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Vol 13, Num 1 l January 2016

Bankruptcy Litigation

► In This Issue:

Ferve E. Ozturk
Committee Newsletter Editor

We are excited to present this newsletter edition focusing on debt-equity recharacterization.  The newsletter explores recent decisions that have clarified case law on recharacterization, including analyzing the Tenth Circuit’s Alternate Fuels decision and other rulings.  The newsletter also features an article advising how practitioners can effectively use section 510(b) of the Bankruptcy Code, and discussing how courts have reviewed contemporaneous business records to evaluate the parties’ intentions at the time of the transaction.  We hope these articles will be useful to your practice.


Digging Deep into the Tenth Circuit’s Alternate Fuels Decision

Laura Coordes
Arizona State University
Sandra Day O’Connor
College of Law
Tempe, Ariz.

In June 2015, the Tenth Circuit Court of Appeals decided In re Alternate Fuels Inc., clarifying its position on debt-equity recharacterization in light of two Supreme Court decisions and further entrenching a circuit split on recharacterization analysis. This article provides an in-depth discussion of the case, as well as some thoughts on the implications for recharacterization analysis going forward.

Case Summary

Alternate Fuels Inc. (AFI) was a corporation that had engaged in surface coal mining operations. In 1996, after AFI filed its first bankruptcy petition and stopped all mining operations, John Warmack assumed control of AFI and formed a new company, Cimarron, to handle AFI’s remaining mining work. Cimarron completed the mining work in 1999, leaving AFI responsible for fulfilling reclamation obligations under Missouri law. » Read More

Guarding Your Character: Demonstrating Intent in Private-Equity Funding

Neil Steinkamp
Stout Risius Ross Inc.
New York

Robert Levine
Stout Risius Ross Inc.
New York

Private-equity funds typically provide capital to portfolio companies through equity infusions and debt financing depending on the fund’s investment strategy and the needs of the portfolio company. These strategies utilized by private-equity funds often unlock value for investors, but in the case of bankruptcy may make the fund a target of a recharacterization action by the trustee or other investors and creditors of a debtor. Fund principals should be mindful of the structure of the financing utilized, the documentation of those transactions, and the choice of law specified in order to avoid future recharacterization.

The federal circuits are currently split on the question of whether state law or federal bankruptcy law “provides the correct rule of decision regarding recharacterization,” which complicates any fund’s evaluation of the risks it faces. However, a number of decisions do provide guidance as to what represents a strong claim that can withstand a recharacterization challenge. Consistently, courts have considered multi-factor tests to frame a recharacterization inquiry. This piece will review the Third Circuit’s decision in Cohen v. KB Mezzanine Fund II, L.P. to provide guidance to private-equity funds and other investors considering the risks of a recharacterization challenge. » Read More

The Broad but Underused Subordination Under § 510(b)


Andrew D. Johnson
Onsager | Guyerson |
Fletcher | Johnson, LLC


Christian C. Onsager 
Onsager | Guyerson |
Fletcher | Johnson, LLC

Section 510(b) of the Bankruptcy Code expressly subordinates claims arising from the purchase or sale of a security in the debtor or an affiliate to the level of equity. It thus functions as a form of recharacterization. Despite its broad scope, § 510(b) is relatively underused, making it a potentially powerful tool for creative debtors, committees and trustees.

Section 510(b) Plain Language

Sandwiched between the enforceability of subordination agreements in § 510(a) and equitable subordination in § 510(c), § 510(b) provides:

For the purpose of distribution under this title, a claim arising from rescission of a purchase or sale of a security of the debtor or of an affiliate of the debtor, for damages arising from the purchase or sale of such a security, or for reimbursement or contribution allowed under section 502 [11 USCS § 502] on account of such a claim, shall be subordinated to all claims or interests that are senior to or equal the claim or interest represented by such security, except that if such security is common stock, such claim has the same priority as common stock. » Read More

Recharacterization of Debt to Equity in Bankruptcy Proceedings: A Split in the Circuits


Dale C. Schian
Schian Walker PLC


Tyler J. Grim
Schian Walker PLC

Courts have held that bankruptcy courts have the authority to recharacterize debt to equity if the circumstances warrant such treatment. However, circuit courts are divided as to which provision of the Bankruptcy Code provides such authority. The majority looks to the court’s equitable powers. The minority holds that the ability must be grounded in the allowance of claims pursuant to state law.

The Majority Approach: Authority to Recharacterization Pursuant to General Equitable Powers

The majority approach, adopted by the Third, Fourth, Sixth and Tenth Circuits, holds that a court’s power to grant such a remedy rests in the court’s equitable powers granted by Code § 105(a). Courts adopting the majority approach utilize multi-factor balancing tests patterned on federal tax law cases.

In In re AutoStyle Plastics, the Sixth Circuit articulated an 11-factor test that included (1) the names given to the instruments, if any, evidencing the indebtedness; (2) the presence or absence of a fixed maturity date and schedule of payments; (3) the presence or absence of a fixed rate of interest and interest payments; (4) the source of repayments; (5) the adequacy or inadequacy of capitalization; (6) the identity of interest between the creditor and the shareholder; (7) the security, if any, for the advances; (8) the corporation’s ability to obtain financing from outside lending institutions; (9) » Read More

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