The Argument for a Federal Rule of Decision for a Bankruptcy Court's Recharacterisation of a Claim as Equity.

AuthorGrohsgal, Bruce


This article considers whether a federal or state rule of decision applies to a bankruptcy court's recharacterizing a claim as equity. Though every circuit that has considered recharacterization has authorized it, the circuits are split on whether federal or state law governs. I conclude that a federal decisional rule applies for several reasons.

The authority to recharacterize a claim as equity follows from the principle that a bankruptcy court must look to substance over form in determining claims and their distributional entitlements. A claim may be recharacterized if for example, the transaction giving rise to it was with an insider, was not at arm's length, and was structured for the insider's benefit in the form of a loan or other claim notwithstanding that in substance it was neither. Recharacterization disallows a claim qua claim and treats it as equity. Because under the bankruptcy statute's distributional rules, commonly called the absolute priority rule, equity holders generally are entitled to a distribution only if all creditors are paid in full, recharacterization safeguards creditors' distributional entitlements from the assertion of a claim, especially by an insider, that is a claim in name only.

My conclusion that a federal rule of decision applies to recharacterization begins with the bankruptcy court's statutory power to disallow a claim "according to the equities of the case." The Supreme Court in Pepper v. Litton authoritatively construed these words to authorize a bankruptcy court to recharacterize or otherwise disallow a claim on equitable grounds, especially when an insider who controlled the debtor structured the form of a transaction to elevate its distributional priority at the expense of the debtor's arm's-length creditors. Though [section] 57k of the Bankruptcy Act referred to the reconsideration of a claim, the Pepper Court held that the bankruptcy court's authority to recharacterize or otherwise disallow a claim extended to its determination of the claim in the first instance. The Pepper Court applied a federal rule of decision-to a claim that arose under state law-based on the equities referred to in the Act's text. It did not resort to Virginia law, which lively would have governed had state law applied, nor did it engage in any choice of law analysis.

In 1978, Congress, in Bankruptcy Code [section] 502(j), reenacted the "according to the equities of the case" provision of [section] 57k of the Act. The conclusion that Congress by this reenactment adopted Pepper's federal rule of decision is especially strong, because the Bankruptcy Code was the result of years of legislative deliberations intended to overhaul United States bankruptcy> law. Congress's delegation of authority to the bankruptcy courts to apply and develop a federal rule of decision on recharacterization is supported by the Code's text and legislative history, is in harmony with the structure of the Code, which contains many similar delegations, furthers bankruptcy policy, and is consistent with Erie v. Tompkins.


Introduction I. Recharacterization of Debt as Equity and the Related Doctrine of Equitable Subordination under Bankruptcy Law A. Recharacterization B. Equitable Subordination C. Recharacterization and Equitable Subordination Compared II. Federal' or State-Law Rule of Decision for Recharacterization--the Circuit Split III. The Supreme Court's Decision in Pepper v. Litton IV. The Effect of Erie on the Question V. The Congressional Reenactment of Pepper v. Litton's Federal Decisional Rule for Recharacterization A. Reenactment of the Federal Rule of Decision B. The Implication of the Code's Providing for Equitable Subordination Under [section] 510(c) VI. The Text of Code [section] 502(j) in the Context of Other Provisions of the Bankruptcy Code A. State-Law Rules of Decision Under the Bankruptcy Code B. Federal Rules of Decision Under the Bankruptcy Code C. Code References to Equitable Rules of Decision and the Consistency of These Equitable Rules with the Latitude Given by Congress to the Bankruptcy Courts on Other Decisional Matters D. Federal and State Law in the Allowance and Disallowance of Claims in Bankruptcy E. "Equities of the Case" in the Context of Other Code Provisions Regarding Claims VII. Policy Considerations A. Effectuating Bankruptcy Law's Fundamental Purpose of Distributions to Stakeholders in Accordance with the Code's Distributional Entitlements B. Certainty C. Encouraging the Extension of Credit to Troubled Companies D. Federal Question and Furtherance of the Erie Doctrine VIII. Conclusion INTRODUCTION

This article addresses whether a bankruptcy court, in recharacterizing a claim as equity, is required to apply a federal rule of decision or whether, instead, it must look to state law. Five circuits have applied a federal rule of decision, while the two circuits to consider the question most recently have held that state law applies. Resolving the issue requires consideration of both the Supreme Court's opinion in Butner v. United States, (1) holding that property rights generally are determined by state law in a bankruptcy case, and the provisions of the Bankruptcy Code of 1978, (2) by which Congress can alter state law pursuant to express Constitutional authority. For the reasons set forth, I conclude that the stronger argument is that a federal rule of decision applies under the provisions of the Code.

Recharacterization provides a significant remedy in bankruptcy by which the court determines that the form of debt asserted as owed to the claimant must give way to the substance of the transaction. (3) Bankruptcy courts may recharacterize debt as an equity ownership interest if, for example, the transaction that gave rise to the claim was with an insider and, thus, was not at arm's length; was structured to have the appearance of debt for the benefit of the insider; and was unfair to the company's "true" creditors who, if the insider's "claim" is allowed, might receive little or nothing on their genuine claims. Equity holders, such as shareholders, are entitled to a distribution in a bankruptcy case only if all creditors are paid in full. (4) The recharacterization of an asserted "claim" as equity thus both disallows and subordinates the claim to the holders of "true" claims, who will be paid before it, and preserves the Bankruptcy Code's rules for orderly distribution. Recharacterization is closely related to the doctrine of equitable subordination, pursuant to which a bankruptcy court, on equitable principles, may subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim. (5)

My conclusion that a federal rule of decision applies to recharacterization begins with the Supreme Court's authoritative construction in Pepper v. Litton (6) of Bankruptcy Act [section] 57k, discussed in Part III, which Congress in 1978 reenacted in Code [section] 502(j). (7) Bankruptcy Act [section] 57k expressly empowered a bankruptcy court to disallow a claim "for cause," "according to the equities of the case." (8) The Pepper Court construed this "equities of the case" provision to authorize the recharacterization or other disallowance of a claim because it was a claim in form only, was asserted by an insider, and the allowance of such claim would be inequitable to those creditors who had dealt at arm's length with the debtor. (9) Though [section] 57k referred to the court's "reconsideration" of an allowed claim (as does Code [section] 502(j), (10) by which Congress reenacted [section] 57k), the Court in Pepper construed that section to authorize disallowance on the same basis in the first instance, without regard to whether the claim previously had been allowed. (11)

The Court in Pepper did not consider Virginia law, which likely would have governed under the choice-of-law rules applicable to a state-law determination. Nor did the Court engage in any choice-of-law analysis. Its decision was founded on the words in [section] 57k that authorised disallowance of a claim "according to the equities of the case," with no mention of state law or other nonbankruptcy law. Notably, Pepper was decided in 1939-more than one year after its ground-shifting opinion concerning the lack of a federal general common law in Erie Railroad Co. v. Tompkins (12)--without any mention of Erie. In other bankruptcy cases decided after Pepper, however, the Court held that the rule of Erie-which might otherwise direct federal courts to a state-law decisional rule-was not implicated because the Act authorised a bankruptcy court, on equitable principles, to disallow a claim that arose under state law. (13) These Supreme Court decisions-citing both Pepper and Erie-underscore that the enacted provisions of the bankruptcy statute, and not state law, are the ultimate ground on which a claim is allowed or disallowed in a bankruptcy proceeding, notwithstanding that the claim arises under state law. (14)

Congress expressly reenacted the key clause of [section] 57k of the Act-which the Court had authoritatively construed to provide a federal rule for disallowance "according to the equities of the case"-in [section] 502(j) of the Code in 1978, as discussed in Part IV. (15) Under ordinary rules of statutory construction, this reenactment is presumed to be understood according to "settled judicial construction" under the prior law of the Act. (16) The presumption is all the stronger with the Bankruptcy Code, for the reasons considered in Part V of this article. The text of the Code, as discussed in Part VI, also indicates that Congress has directed the bankruptcy courts in appropriate cases to disallow claims, which arise under state law, if a federal equitable rule re* quires it.

Strong policy reasons also support a federal rather than a state rule of decision for recharacterization. The most fundamental purpose of bankruptcy law is the orderly distribution of...

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