Seeking to recharacterize a debt claim as an equity contribution to the debtor through the equitable powers of the bankruptcy court (something we’ve written about quite a bit in our blog) is one way to reduce creditor claims against the bankruptcy estate, but only in certain circuits. In addition to the Tenth Circuit’s recent decision In re Alternate Fuels, Inc., on which we will be publishing shortly, recent decisions from courts in the Fourth and Eighth Circuits serve as a reminder that the law on whether it is even within the equitable powers of the bankruptcy court to recharacterize a debt claim as an equity interest continues to vary among the circuits. 

Background

In both In re Province Grande Olde Liberty, LLC and In re MSP Aviation, LLC, plaintiffs initiated an adversary proceeding to have a transaction classified as an equity interest in, instead of debt claims against, a debtor.

In Province, the debtor acquired its principal assets with proceeds from two loans: one from Lakebound Fixed Retirement Fund, LLC, an entity funded by the plaintiffs, and one from Paragon Commercial Bank. The debtor defaulted on the loan with Paragon and, to prevent a foreclosure on the debtor’s principal assets, the debtor and certain insiders of the debtor entered into a settlement agreement pursuant to which Paragon would receive approximately $1.2 million for the $6.5 million loan. The settlement was funded by (i) the proceeds of two loans with PEM Entities LLC (“PEM”), an entity formed by insiders of the debtor, as the borrower and secured by the assets of the debtor, and (ii) a $300,000 “contribution” by PEM. As a result of the transaction, PEM acquired the $6.5 million loan from Paragon. In its bankruptcy schedules, the debtor listed PEM’s claim as secured debt in the amount of $7,000,000. Plaintiffs, seeking to increase recoveries on their loan claims, sought to recharacterize as equity the $300,000 PEM contribution portion of the $1.2 million settlement price for the Paragon loan. If you are confused, so are we. The facts of the opinion are not entirely clear, but as noted below, the $300,000 PEM contribution did not appear to be documented as a loan.

In MSP Aviation, the debtor MSP, co-owned by two individuals (Balagna and Ashenfelter), was obligated to Signature Bank for $400,000 under a loan secured by the assets of MSP and guaranteed by Balagna. Balagna left MSP, transferred his membership interest back to MSP (making Ashenfelter the sole owner of MSP), and asked Signature Bank for a release of his personal guaranty. In exchange for the release, Signature Bank required the MSP loan be paid down by $200,000. To fund the repayment, MSP took out a loan from Ashenfelter for up to $300,000. Following MSP’s voluntary chapter 7 filing, the chapter 7 trustee initiated the adversary seeking to recharacterize the $300,000 advanced by Ashenfelter as an equity contribution.

Applicable Law

For the court in Province, the path for determining whether a debt should be recharacterized as equity was clear-cut. In the Fourth Circuit, the “bankruptcy court’s equitable powers have long included the ability to look beyond form to substance.” In re Official Comm. of Unsecured Creditors for Dornier Aviation (North America), Inc. In fact, the equitable power of the court to recharacterize is viewed as essential to effectuating the Bankruptcy Code’s priority scheme. Id. at 233.

A court must evaluate several factors in determining whether a debt claim should be recharacterized as equity. The factors identified in Dornier Aviation are: (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 stockholder; (7) the security, if any, for the advances; (8) the corporation’s ability to obtain financing from outside lending institutions; (9) the extent to which the advances were subordinated to the claims of outside creditors; (10) the extent to which the advances were used to acquire capital assets; and (11) the presence or absence of a sinking fund to provide repayments. Id.

On the other hand, for the court in MSP Aviation, the path was less clear-cut because the Eighth Circuit (where the case was pending) has not ruled on whether the equitable powers of the bankruptcy court under section 105(a) of the Bankruptcy Code include recharacterization. Moreover, the court noted a recent decision by the chief bankruptcy judge in the District of Minnesota granting a Fed. R. Civ. P. 12(b)(6) motion to dismiss a claim of equitable recharacterization. Rather than stopping its analysis there and holding that the remedy sought by the chapter 7 trustee was unavailable under the Bankruptcy Code, the court proceeded to evaluate Ashenfelter’s advance under the Sixth Circuit equivalent of Dornier Aviation –Roth Steel Tube Co. v. Comm’r of Internal Revenue. The Roth Steel factors are the same as those enumerated in Dornier Aviation.

Analysis

In Province, the district court upheld the bankruptcy court ruling that PEM’s $300,000 contribution to the total settlement price for the Paragon loan was equity and not debt. Indeed, all the Dornier Aviation factors including the lack of repayment terms, the lack of any interest payments, the admitted undercapitalization of the debtor, and the insider relationship between PEM and the debtor weighed in favor of treating the $300,000 as equity instead of debt. Thus, the bankruptcy court held, and the district court affirmed, that the $300,000 PEM contribution was equity. It also held, for reasons that are not clear, that PEM’s secured claim for $7,000,000 was void.

Conversely, the vast majority of the factors in MSP Aviation weighed toward characterizing the Ashenfelter $300,000 advance as debt: the transaction was documented as a loan; the loan was secured; the loan was only subordinated to Signature Bank’s claims and not to the claims of other creditors; and MSP was adequately capitalized. In finding that recharacterization was unwarranted, the court avoided the larger question of whether recharacterization is an appropriate remedy under the Bankruptcy Code.

Conclusion

It is highly likely that courts in the Fourth Circuit faced with the facts in MSP Aviation would also find that recharacterization was unwarranted under the factors enumerated in Dornier Aviation. The flip side – whether the MSP Aviation court would hold that it had the equitable power under the Bankruptcy Code to recharacterize the PEM contribution in Province – is an open question that highlights the continued disparity among the circuits over whether equitable recharacterization is an appropriate remedy.  One potential result of this disparity, just like any disparity between circuits, is forum shopping. Insiders with questionable “loans” to companies that have a choice of venue may seek to have the company file in a jurisdiction where the ability of a bankruptcy court to order equitable recharacterization is limited or uncertain. Another potential result is a trip to the U.S. Supreme Court. We’ll be on the lookout for more recharacterization cases in this circuit split.