Restructuring

Contributed by Christopher Hopkins
Recharacterization: an overview
The Bankruptcy Code provides numerous mechanisms to ensure the equitable and efficient administration of claims against a debtor’s estate.  Certain courts, however, have gone beyond the express provisions of the Bankruptcy Code and fashioned the remedy of recharacterization as a means of enforcing the Bankruptcy Code’s priority scheme.  Recharacterization involves the reclassification of a purported debt claim to equity based on the economic substance of the transaction.  In so doing, courts endeavor to prevent parties from disguising equity investments or capital contributions as debt transactions as a means to receive treatment on par with a debtor’s creditors in the event the investment fails (i.e., the debtor files for bankruptcy).  
Are you my code section?  Recharacterization and the Bankruptcy Code
Courts are divided as to which provision of the Bankruptcy Code grants courts authority to recharacterize debt claims as equity.  The Third, Fourth, Sixth, and Tenth Circuits have held that a court’s power to grant such a remedy is within the scope of the court’s equitable powers granted by section 105(a) of the Bankruptcy Code.  In contrast, the Fifth and Ninth Circuits have rejected reliance on section 105(a), and held that, pursuant to section 502(b) of the Bankruptcy Code, courts may only recharacterize debt as equity where applicable state law would treat the asserted interest as equity.
Whether a court relies on section 105(a) or 502(b) for the authority to recharacterize a claim has a real effect on the degree of recharacterization risk faced by a lender entering into a financing transaction with a distressed entity.  Courts that recharacterize debt as equity pursuant to section 105(a) generally apply a multi-factor test that looks to the economic terms of the relevant transaction and the surrounding circumstances to determine whether, as an equitable matter, a purported debt claim should be reclassified as equity.  Courts that apply section 502(b), on the other hand, will only recharacterize where the applicable “claim” would be treated as equity under applicable state law.  Accordingly, parties structuring financing transactions with a distressed entity should consider whether, if the borrower commenced a bankruptcy case, the relevant court would apply an equitable test or look to state law to determine whether recharacterization is appropriate.
The Tenth Circuit’s recent split decision in In re Alternate Fuels, Inc. addressed these issues, including whether two recent Supreme Court decisions—Travelers Casualty & Surety Co. of America v. Pacific Gas & Electric Co. and Law v. Siegel—resolved the circuit split regarding the court’s authority to recharacterize debt as equity under the Bankruptcy Code.  In addition, the case provides a useful example of how courts that rely on section 105(a) apply the multi-factor test to determine whether recharacterization is appropriate.
In re Alternate Fuels, Inc.
As early as 1999, Alternate Fuels, Inc. (“AFI”) was a shell of a coal mining company that had already been through one bankruptcy proceeding and no longer conducted any active mining operations.  Instead, Cimarron Energy Co., LLC (“Cimarron”), an entity in which AFI’s sole shareholder held 99% of the equity, operated AFI’s mining sites.  AFI retained certain obligations, however, including certain “reclamation obligations” owed to the State of Missouri, which required AFI to reclaim its mining sites once mining operations ceased.  As security for these obligations, AFI’s sole shareholder provided reclamation bonds to the state.  The reclamation bonds were secured by certificates of deposit valued at approximately $1.4 million.
AFI’s sole shareholder subsequently sold his interest in Cimarron and AFI to an investor (the “Purchaser”), and assigned the certificates of deposit securing AFI’s reclamation obligations to the Purchaser.  The Purchaser planned to fulfill AFI’s reclamation obligations for less than the value of the certificates of deposit, thereby making a profit when the certificates were released back to the Purchaser.  It had no intention of operating AFI as a going concern.
Following the sale, AFI issued three promissory notes of varying amounts to the Purchaser that were due on the earlier of (i) five years from the execution date of the notes and (ii) the issuance of reclamation bond receipts by the State.  AFI would owe no money on the notes if the Purchaser received the certificates of deposit.  AFI had no income during this time other than certain advances provided by the Purchaser, which were used to pay Cimarron’s operating expenses.
In 2002, AFI brought and won a lawsuit against the State, eventually obtaining an award of $5.5 million plus punitive damages of $900,000.  After the commencement of the suit, but prior to the issuance of the judgment in AFI’s favor, the Purchaser required AFI to assign $3 million of any potential award over to the Purchaser as security for the continued cash advances and outstanding promissory notes.  AFI also issued an additional promissory note to the Purchaser.  After receiving the judgment, however, AFI’s creditors began making claims against the judgment proceeds, which eventually led AFI to commence another bankruptcy case.
The Purchaser filed a proof of claim against the estate, which included a claim for $3.8 million for payment of the promissory notes, secured by AFI’s assignment of $3 million of the lawsuit proceeds.  After the Bankruptcy Appellate Panel for the Tenth Circuit affirmed the bankruptcy court’s decision to recharacterize the transfers underlying the promissory notes as equity, the Purchaser appealed to the Tenth Circuit.
Section 105(a) still rules in the Tenth Circuit
The Tenth Circuit first addressed the Purchaser’s argument that the Supreme Court’s decisions in Travelers and Siegel implicitly overruled the Tenth Circuit’s precedent and held that a court’s power to recharacterize arises solely from the disallowance provisions of section 502(b), rather than section 105(a).   The court rejected the Purchaser’s argument, noting in the first instance that neither Supreme Court decision specifically addressed recharacterization.  Rather, Travelers held that claims enforceable under state law will be allowed in bankruptcy unless they are expressly disallowed under the Bankruptcy Code, and Law held that a court may not employ section 105(a) to override other explicit mandates in the Bankruptcy Code.
In addition, the court found that, by attempting to apply Travelers and Law to the Tenth Circuit’s recharacterization precedent, the Purchaser conflated disallowance of a claim under section 502(b) with recharacterization under section 105(a).  Unlike claim disallowance under section 502(b) – which is appropriate when the claimant has no right to payment under state law – recharacterization is not an inquiry into the enforceability of claim.  Rather, it is an inquiry into the “true nature” of the transaction underlying the claim to determine whether the obligation should be treated as debt or equity.  Disallowance under section 502(b) extinguishes the debtor’s obligation to repay.  Recharacterization under section 105(a) simply reclassifies the obligation as equity.  Although the effect of recharacterization is often that the claimant’s obligation is never repaid, that is only because equity is repaid after all of the debtor’s creditors under the Bankruptcy Code’s priority scheme, not because the claimant has no right to repayment whatsoever from the debtor.
Recharacterization was not appropriate under the Tenth Circuit’s Hedged-Investments test
Turning to whether recharacterization of the Purchaser’s claim was warranted under section 105(a), the Tenth Circuit applied a thirteen-factor test first adopted by the court in Sender v. The Bronze Group, Ltd. (In re Hedged-Investments Assoc., Inc.) and held that recharacterization was not warranted.   The thirteen factors, which the court noted are generally indicative of an arms-length transaction, are as follows:

1. names given to the certificates evidencing the indebtedness;
2. presence or absence of a fixed maturity date;
3. source of payments;
4. right to enforce payment of principal and interest;
5. participation in management flowing as a result;
6. status of the contribution in relation to other corporate creditors;
7. intent of the parties;
8. undercapitalization;
9. identity of interest between the creditor and stockholder;
10. source of interest payments;
11. ability of the corporation to obtain loans from outside lenders;
12. extent to which funds were used to acquire capital assets; and
13. failure of the debtor to repay on the due date or to seek a postponement.

In determining that recharacterization was not warranted, the court focused on the enforceability of the promissory notes under state law and the policy considerations that support applying the remedy of recharacterization sparingly.
The court began its analysis by noting that bankruptcy court had not found that the promissory notes were invalid or unenforceable under applicable state law.  The parties had named the certificates “Promissory Notes,” and they were “plainly instruments of indebtedness” because they reflected “an unconditional promise to pay a certain party a fixed amount of money, with interest, at a definite time.”  The court also noted that it was unlikely that the Purchaser – already the holder of 100% of the debtor’s equity prior to entering into the promissory notes – “would make additional equity investments for no additional equity,” reasoning that “after all, one cannot own more than all of a company’s stock.”
Further, the majority noted the “unhealthy deterrent effect” applying too much emphasis on undercapitalization in the recharacterization analysis would have on the ability of distressed entities to obtain rescue financing.  The majority reasoned that the market for rescue financing would be chilled if courts give disproportionate weight to the poor capital condition of faltering entities.  Finally, the majority was reluctant to recharacterize the Purchaser’s claim because it found no “improper purpose” in the Purchaser’s plan to purchase AFI solely for the purpose of fulfilling its reclamation obligations.
Conclusion
Although the circuit split continues as to whether a court’s authority to recharacterize debt as equity arises under section 105(a) or 502(b) of the Bankruptcy Code, it is at least clear in the Tenth Circuit that section 105(a) – and the equitable, multi-factor test applied thereunder – still applies.