Codification and Clarity: Debt Recharacterization
| Publication year | 2018 |
Codification and Clarity: Debt Recharacterization
Rebecca S. McMahon
Judicial recharacterization is a judge-made doctrine that allows a court to recharacterize a creditor's claim as an equity investment. Courts use judicial recharacterization as a mechanism to reorder the priority of payments if the judge believes that the true nature of the transaction has the characteristics of an equity relationship from the outset, despite being classified as a loan.
When a corporate entity files for bankruptcy, the court will follow a statutorily prescribed order by which creditors are entitled to receive payments. Only after all the creditors have been paid back will any remaining funds be distributed among the equity holders. By recharacterizing a debt transaction under the doctrine, a creditor's purported loan will be transformed into an equity investment. The judge's decision to recharacterize will push that creditor to the back of the line, making it unlikely that the party will receive any payout.
Recent debate has centered around the unwieldy and unpredictable nature of these recharacterizations. Creditors often face dramatic differences in the outcome of litigation depending on the jurisdiction in which their claim arises.
While analyzing a question of judicial recharacterization, jurisdictions that recognize the doctrine will confront three major considerations: (1) whether the Bankruptcy Code gives judges the authority to recharacterize debt as equity, absent an express provision; (2) what factors a judge with proper authority may utilize when recharacterizing a purported loan as equity; and (3) what standard of review a judge's recharacterization decision should be given.
Courts facing questions of judicial recharacterization have analyzed these aspects in dramatically different ways creating a split among the circuit courts on all three aspects. Without a Code provision directly addressing recharacterization, such splits among the circuits will only deepen and cause more confusion. Since recharacterization in a bankruptcy proceeding is the difference between receiving payment or receiving nothing at all, policy and equity considerations mandate a more uniform approach. This Comment argues for the codification of the doctrine of judicial recharacterization.
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A bankruptcy court has the ability to reorder the priority of claims by imposing the doctrine of equitable subordination1 or judicially recharacterizing a debt as equity.2 These doctrines are used under different circumstances to recharacterize investors' loans as equity, pushing them to the bottom of the payout.3 The effect of a bankruptcy court's recharacterization is similar to equitable subordination because in both cases the claim is subordinated below that of other creditors.4 However, these two doctrines arise under different scenarios. Section 510(c) of the Bankruptcy Code (the Code) codifies the doctrine of equitable subordination allowing courts to push a bad acting investor's loan to the bottom of the payout scheme.5 At the other end, judicial recharacterization of debt as equity is another mechanism courts often use to achieve the same end, absent misconduct.6 Although this doctrine is not codified, when recharacterized, the loan is transformed into equity which has the effect of being subordinated below the other creditors of the corporation. Such recharacterization adversely changes the creditor's payout point in the priority scheme in bankruptcy.
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For the purposes of comparison between equitable subordination and recharacterization, it is important to note that courts can "subordinate a claim only to another claim, or an equity interest to another equity interest. If a court equitably subordinates a claim as deeply as possible, that is, beneath all other claims, the subordinated claim must be satisfied in full before any distribution can be made to equity holders."7
As currently practiced, judicial recharacterization can be unpredictable and its application varies greatly across circuits that recognize it. Hence, there needs to be a more uniform standard for judicial recharacterizations. Such uniformity will result in more predictability for potential investors and may dissuade the upward trend in bad-acting institutions issuing those loans. While recognizing recharacterization may allow courts to subordinate an otherwise improper claim, absent misconduct, courts have construed their equitable powers too broadly due to the lack of statutory authority to recharacterize debt as equity under their general powers of equity.
Consider the following two scenarios when determining the relationship between judicial recharacterization, equitable subordination, and their respective impacts on the priority scheme mandated by the Code.
Scenario One, a vendor makes a "loan" to a troubled borrower and agrees to accept repayment only when the borrower begins making money again. Here, the entire amount of the "loan" would be ripe for recharacterization (from an unsecured debt claim to an equity interest) because the parties in fact treated the transfer as an equity investment (recovery dependent on company's performance) rather than a loan (payment due at stated maturity).
In Scenario Two, a major equity holder sitting on a debtor's board of directors obtained confidential information that claims will be paid at a higher rate under the debtor's plan of reorganization than the market generally perceives. He then surreptitiously purchases claims against the debtor in order to enhance his or her own recovery. His claims will remain what they were-claims-but they may be equitably subordinated to other claims if his acts are found to have been both inequitable and harmful to debtor or creditors.8
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These scenarios highlight the differences between the two doctrines that will be explained below and raise questions under what circumstances may each doctrine apply and how to apply them.
This Comment argues Congress should codify the concept of judicial recharacterization to promote more uniformity across courts by determining the most common circumstances for recharacterizing a loan. This Comment will also propose a proper federal recharacterization test and standard of review in the event of an appeal. Additionally, this Comment proposes a five-factor approach to federal recharacterization based on the most substantive factors the circuit courts have considered in their analyses. Finally, this Comment provides reasons for rejecting the remaining elements the circuits have considered.
Proponents of judicial recharacterization attempt to tie its power to the Code by either § 105(a), the general equitable provision, or § 502(b), the claim allowance provision.9 However, no circuit considers recharacterization under § 510(c). Section 510(c), the provision of the Code that permits equitable subordination, is an independent claim from recharacterization. Although often invoked in the same proceeding, courts do as they should; separate the claims and analyze them independently.
The most recognized mechanism to move a claim lower on the priority ladder is equitable subordination. However, equitable subordination is only triggered by "misconduct that causes injury to creditors (or shareholders) or confers an unfair advantage on a single creditor at the expense of others."10 In many instances, there is insufficient misconduct to trigger § 510(c), as the scenarios above highlight. In that event, the door is left open for those in a debtor-creditor relationship to manipulate the terms of the loan such that the true nature of the loan should have been classified as an equity transaction.
The first cases regarding recharacterization emerged in the late 1980's, meaning this not a novel issue. However, the lack of a specific Code provision surrounding the nearly thirty years of diverging case law has made this an unavoidable problem with a clear solution: codification.
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A. The Bankruptcy Code's Priority Scheme Affected by Judicial Recharacterization and Equitable Subordination
First, to understand the necessity for clarity of the law regarding recharacterization, it is essential to understand how the priority scheme in bankruptcy works. Where a creditor's transaction falls within the priority scheme will often dictate if and how much they will be paid back.11 In a bankruptcy proceeding, a priority scheme exists for the distribution of the debtor's assets.12 For this reason, creditors prefer their claims to be higher on the payout ladder.13
Congress included § 726 of the Code to determine the priority scheme, which requires all debt creditors to be paid before equity holders.14 However, with the codified authority from § 510(c), a bankruptcy court may alter the priority of an allowed claim via equitable subordination; that is, the court may reduce the priority of all or part of an allowed claim if it finds that the creditor engaged in inequitable conduct.15
Judicial recharacterization affects the statutorily prescribed priority scheme in the same way by moving a creditor's claim to the bottom of the payout, where it is likely they will receive no payments from the now-bankrupt corporation.
B. Equitable Subordination
Courts use the doctrine of equitable subordination to "remedy misconduct that causes injury to creditors (or shareholders) or confers an unfair advantage on a single creditor at the expense of others."16 Section 510(c) of the Code states, "the court may . . . under principles of equitable subordination, subordinate for purposes of distribution . . . an allowed claim to . . . another allowed claim or . . . an allowed interest to all or part of another allowed interest."17 In order for
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a claim to be equitably subordinated, most courts follow the analysis set forth in Benjamin v. Diamond (In re Mobile Steel Corp.):18 (1) "the claimant...
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