scrutiny should be brought to bear on the transaction between
Quantum and OMC. See, e.g., Koch Ref. v. Farmers Union Cent.
Exch., Inc., 831 F.2d 1339, 1350 (7th Cir. 1987) (citing 2 ConLrER on
BANKRUPTCY {7 101.28 at 101-42.14 (15th ed., King ed., 1986)). The
effect of finding that Quantum’s purchase of a participation
interest under these circumstances is in fact an equity
contribution would be to recharacterize the two-step transaction as
a single equity transaction between Quantum and OMC. The Court
notes that because Quantum paid BofA the full amount of the loan
under Tranche B to purchase a participation interest in Tranche B,
BofA’s position with respect to the loan under Tranche A would be
untouched.

The bankruptcy court’s decision with respect to Count IV is
reversed and remanded for reconsideration using the thirteen
factors detailed above.

B. Counts I, II, and III

The Court now turns to the second issue on appeal, namely,

whether the Trustee alleged that Quantum had a claim against OMC.
1. Counts I and Iii

In Count I of the third party complaint, the Trustee sought a
declaratory judgment that Quantum’s and the lenders’ claims to
OMC’s estate are subordinate to OMC’s right to reimbursement of its
debtor in possession expenses under 11 U.S.C. § 506(c)

Section 506(c) authorizes a trustee to recover “the reasonable

-13-


the motion as to Count IV. The Trustee appealed the bankruptcy
court’s decision on all four counts to this Court.
II. STANDARD OF REVIEW

The Court reviews the bankruptcy court’s decision to dismiss.
the Trustee’s third-party complaint with prejudice under the de
novo standard of review. Home Valu, Inc. v. Pep Boys, 213 F.3d
960, 963 (7th Cir. 2000). The purpose of a motion to dismiss under
Rule 12(b) (6) is to challenge the legal sufficiency of a complaint,
not the merits of the case. Autry v. Northwest Premium Servs.,
Inc., 144 F.3d 1037, 1039 (7th Cir. 1998); United States v.
Sherwin-Williams Co., 165 F. Supp. 2d 797, 803 (C.D. Ill. 2001).
When ruling on a motion to dismiss, the court “must accept as true
all well-pleaded factual allegations in the claim, and draw all
reasonable inferences in the light most favorable to the nonmoving
party.” Sherwin-Williams, 165 F. Supp. 2d at 803 (citing Gutierrez
v. Peters, 111 F.3d 1364, 1368-69 (7th Cir. 1997)). The Court may
also consider “those matters of which the court may take judicial
notice,” Gomez v. Ill. State Bd. of Educ., 811 F.2d 1030, 1039 (7th
Cir. 1987), specifically existing law. Sherwin-Williams, 165 F.
Supp. 2d at 803. Dismissal is appropriate only if it appears
beyond doubt that the nonmoving party can prove no set of facts
that would entitle the nonmoving party to the relief requested in
the complaint. Henderson v. Sheahan, 196 F.3d 839, 846 (7th Cir.

1999). The nonmoving party must allege all the elements for each


in inequitable conduct, in which case the remedy is

subordination of the creditor’s claim “to that of another

creditor only to the extent necessary to offset injury or
damage suffered by the creditor in whose favor the
equitable doctrine may be effective.” In re W.T. Grant

Co., 4 B.R. 53, 74 (Bankr. S.D.N.Y. 1980) (emphasis

added).

If a claim is recharacterized and, therefore “the advance

is not a claim to begin with” and the creditor is not a

legitimate one, “then equitable subordination never comes

into play.” In re Georgetown Bldg. Assocs., 240 B.R. 124,

137 (Bankr. D.D.C. [1999]). Indeed, “where shareholders

have substituted debt for adequate risk capital, their

claims are appropriately recast as equity regardless of

satisfaction of the other requirements of equitable

subordination.” In re Hyperion Enterprises, Inc., 158

B.R. 555, 561 (D.R.I. 1993).

Id. at 748-49 (emphasis in original).

The Court agrees that the recharacterization of a debt as
equity is distinct from equitable subordination despite the fact
that the doctrines may have similar effects on the debt. The
recharacterization of a debt as equity involves a factual
determination as to whether or not the asserted debt is in fact
debt or is instead an equity contribution disguised as debt.
Equitable subordination, on the other hand, is an equitable remedy
applied against a legitimate creditor who has acted inequitably.
Given these distinctions, the Court believes that the Sixth Circuit
correctly recognized recharacterization as a tool that may be used
by bankruptcy courts.

The bankruptcy court raised one other objection to
recharacterization, referring to the holdings in United States v.

Noland, 517 U.S. 535, 537 (1996) (holding that the bankruptcy court

-9-


recharacterize” and “in my opinion there is no basis in bankruptcy
law to recharacterize a debt as equity.” (R. at 31.) The court
based its ruling, in part, on the provision of the remedy of
equitable subordination in the Bankruptcy Code (the “Code”), 11
U.S.C. § 510(c), a doctrine that permits a creditor’s claim to be
subordinated to other claims when that creditor has acted
inequitably. See, e.g., In re Lifschultz Fast Freight, 132 F.3d
339, 344-45 (7th Cir. 1997). The court reasoned that, because a
claim can be subordinated to other claims under the doctrine of
equitable subordination and because equitable subordination is
explicitly codified in § 510(c) while recharacterization is not
explicitly codified but would produce a similar result, then the
principle of inclusio uno, exclusio alterus suggests that Congress
did not intend bankruptcy courts to have the authority to
recharacterize a debt. The Court disagrees with the bankruptcy
court’s reasoning and holds that a bankruptcy court has the
authority to recharacterize a debt as equity. The Court also holds
that the Trustee need not allege that Quantum has a right to
payment, or “claim,” against the debtor in order to access this
remedy.

While the Seventh Circuit has never ruled specifically on the
propriety of recharacterizing a debt as equity in a bankruptcy
proceeding, the court has acknowledged in passing a cause of action

for recharacterization that is distinct from equitable


cause of action to withstand a motion to dismiss. Lucien v.
Preiner, 967 F.2d 1166, 1168 (7th Cir. 1992).
III. DISCUSSION

This appeal presents two discrete questions. First, the
Trustee argues that Quantum does in fact have a “claim” against the
debtor, OMC, despite the absence of a direct transaction between
OMC and Quantum and that.the bankruptcy court erred in dismissing
Counts I, II, and III of the Trustee’s complaint against Quantum.
Second, the Trustee argues that the bankruptcy court erred in
granting Quantum’s motion to dismiss Count IV of the Trustee’s
third party complaint because the court erroneously found that it
lacked the authority to recharacterize the transaction between OMC,
BofA, and Quantum outside of the remedy of equitable subordination.
The Court affirms the bankruptcy court’s decision with respect to
Counts I, II, and III and reverses with respect to Count Iv.

A. Count IV - Recharacterization

The Court first addresses the threshold issue of whether a
bankruptcy court has the authority to recharacterize a debt as
equity. The Trustee argues that the transaction involving BofA,
Quantum, and OMC was, in reality, an equity investment in OMC by
Quantum that was disguised as a participation interest in a loan.
In an oral ruling, the bankruptcy court dismissed Count IV because
“Quantum is not alleged to have a claim [right to payment] against

the debtor, and, therefore, there is . . » no debt to


Circuit stated that “{r]echaracterization is appropriate where the
circumstances show that a debt transaction was ‘actually [an]
equity contribution [ ] ab initio.’” Id. at 747-48 (citing In re
Cold Harbor Assocs., 204 B.R. 904, 915 (Bankr. E.D. Va. 1997)).
The Autostyle court noted that bankruptcy courts have claimed the
authority to test the validity of debts under the general equitable
powers provided in 11 U.S.C. § 105(a), “which states that
bankruptcy judges have the authority to ‘issue any order, process
or judgment that is necessary or appropriate to carry out the
provisions’ of the Code.” Id. at 748; see also i1 U.S.C. § 105(a).

Unlike the Ninth Circuit, the Sixth Circuit draws a clear line
between recharacterization of a debt and the equitable
subordination of a creditor’s claim based on their differing
functions and effects. Autostyle, 269 F.3d at 748.

Not only do recharacterization and equitable
subordination serve different functions, but the extent
to which a claim is subordinated under each process may
be different. These are facts that the In re Pacific
Express court appeared not to recognize.
Recharacterization cases “turn on whether a debt actually
exists, not on whether the claim should be equitably
subordinated.” Matthew Nozemack, Note, Making Sense Out
of Bankruptcy Courts' Recharacterization of Claims: Why
Not Use § 501(c) Equitable Subordination?, 56 WAsH. & LEE
L. REV. 689, 716 (1999) (criticizing Pacific Express). In
a vecharacterization analysis, if the court determines
that the advance of money is equity and not debt, the
claim is recharacterized and the effect is subordination
of the claim “as a proprietary interest because the
corporation repays capital contributions only after
satisfying all other obligations of the corporation.” Id.
at 719. In an equitable subordination analysis, the
court is reviewing whether a legitimate creditor engaged


United States District Court, Northern District of Iinois

Harry D. Leinenweber siting et Sadlee
CASE NUMBER 02 C 1594 DATE 7121/2003
CASE Alex D. Moglia vs. Quantum Industrial Partners
TITLE

[In the following box (a) indicate the party Hiling the motion, ¢.g,, plaintiff, defendant, 3rd party plaintiff, and (b) state briefly the nature
of the motion being presented.)

MOTION:

DOCKET ENTRY:

(i) im Filed motion of [ use listing in “Motion” box above.]

(2) Qo Brief in support of motion due

(3) a Answer brief to motion due___. Reply to answer brief due.

(4) im Ruling/Hearingon set for at

(5) Oo Status hearing[held/continued to] [set for/re-set for]on set for at

(6) im Pretrial conference[held/continued to] [set for/re-set for]on___— set for aatt
(7) Oo Trial{set for/re-set for]on att

(8) Q (Bench/Jury triat] [Hearing] held/continuedto_— at.

(9) Qo This case is dismissed [with/without] prejudice and without costs[by/agreement/pursuant to]

OQFRCP4(m) OLocal Rule 41.1 OFRCP41(a)(1) OO FRCP41(a)(2).

(10) ME [Other docket entry} ENTER MEMORANDUM OPINION AND ORDER: The Bankruptcy Court’s
judgment as to Counts { and Ill is AFFIRMED on different grounds, the bankruptcy court’s judgment as
to Count [I is AFFIRMED, while the bankruptcy court’s decision to grant Quantum’s motion to dismiss
Count [V is REVERSED AND REMANDED for further proceedings.

dl) (For further detail see order attached to the original minute order.]

No notices required, advised in open court, 7 Docunient
Number

No notices required,
0 q umber of notices

Notices mailed by judge’s staff

Notified counsel by telephone

Y | Docketing w mail notices,

Mail AQ 450 form.

cckering Heobty initnds

JUA09 Lop

Copy to judge/magistrate j

courtroom rena) Ze dave mailed novice
War deputy’s
initials or
. Date/timg received in

central Clerk’s Office nating deputy initials



OMC was in reality a loan, “or rather a method used to funnel an
equity contribution to” OMC. Autostyle, 269 F.3d at 749 n. 11.

To determine the character of the transaction, the Court
directs the bankruptcy court to use the following standards.
First, the Court adopts the Sixth Circuit’s use of the eleven
factors from Roth Steel Tube Co. v. C.I.R., 800 F.2d 625, 630 (6th
Cir. 1986), to determine if recharacterization is appropriate,
i.e., whether the transfer of funds was a loan or an equity
contribution. Autostyle, 269 F.3d at 749-50. The eleven factors
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.

Roth Steel, 800 F.2d at 630. Second, the Court adds to the eleven
Roth Steel factors two additional factors from In re Hyperion
Enterprises, 158 B.R. 555 (D.R.I. 1993): (12) the ratio of
shareholder loans to capital and (13) the amount or degree of
shareholder control. Id. at 561. No one factor is to be

determinative, and the more the transaction seems like an arms-

-l1l-



may not reorder “Congress’s scheme of priorities” set forth in the
Code), and Raleigh v. Illinois Department of Revenue, 530 U.S. 15,
26 (2000) (nolding “that in the absence of modification expressed in
the Bankruptcy Code the burden of proof on a tax claim in
bankruptcy remains where the substantive tax law puts it.”). These
cases are inapposite because recharacterization does not reorder
the priorities established by 11 U.S.C. § 726 nor does it reorder
distributions. Recharacterization is simply a factual inquiry that
determines, in the first instance, whether an asserted debt is in
fact a debt or a concealed equity contribution. Therefore, the
Court finds that the bankruptcy court erred when it granted
Quantum’s motion to dismiss Count IV on the grounds that it did not
have the authority to recharacterize a debt as equity.

The Court also finds that the bankruptcy court erred when it
granted Quantum’s motion to dismiss Count IV on the grounds that
the Trustee had failed to allege that Quantum had a claim against
omc. Even though Quantum is not asserting its own claim against
OMC’s bankruptcy estate, as it is barred from doing under the
participation agreement Quantum signed with BofA, a
recharacterization analysis is appropriate. By participating in
BofA’s credit facility, Quantum receives the benefit of BofA’s
perfected security interest and will receive funds ahead of all
other non-secured lenders. The Court directs the bankruptcy court

to determine whether Quantum’s 100% participation in BofA’s loan to


subordination. In re Lifschultz, 132 F.3d at 345 n. 3. In
addition, a bankruptcy court for the Northern District of Illinois
recognized recharacterization of debt to equity as a valid cause of
action distinct from equitable subordination. In re Kids Creek
Partners, L.P., 212 B.R. 898, 931-32 (Bankr. N.D. Ill. 1997).
After laying out the contours of a recharacterization cause of
action, the bankruptcy court ultimately held that
recharacterization was not appropriate in that case. Id. at 933.

There is a split in authority amongst the Circuits that have
ruled on the question of whether recharacterization of a debt to
equity is a valid cause of action under the Code. The Ninth
Circuit rejected the idea of recharacterization as its own entity
and held that debts can only be subordinated by invoking the
equitable subordination doctrine. In re Pacific Exp., Inc., 69
B.R. 112 (B.A.P. 9th Cir. 1986). The Ninth Circuit argued that
because recharacterization has the same result as the successful
application of equitable subordination, permitting the
recharacterization of debts to equity under the court’s equitable
powers would result improperly in inconsistent standards under the
Code for the subordination of debts. Id. at 115.

More recently, however, the Sixth Circuit unequivocally
recognized recharacterization of debt to equity as valid and
distinct from equitable subordination in In re Autostyle Plastics,

Inc., 269 F.3d 726 (6th Cir. 2001). In its opinion, the Sixth


against OMC over to Bank of America (the “BofA”), the lead lender
in OMC’s credit facility.

On December 22, 2000, OMC voluntarily filed for bankruptcy
under Chapter 11. BofA subsequently brought an action against OMC
to collect on BofA’s secured loans. In response, the Trustee filed
counterclaims against BofA, among others, as well as a third party
complaint against Quantum. Counts I and II of the third party
complaint sought a declaratory judgment that Quantum’s and the
lenders’ claims to OMC’s estate are subordinate to OMC’s right to
reimbursement of its debtor in possession expenses under 11 U.S.C.
§§ 506(c) and 552(b). Count III of the third party complaint
sought a declaratory judgment that Quantum and the lenders were not
entitled to collect interest and reasonable fees, costs, or charges
under 11 U.S.C. § 506(b) because the collateral for the credit
facility is allegedly less than $128 million. Count IV of the
third party complaint sought the recharacterization of OMC’s $45
million debt, allegedly owed to Quantum, as an equity security and
not a secured debt. Quantum filed a motion to dismiss the
Trustee’s complaint pursuant to Rule 12(b) (6). The bankruptcy
court, finding that the Trustee had not alleged that Quantum had a
claim against OMC for payment of the debt, granted the motion as to
Counts I, II, and III. In addition, the bankruptcy court, finding

that it had no authority to recharacterize debt as equity, granted


necessary costs and expenses of preserving, or disposing of, such
property to the extent of any benefit to the holder of such claim.”
11 U.S.C. § 506(c). In Count III, the Trustee sought a declaratory
judgment that Quantum and the lenders were not entitled to collect
interest and reasonable fees, costs, or charges under 11 U.S.C.
§ 506(b) because the collateral for the credit facility is
allegedly less than $128 million. Section 506(b) permits the
holder of a claim secured by property to collect interest on the
claim as well as “reasonable fees, costs, or charges provided for
under the agreement under which such claim arose” when the value of
the property, after recovery under § 506(c), is greater than the
amount of the claim. 11 U.S.C. § 506(b). The bankruptcy court
found that the Trustee did not allege that Quantum has a claim in
bankruptcy against OMC and, therefore, that neither § 506(b) nor
§ 506(c) applied to Quantum. As a result, the court dismissed
Counts I and III.

On appeal, the Trustee argues that Quantum does in fact have
a right to receive payment from the debtor, OMC, despite not having
a direct transaction with OMC and that the Trustee is entitled to
priority over Quantum under §§ 506(b) and 506(c). A claim is
defined under 11 U.S.C. § 101 as a “right to payment,” including
disputed, undisputed, legal, equitable, secured, and unsecured
rights. 11 U.S.C. § 101(5) (A). If the bankruptcy court finds that

the recharacterization of Quantum’s loan to an equity contribution

- 14 -


933 F.2d 466, 467 (7th Cir. 1991) (“only the lead bank has a direct
contractual relationship with the borrower”). Quantum, as a
result, is contractually prohibited from asserting a right to
payment against OMC and may only make a claim against BofA.
Therefore, the bankruptcy court’s decision to grant Quantum’s
motion to dismiss Counts I and III is affirmed on different
grounds.
2. Count II
Section 552(b), the basis for Count II, dictates the effect of
a security agreement between a debtor and another entity after the
debtor files for bankruptcy protection. 11 U.S.C. § 552(b). The
bankruptcy court correctly found that the Trustee failed to allege
that Quantum entered into any security agreement directly with OMC
as required under § 552({b). 11 U.S.C. § 552(b). As a result, the
Court affirms the bankruptcy court’s dismissal of Count II.
CONCLUSION
For the reasons set forth above, the bankruptcy court’s
judgment as to Counts I and III is AFFIRMED on different grounds,

the bankruptcy court’s judgment as to Count is AFFIRMED, while

the bankruptcy court’s decision to gra antum’s motion to

dismiss Count IV is REVERSED AND REMANDED rther proceedings.

IT IS SO ORDERED.

Harry D. Leinenweber, Judge

by 2) j0038 United States District Court
Date:
a

- 16 -



and reversed in part and remanded for further proceedings
consistent with this opinion.
I. BACKGROUND

Outboard Marine Corporation (“OMC”) and its related debtor
entities once constituted one of the world’s largest designers
manufacturers, and sellers of boats, outboard marine engines, and
marine parts. In January 1998, OMC and its pre-petition lenders
created a loan and security agreement. OMC granted the lenders a
security interest in many of OMC’s assets, including accounts
receivable, inventory, and general intangibles.

Two years later, OMC sold 650,000 shares of convertible
preferred stock and warrants to Quantum and to Greenlakes
Holding II, LLC, for $6.5 million. On May 5, 2000, and again on
July 19, 2000, Quantum bought an additional 200,000 shares for a
total of 400,000 at a cost of $40 million. With these purchases,
Quantum allegedly became the beneficial or direct owner of nearly
100% of OMC stock.

On October 10, 2000, the lenders and OMC made the tenth
amendment to their January 1998 loan and security agreement, adding
an additional $45 million loan as Tranche B. Tranche A consisted
of all the loans made by the lenders to date, a total of $105
million. On the same day, October 10, 2000, Quantum purchased a
100% participation interest in Tranche B. Quantum agreed to have

Tranche B subordinated to Tranche A and gave all its legal rights



IN THE UNITED STATES DISTRICT COURT F | L E D
FOR THE NORTHERN DISTRICT OF ILLINOIS
EASTERN DIVISION JUL 2 1 2003

JUDGE HARRY D. LEINENWEBER
In re: OUTBOARD MARINE U.S. DISTRICT COURT JUDGE
CORPORATION et al.,

Debtors.
Case No. 02 C 1594
Adversary No. 01 A 0471
ALEX D. MOGLIA, not Bankruptcy No. 00 B 37405
individually, but as Chapter 7
Trustee for Outboard Marine
Corporation and its Related Hon. Harry D. Leinenweber
Debtor Entities,

Appellant,
Vv.
QUANTUM INDUSTRIAL PARTNERS, FF OS 89 te
Loc, DOCKETED
JUL 2 9
Appellee. 2 % 2003

MEMORANDUM OPINION AND ORDER

This matter comes before the Court on appeal from the United
States Bankruptcy Court for the Northern District of Illinois. The
Appellant, Alex D. Moglia (hereinafter, “Moglia” or the “Trustee”),
appeals the bankruptcy court’s decision to grant third party
defendant Quantum Industrial Partners, LDC’s (“Quantum”) motion to
dismiss brought under Federal Rule of Civil Procedure
12 (b) (6) (“Rule 12(b) (6)”). Jurisdiction is conferred upon the
Court pursuant to 28 U.S.C. §§ 158(a) and 1334. For the reasons

given below, the bankruptcy court’s decision is affirmed in part



length deal, the more likely the transaction is a loan and not an
equity contribution. Autostyle, 269 F.3d at 749.

The Court notes, as did the Sixth Circuit, that there is some
disagreement about whether tax court recharacterization factors,
such as those from Roth Steel, are suitable for use in bankruptcy
cases. Id. at 749 n. 12. Some courts have argued that the policy
considerations around recharacterization of a debt as equity ina
tax case are distinct from the considerations in a bankruptcy case.
See Rego Crescent Corp. v. Tymon (In re Rego Crescent Corp.), 23
B.R. 958, 962 (Bankr. E.D.N.Y. 1982). No court, however, has
identified what those different policy considerations are, let
alone why those differences should preclude a bankruptcy court that
is determining whether recharacterization is appropriate from
relying on the factors that tax courts employ in conducting the
same type of analysis. These factors serve their purpose; they
enable the finder of fact to assess the true nature of a
transaction. The Court will not jettison this effective set of
factors simply because the factual inquiry occurs in a bankruptcy
setting.

The instant case is perfectly suited to a recharacterization
analysis. Quantum, the direct or beneficial owner of nearly 100%
of OMC, allegedly purchased a 100% participation interest in the
$45 million loan that BofA made to OMC on the same day that BofA

made the loan to OMC. Given Quantum’s clear insider status, heavy

-12-


is appropriate, then Counts I and III of the third-party complaint
should be dismissed as moot, because Quantum will be an equity
security holder and will no longer have a claim, secured or
otherwise. See 11 U.S.C. § 101(17)

If the bankruptcy court finds that recharacterization is
inappropriate in this case, the Court affirms the bankruptcy
court’s judgment but reaches its conclusion through different
analysis. See, e.g., Rauen v. U.S. Tobacco Mfg. Ltd. P’ship, 319
F.3d 891, 895 (7th Cir. 2003). The Court finds that the Trustee
did sufficiently allege in its third party complaint that Quantum
has a right to payment against OMC. The Trustee alleged that “$45
million was owed to Quantum under Tranche B.” (Committee’s
Countercl. & Third Party Claims at 36.) Under the liberal notice
pleading standards, this is sufficient to put Quantum on notice
that the Trustee is alleging that Quantum has a claim against OMC.
However, the Court also finds that the Counts asserted against
Quantum are not causes of action for which relief can be granted,
Fep R. Civ. P, 12(b) (6), because the Participation Agreement between
Quantum and BofA makes it clear that Quantum cannot assert any
rights on its own behalf against OMC. (Participation Agreement
§ 5(c).) BofA, as lead lender, has the “sole right to enforce the
obligations of the borrowers relating to its Loans and its Notes.”
Prepetition Loan Agreement § 14.1(d); see also First Nat’l Bank of

Louisville v. Continental Ill. Nat’l Bank & Trust Co. of Chicago,

- 15 -