Advanced Distressed Debt: Recharacterization

One of the the more fought over issues in contentious bankruptcy proceedings revolves around whether a loan is really a loan. Unsecured creditors often fight to "recharacterize" a loan as really equity. Why? Because that leaves a much larger piece of the pie for them, relative to diminished recoveries that would be absorbed by senior lenders. While the bankruptcy code doesn't specifically address the issue of recharacterization, jurisdictions across the country have developed their own ways and analyses to test whether an instrument can be recharacterized.

DDI contributor George Mesires has penned a fantastic piece below regarding a recent decision in the ninth circuit of appeals on this very issue. Enjoy!

Recharacterizing Debt as Equity

A recent decision issued by the Ninth Circuit Court of Appeals underscores a risk that a presumptive creditor faces when a bankruptcy court is authorized to review a loan transaction and recharacterize the purported debt as equity in a bankruptcy proceeding. See generally, In re Fitness Holdings International, Inc., 714 F.3d 1141 (9th Cir. 2013). Although not breaking new ground, the Ninth Circuit resolved a split within its circuit, and joined four other circuit courts of appeals in holding that a bankruptcy court has the authority to recharacterize a debt claim as equity.


Over the course of four years preceding its bankruptcy case, the Debtor, a home fitness company, borrowed over $24 million from its sole shareholder, Hancock Place. Thereafter, the Debtor borrowed $12 million on a secured basis, consisting of both term and revolving loans, from Pacific West Bank, guaranteed by Hancock Place. Subsequently, the loans were amended several times to accommodate the Debtor and its weakening financial position. In 2007, Pacific West Bank agreed to refinance Fitness Holdings’ growing debt burden. The loan proceeds were used to pay off Pacific West’s secured debt, which released Hancock Place from its guaranty, and to pay down, in part, Hancock Place’s unsecured debt. Notwithstanding these restructurings, Fitness Holdings filed a voluntary petition under chapter 11 of the Bankruptcy Code.

During the bankruptcy case, the unsecured creditors committee sued Fitness Holdings, the Bank, and two of the company’s directors to recover the payments made to the Debtor’s sole shareholder (Hancock Place) alleging, among other things, that the payments were fraudulent transfers. The committee alleged that the payments were not loan repayments, but rather, improper distributions by the Debtor to the equity holder for less than reasonable equivalent value.

The bankruptcy court dismissed the lawsuit for failure to state a claim. During the subsequent chapter 7 case, the liquidating trustee appealed the bankruptcy court’s decision. The district court affirmed the dismissal, citing the Ninth Circuit Bankruptcy Appellate Panel’s Pacific Express precedent, which held that bankruptcy courts are limited to the statutory remedy of equitable subordination under section 510 of the Bankruptcy Code, and accordingly that the chapter 7 trustee was barred from bringing a recharacterization action. By so holding, the payments made to the defendants were deemed to be debt, and by definition, the payments could not be fraudulent transfers.

The Ninth Circuit’s Decision

On appeal to the Ninth Circuit, the appellate court held that the district court was not bound by the BAP’s Pacific Express decision, and overruled that decision, holding that the remedy of equitable subordination is separate and distinct from the remedy of debt recharacterization. In the fraudulent conveyance context, the Ninth Circuit held that when a defendant asserts that the payments were debt payments, the court must determine under state law whether the purported debt is, in fact, debt. If the court determines that the payment is not a payment on account of an underlying debt, the court may recharacterize it as equity under state law principles.

The Ninth Circuit is the Fifth Court of Appeals to hold that a bankruptcy court has the authority to recharacterize claims in bankruptcy proceedings. However, this growing consensus has not resulted in unanimity over the analytical framework for recharacterization. For instance, the Fifth Circuit looks to state law to define claims. The influential Third Circuit, home to the Delaware courts, holds that a court may exercise its equitable authority to determine if a claim is more like debt or equity, and considers several factors, including (i) the name of the instrument; (ii) whether the instrument includes a right to enforce payment of principal and interest; (iii) whether the instrument includes a fixed maturity date; and (iv) whether the instrument affords the holder a right to share in profits or participate in management. The Sixth Circuit uses an 11-factor test derived from federal tax law to review a claim for recharacterization. Although the Second Circuit has not addressed the issue, bankruptcy courts in New York follow the Sixth Circuit and  consider factors such as those identified above by the Third Circuit, but also the following: (i) presence or absence of a fixed maturity date and schedule of payments; (ii) the source of repayments; (iii) the adequacy or inadequacy of capitalization; (iv) identity of interest between creditor and stockholder; (v) the security, if any, for the advances; (vi) the corporation’s ability to obtain financing from outside lending institutions; (vii) the extent to which the advances were subordinate to the claims of outside creditors; (viii) the extent to which the advance was used to acquire capital assets; and (ix) the presence or absence of a sinking fund to provide repayment.

Although the Seventh Circuit, which includes courts in Illinois, has not addressed the issue, a federal district court has expansively construed the scope of a bankruptcy court's equitable powers stating that other circuit courts have “correctly recognized recharacterization as a tool that may be used by bankruptcy courts.” In re Outboard Marine, 2003 WL 21697357 (N.D. Ill. 2003).  It accordingly remanded the case to the bankruptcy court to consider whether the loan should be recast as equity upon consideration of the factors identified by the Sixth Circuit.

The Ninth Circuit joined the Fifth Circuit in holding that a bankruptcy court shall look to the underlying state law to determine if a particular obligation owed by the debtor is debt or equity, which is consistent with U.S. Supreme Court precedent that holds that the determination of property rights is generally determined by state law.

Although this decision should be welcomed by third party creditors insofar as it allows estates to recharacterize debt and potentially increase the pool of funds available for unsecured creditors, it also underscores the importance of being familiar with the state law requirements of creating a debt obligation. If improperly structured, a presumptive secured creditor may be in the unenviable position of finding its debt recharacterized as an equity claim, commonly worth nothing in a bankruptcy proceeding.

George Mesires is Co-Chair of the Finance and Restructuring Practice at Ungaretti & Harris, LLP in Chicago, and concentrates his practice on finance, corporate restructuring, bankruptcy, distressed mergers and acquisitions, and general corporate matters. George can be reached at grmesires [at] uhlaw.com


Unknown 11/07/2013  
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Anonymous,  11/07/2013  

Thanks for that write-up. This is a bit of a sprawling issue and it's good to see this summarized in a concise way.
It would be interesting to discuss this in the context of forum shopping when insider transactions are involved. In other words, insiders who made "loans" to distressed companies may try to steer the filing to a jurisdiction where they have the best chance to win a recharacterization fight.


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About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.