While bankruptcy law in the U.S. and most other countries is largely a matter of national-level bankruptcy law, the battle between local (state) and national (federal) law causes persistent confusion in the United States, and the choice between the two is often outcome determinative. One area where this is true, and of particular interest to hedge fund investors, is the bankruptcy court’s power to recharacterize a debt claim, as an equity investment.
Since debt enjoys priority of payment in insolvency proceedings, demoting a debt claim to the lower rank of an equity interest likely means a total loss for the distressed investor. The threat here is greater and more nuanced than the similar procedure of equitable subordination. While “inequitable” conduct by the claimant is the lynchpin of the bankruptcy court’s subordinating a debt claim, having one’s debt claim relabeled as an out-of-the-money equity stake has a very similar effect but often with a “no fault” analysis.
Anticipating a potential recharacterization should be an essential aspect of due diligence preceding any distressed lending decision, especially in the context of loans from hedge funds that already occupy substantial equity positions in the potential borrower. The relevant analysis and risk level vary considerably depending upon which rules one applies. State law on debt-to-equity recharacterization tends to be fairly underdeveloped and favorable to the lender; that is, without some “fault” on the part of the lender, the parties’ debt label for their transaction will usually not be disturbed.1
As for federal law, while no provision of the U.S. Bankruptcy Code addresses recharacterization directly, the bankruptcy courts have developed a bewildering doctrine that applies objective, but unpredictable, multi-factor tests to recast loans as equity investments, often in situations involving no fault on the part of the lender at all.
If a distressed borrower ends up in US bankruptcy court, which of these approaches a lender can expect to have applied to a claim depends on the location of the bankruptcy filing and is currently in flux, as illustrated by two relatively recent appellate court holdings.
First, in April 2013, the 9th Circuit Court of Appeals (governing federal courts in California and much of the western quarter of the US) issued a groundbreaking opinion that might portend a constructive shift in recharacterization jurisprudence.2 In the reorganization and then liquidation of a home fitness company, Fitness Holdings International (FHI), the creditors’ committee and later the trustee sought to recast nearly $25 million in loans from FHI’s sole shareholder as equity.
The lower courts refused this request and abided by earlier precedent in that circuit prohibiting debt-to-equity recharacterization. Since recharacterization is so similar to subordination, and the former lacks any specific statutory treatment in the Bankruptcy Code, the 9th Circuit Bankruptcy Appellate Panel had ruled that subordination by extra-statutory means was implicitly excluded by statute. The 9th Circuit Court of Appeals rejected this longstanding prohibition and held that recharacterization is, indeed, allowed in that circuit, but not in the way many had expected.
In other circuits that had addressed the issue, most notably the 3rd Circuit (governing the all-important Delaware bankruptcy court) and many bankruptcy courts in New York, the standards for recharacterizing debt as equity had developed organically. Relying on their equitable powers to administer bankruptcy estates, the federal bankruptcy courts had cobbled together a series of tests with varying numbers of factors, never indicating which factors were most important, and never offering much clarity in terms of specific transaction details which likely would or would not trigger recharacterization. Standard, well-documented and enforced arm’s-length loan transactions from insider-lenders would likely withstand scrutiny, while non-traditional, after-the-fact, or sloppy loan documentation might well have the opposite effect, but these tests offered little certainty or predictability.
The 9th Circuit rejected this ad hoc approach, opting instead for the approach taken earlier by the 5th Circuit (governing federal courts in Texas, Louisiana, and Mississippi). The Supreme Court had indicated repeatedly that, in the absence of a specific federal rule for any given issue, “applicable law” should be state law, particularly with respect to property and contract rights, such as whether a creditor’s claim is properly characterized as debt or equity.
If the relevant state’s jurisprudence lacks sufficient guidance on whether and under what circumstances to recast debt as equity, the federal courts have processes to overcome this problem (such as certifying a question to the state’s Supreme Court or predicting what the state Supreme Court would do based on cognate state jurisprudence). But making up new federal tests out of whole cloth will not do, the 9th Circuit held, remanding the case for a determination of the relevant state law.
In contrast, in a decision handed down in March 2014, the 10th Circuit Bankruptcy Appellate Panel (BAP) seems to have misunderstood this line of argumentation entirely.3 In the Chapter 11 case of the Kansas mining company Alternate Fuels, Inc., the Chapter 11 trustee sought to have about $4.5 million in loans from the company’s beneficial owner recharacterized as equity.
Applying the applicable 13-factor test applied in the 10th Circuit, the bankruptcy court granted the Trustee’s request, and the BAP affirmed this ruling. Given the facts of the insider-lender’s intent in making the loan and its sloppy documentation, this claim would likely have been recharacterized under any federal standard. But the lender pointed to the Supreme Court bankruptcy precedent mentioned above.
He argued that Kansas law, not federal law, should determine the nature of his claim, and he asserted that Kansas law did not allow for recharacterization. The BAP seemed not to understand the argument, and in any event, it rebuffed the challenge, concluding curtly that Supreme Court precedent had neither explicitly nor implicitly abrogated the 10th Circuit’s longstanding recharacterization doctrine.
A serious approach to the Supreme Court’s bankruptcy federalism jurisprudence could and perhaps should have compelled the 10th Circuit BAP to a different conclusion. The 9th Circuit’s conclusion in Fitness Holdings took this jurisprudence seriously and oriented that circuit’s recharacterization doctrine in a more consistent, possibly more certain, and likely more lender-friendly position. The compelling argument advanced in Wilson’s and Moeller-Sally’s very fine article in The Business Lawyer (see above, note 1) has gained traction in two important circuits now, and one suspects it will only be a matter of time before other circuits follow suit.
- A particularly illuminating source on this issue is James M. Wilson’s and Stephen Moeller-Sally’s article in volume 62 (August 2007) of The Business Lawyer, “Debt Recharacterization Under State Law” (pp. 1257-80).
- Official Comm. of Unsecured Creditors v. Hancock Park Capital II LP (In re Fitness Holdings Int’l Inc.), 714 F.3d 1141 (9th Cir. 2013).
- Redmond v. Cimarron Energy Co. (In re Alternate Fuels, Inc.), BAP No. KS-12-110, Bankr. No. 09-20173 (BAP 10th Cir., Mar. 18, 2014).