US Stock MarketWhen a bankruptcy court ‘‘recharacterizes’’ debt, it causes something the parties have identified as debt to be converted into equity. Unlike an equitable subordination analysis, in which courts determine whether an acknowledged claim should be subordinated to that of other creditors due to a creditor’s inequitable conduct, a recharacterization analysis involves determining whether a debt actually exists.

There is a split of federal circuit court authority on a fundamental tenet of the recharacterization doctrine.  As discussed in the Tenth Circuit’s recent opinion in In re Alternative Fuels, 14-3086, 10th Circuit, June 12, 2015 (“Alternative Fuels“), the circuit courts are divided on the question of whether state law or federal bankruptcy law provides the correct rule of decision regarding recharacterization.

The term “recharacterization” is not found in the Bankruptcy Code.  Some courts have relied upon § 105(a) of the Bankruptcy Code as the source of authority to announce a federal law rule of recharacterization.  However § 105(a) only confers authority to “carry out” the provisions of the Code, and there is no “provision” of the Code addressing recharacterization to be carried out.  Nonetheless, citing § 105(a) of the Bankruptcy Code, the Sixth Circuit announced an influential 13 factor test for recharacterizing loans, see In re AutoStyle Plastics, Inc., 269 F.3d 726, 748, 750 (6th Cir. 2001).  The Tenth Circuit followed the AutoStyle approach in In re Hedged-Investments Assocs., Inc., 380 F.3d 1292 (10th Cir. 2004).

Alternatively, other circuits have instead focused on § 502(b) of the Bankruptcy Code as the initial source of authority to recharacterize. § 502(b) governs the allowance of claims in bankruptcy, and generally under § 502(b) non-bankruptcy (usually state) law provides the substantive elements of a claim.  See Raleigh v. Illinois Department of Revenue, 530 U.S. 15 (2000). Thus these circuit courts have held that to determine whether a particular obligation owed by the debtor is a ‘claim’ for purposes of bankruptcy law, including for purposes of a claim versus equity recharacterization analysis, a court must simply “determine whether that obligation gives the holder of the obligation a ‘right to payment’ under state law.” In re Fitness Holdings Int’l, Inc., 714 F.3d 1141, 1148–49 (9th Cir. 2013); see also In re Lothian Oil, Inc., 650 F.3d 539, 542–44 (5th Cir. 2011).

In Alternative Fuels, the Tenth Circuit considers then rejects these state law based tests for recharacterization, reasoning:

Although related, disallowance and recharacterization require different inquiries and serve different functions. Under § 502(b), disallowance of a claim is appropriate “when the claimant has no rights vis-à-vis the bankrupt, i.e., when there is ‘no basis in fact or law’ for any recovery from the debtor.” [citation omitted]

Recharacterization, on the other hand, is not an inquiry into the enforceability of a claim; instead, it is an inquiry into the true nature of a transaction underlying a claim. In this way, recharacterization is part of a long tradition of courts applying the “substance over form” doctrine. [citation omitted]

While unanimously rejecting the creditor’s argument that state law governed, the Tenth Circuit panel voted 2-1 in favor of the creditor on the merits.  At issue was the substance of a claim asserted by the debtor’s sole stockholder.  In holding the sole stockholder held a true debt claim, the majority opinion places significant weight on the fact the sole stockholder held written promissory notes evidencing the debt, which contained a maturity date for when the loans were due, and which provided for interest.

The majority opinion also addressed the applicability of an AutoStyle based factor to the single stockholder situation: “if advances are made by stockholders in proportion to their respective stock ownership, an equity contribution is indicated.” The majority opinion limits the application of this factor in the single shareholder context stating:

“We see no reason to assume that all funds transferred to a business owned by a single stockholder must be in the nature of equity. To be sure, there may be circumstances where a single stockholder may infuse equity to finance fixed assets or expand the business. But absent some conscious purpose, and given the nature of recharacterization, we question why a holder of all of a company’s stock would make additional equity investments in exchange for no additional equity; after all, one cannot own more than all of a company’s stock.”

The dissent argued that while there was documentary evidence of debt, most factors support recharacterization because the single shareholder had put money in as a gamble and the funds were thus best understood as equity investments.

In sum, the Alternative Fuels opinion serves as a reminder that the federal circuits are in conflict regarding the legal basis for the recharacterization doctrine.   This disagreement may present the U.S. Supreme Court with an opportunity to eventually weigh in and clarify the proper source of the standards governing recharacterization.  If and when the Supreme Court reviews this doctrine, it can be expected that either the Court will adopt a single, uniform federal law base rule for recharacterization, or hold that state law governs, potentially resulting in a patchwork of up to 50 state law based rules for recharacterization.