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Vol 12, Num 3 l August 2015

Secured Credit - an ABI Newsletter


Recharacterizing Debt as Equity and Equitable Subordination: Some Disagreement


Donald L. Swanson
Koley Jessen P.C., L.L.O.
Omaha, Neb.

In In re Alternate Fuels Inc.[1], the Tenth Circuit Court of Appeals describes and applies standards for (1) recharacterizing debt claims as camouflaged equity and (2) equitably subordinating debt claims. In doing so, the court confirmed two things:

  1. Describing the legal standards is relatively easy: In Alternate Fuels, seven judges (one bankruptcy, three BAP and three circuit) all describe the same legal standards; but
  2. Applying the standards in Alternate Fuels is not so easy: Five judges (one bankruptcy, three BAP, and one circuit dissent) all recharacterize debt as equity and equitably subordinate the debt, while the circuit’s two-judge majority reviews the same record, applies the same law, disagrees, and reverses on all counts.

How can such a disagreement happen?

Recharacterizing a Debt Claim as Equity
The context for disagreement centers on recharactarization issues. Recharacterization is an extraordinary, judicially created remedy, with a history of controversy. At least seven circuits recognize recharactarization: Third, Fourth, Fifth, Sixth, Seventh, Tenth and Eleventh. Only the Ninth has rejected it. The Eighth is one that hasn’t addressed it. Most recharacterization circuits, including the Tenth, follow a restrained approach: a multi-factor test for arm’s length negotiations. The Fifth, in a more-restrictive approach, allows recharacterization only when authorized by state law. The Eleventh, on the other hand, has a two-pronged test (undercapitalization and unavailability of outside credit) that creates a potentially expansive remedy.[2]

Authority for recharacterization arises under 11 U.S.C. § 105(a). Recharacterization ignores labels and recognizes the true substance of a transaction. It ensures that equity owners don’t “jump the line” and thwart outside creditors. Recharacterized debt is paid only after all other debt claims are satisfied.

The Tenth Circuit first articulated its restrained-approach standards for recharacterization more than a decade ago. The Alternate Fuels majority seems to be insisting that the restrained-approach remain truly restrained.
The Tenth Circuit applies a 13-factor recharacterization test. The test reflects characteristics of an arm’s length negotiation and is “highly fact-dependent.” The factors are nonexclusive, the significance of each varies with circumstances, and none is dispositive. The factors include language used, maturity date and enforcement provisions, sources of repayment, effects on management, intent of parties, adequacy of capitalization, availability of outside credit, use of funds and subsequent defaults.

The majority describes the facts, apply the 13-factors test, and conclude that nothing is “inherently improper about this arrangement.” The “arrangement” is this: “Mr. Jenkins was engaged in a venture with substantial risk.... When the business needed additional financial support to reach its goal, Mr. Jenkins provided advances.”

It’s not that the majority finds the record mostly devoid of evidence supporting recharacterization. Instead, the majority emphasizes an underlying set of policies: (1) business owners must be allowed to become creditors of their own corporations when trying to salvage their failing businesses (“needlessly punishing” such efforts is neither “desirable as social policy” nor required by precedent), and (2) a court must decline to “pick winners and losers” based on its own view of “the social utility” of the businesses.

The bankruptcy court, BAP and dissent all apply the same 13-factor test to the same set of facts and reach an opposite conclusion from the majority. The dissent explains the conflicting conclusions this way: The bankruptcy court “more properly applied” the 13-factor test and “better followed” the “underlying policies.”

Equitable Subordination
The majority reverses the bankruptcy court’s equitable subordination ruling. One basis for reversal is the bankruptcy court’s heavy reliance on its recharacterization analysis for the subordination ruling.

Authority for equitable subordination is granted by U.S.C. § 510(c)(1) in generalized language: “[T]he court may ... under principles of equitable subordination, subordinate for purposes of distribution” one debt claim to another’s claim. Equitable subordination looks to the behavior of the parties.

The Tenth Circuit has three conditions for equitable subordination: inequitable conduct, injury to other creditors, and consistency with the Bankruptcy Code. The majority explains that “special emphasis” is placed on “inequitable conduct,” which comes in three categories: (1) fraud, illegality and breach of fiduciary duties; (2) undercapitalization; or (3) use of debtor as instrumentality or alter ego. “Inequitable conduct” must be gross and egregious, unless an insider or fiduciary is involved — then it need only involve “some unfair conduct, and a degree of culpability.”
As with recharacterization, the majority emphasizes certain policies in its subordination ruling. The majority notes that equitable subordination is an “extraordinary remedy” to be “employed by courts sparingly” and that judicial refusals to honor agreements “on amorphous grounds of equity” will spawn legal uncertainties.
The majority rejects the bankruptcy court’s finding of “unfair” conduct, explaining that the actions in question, though “perhaps atypical,” are not “unfair”: No fraud or illegality is alleged, undercapitalization “is not in itself inequitable conduct,” and alter-ego arguments are unpersuasive.
The equitable subordination reversal appears to be final for further proceedings: (1) the dissent doesn’t even use the term “equitable subordination,” and (2) the trustee’s 15-page petition for en banc hearing uses the term “equitable subordination” only once — in a footnote, to distinguish it from recharacterization.

Standard of Review
It seems that the majority rejects the bankruptcy court’s view of the evidence and substitutes its own view. Shouldn’t such a substitution be subject to a clearly erroneous standard of review?

The majority describes the standard of review like this: Recharacterization is a mixed question of fact and law in which factual findings are reviewed “for clear error,” but the “application of our legal test” to those facts is a question of law and reviewed de novo. So, it seems, the majority applies a de novo standard of review. Moreover, the majority minimizes any need for deference to trial court findings of fact. The majority notes that the bankruptcy court did not rely on an evaluation of oral testimony. Instead, the bankruptcy court admittedly relied heavily on exhibits and stipulated facts because it found neither of the primary fact witnesses to be very credible.

The dissent mentions standard-of-review issues only once, contending that findings on “intent” to repay are “subject to the clear error standard.” However, in his petition for an en banc hearing, the trustee contends that certain findings of fact must be accepted as true and “should be the end of the inquiry.”

Given the differing recharacterization standards among various circuit courts, here’s guessing that the trustee’s petition for an en banc hearing will be followed in due course by a petition for writ of certiorari.


1. No. 14-3086, 2015 WL 3635366 (10th Cir. June 12, 2015).

2. See In re Duke and King Acquisition Corp., 508 B.R. 107, 155- 58 (Bankr. D. Minn. 2014).

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