as an issue of whether the creditor has an allowable "claim" under 11 U.S.C. [section] 502. Section 502 looks to applicable nonbankruptcy law, usually state law, to determine whether a "claim" exists. It then imposes a few additional bankruptcy limitations on the recognition of those claims. (12)

    Regardless of the approach followed, the use of the recharacterization doctrine in bankruptcy is on the rise. Some commentators have noted that the increased usage has led to "fiery debates among bankruptcy practitioners, overreaching by bankruptcy courts, and unpredictability in lending relationships." (13) The lack of consensus as to the proper test has exacerbated this unpredictability. Moreover, there is a fundamental flaw in the courts' analyses of recharacterization to this point. Courts have failed to consider, in any worthy detail, the relationship between the Erie doctrine, (14) debt recharacterization, and the Bankruptcy Code.

    Part I of this Article focuses on the current development of debt recharacterization in the federal courts and the analytical framework on which these courts rely. This will include a discussion on the importance of the "debt" versus "equity" characterization in bankruptcy, the authority of bankruptcy courts to apply the doctrine of equitable subordination, and the original emergence of the debt recharacterization doctrine in bankruptcy. Finally, Part I will chronicle the conflicting recharacterization analyses that exist today in the federal courts.

    Part II discusses the constitutional considerations that are necessarily implicated in debt recharacterization cases. It also proposes a solution. This solution is found within the context of the constitutional limits on the power of the bankruptcy courts and federalism as determined in Erie R. Co. v. Tompkins (15) and its progeny. The latter suggest, and indeed require, that the question of recharacterization be determined by state law. Federal courts should adopt a two-step approach. First, the court must determine whether a claim for recharacterization exists under applicable state law. (16) If state law does, then the court may go through the state law recharacterization analysis. If, however, the state has not recognized recharacterization as either a defense to the existence of a debt or as a cause of action, (17) the federal court does not have the constitutional authority to recharacterize the debt based on a federal common law rule.


    1. The Doctrine of Recharacterization and the Importance of the Debt versus Equity Characterization in Bankruptcy

      The characterization of a financing transaction as either debt or equity in bankruptcy has an undeniably important effect on the substantive rights of claim holders under the Bankruptcy Code's priority scheme. (18) Secured claims and equity are both defined and treated differently under the Code. (19) The term "debt" is defined as "liability on a claim." (20) The Code defines a "claim" as "a right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured." (21) Thus, reading these provisions together, the Code broadly defines "debt" as liability on virtually any type of "right to payment."

      A "creditor" is an "entity that has a claim against the debtor that arose at the time of or before the order for relief concerning the debtor." (22) However, the Code does not define either "right to payment" or "arose." This is, thus, one of the instances where nonbankruptcy law is determinative, and because "nonbankruptcy law" is largely state law, "the Code expressly and impliedly depends on state law." (23) The Code, therefore, "depends on nonbankruptcy law for the determination of who is a creditor eligible to receive a share of the debtors prepetition property." (24) This means that to meet the Code's definition of a "creditor" eligible to receive a distribution from the bankruptcy estate, a "right to payment" must exist under nonbankruptcy law, and the time when that right to payment "arises" must also be determined by nonbankruptcy law. (25)

      In most cases, the determination of who is a creditor is fairly straightforward. For example, "[a] person who signs a note or purchases goods on account incurs an obligation to pay, and the payee has a right to payment that arose at the time of the signing of the note or the purchase of the goods." (26) Typically, creditors "register" or give notice of their claims by filing a "proof of claim." (27) If no party in interest files an objection to the claim, (28) the proof of claim establishes the respective creditors priority in the distribution of the estate assets. (29) The basic system of priority in the Bankruptcy Code determines the order in which the assets of the estate will be distributed for payment of various creditors' claims. (30) The "kind" of claim, how the claim is classified or characterized under applicable law, determines where the claim falls within the priority scheme. (31) As the Court explained in Czyzewski v. Jevic Holding Corp.: (32)

      Secured creditors are highest on the priority list, for they must receive the proceeds of the collateral that secures their debts. 11 U.S.C. [section] 725. Special classes of creditors, such as those who hold certain claims for taxes or wages, come next in a listed order. [section][section] 507, 726(a)(1). Then come low-priority creditors, including general unsecured creditors. [section] 726(a)(2). The Code places equity holders at the bottom of the priority list. They receive nothing until all previously listed creditors have been paid in full. [section] 726(a)(6). (33) In most bankruptcy cases where recharacterization has been an issue, "the party which made the capital contribution typically argues that the transaction created a debt obligation, thereby giving the contributor a claim against the bankruptcy estate." (34) The implication is that by classifying the capital contribution as a debt, the creditor-contributor will receive distribution from the estate as a claim holder before other equity holders are paid, thereby increasing the likelihood of being reimbursed for the pre-petition infusion of capital. (35) The inequities apparent in this scenario are obvious.

      In the not so distant past, most federal courts addressed this type of inequity by equitably subordinating (36) the insider's claim to a lower rung of the priority ladder. (37) Under the doctrine of equitable subordination, a bankruptcy court has the equitable power to subordinate a claim (i.e. reorder priorities) in circumstances where the creditor engaged in inequitable conduct, such as fraud, breach of fiduciary duty, undercapitalization, or due to use of the debtor as an alter ego. (38) Pursuant to section 510(c) of the Bankruptcy Code, after notice and a hearing, a bankruptcy court may:

      (1) under principles of equitable subordination, 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...

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