Making Sense Out of Bankruptcy Courts'Recharacterization of Claims: Why Not Use§ 510(c) Equitable Subordination?

I. Introduction In order to remedy creditor misconduct that harms the debtor or other creditors,1 bankruptcy courts have the authority to subordinate claims in bankruptcy on equitable grounds.2 The courts remedy creditor misconduct by moving otherwise valid, superior claims behind inferior claims.3 The subordinated claims receive a distribution from the bankruptcy estate only after the estate satisfies all the superior claims.4 Although bankruptcy courts had exercised equitable jurisdiction for years,5 in 1978, Congress finally codified the bankruptcy courts' use of equitable subordination in sec 510(c) of the Bankruptcy Code (Code).6 Despite the availability of sec 510(c) equitable subordination, some bankruptcy courts have achieved the same remedial result by recharacterizing purported debt transactions as equity contributions by using the bankruptcy courts' general equitable powers.' Bankruptcy courts have based these recharacterizations on sec 105 of the Code, which grants bankruptcy judges the authority to "issue any order, process or judgment that is necessary or appropriate to carry out the provisions" of the Code.8 Bankruptcy courts have pointed to their authority to disregard the form of a transaction and to determine its true substance to support their recharacterization of claims.9 The lack of a specific code provision governing recharacterization of claims, however, has left the courts with a large number of factors to sort through when considering whether to recharacterize a transaction.10 According to the United States Court of Appeals for the Ninth Circuit Bankruptcy Appellate Panel's (B.A.P.)11 decision in Unsecured Creditors' Committees of Pacific Express, Inc. v. Pioneer Commercial Funding Corp. (In re Pacific Express, Inc.),12 bankruptcy courts do not have the authority to recharacterize debt into equity.13 The Pacific Express panel determined that the Code does not provide for the characterization of claims as debt or equity.14 The B.A.P. refused to adopt the tax court's analysis to determine whether an advance is a loan or capital contribution.15 The panel rejected this analysis as irrelevant, but never stated how it reached that conclusion.16 The B.A.P. ruled that sec 510(c) equitable subordination governs all actions resulting in the subordination of claims in bankruptcy proceedings.17 This Note examines the practice of recharacterizing claims in bankruptcy proceedings and considers whether recharacterization differs materially from sec 510(c) equitable subordination. To answer this question, this Note evaluates why the Pacific Express B.A.P. prohibited bankruptcy judges from going beyond traditional sec 510(c) equitable subordination concepts to subordinate claims. Part II discusses the evolution of equitable subordination and how bankruptcy courts apply sec 510(c) to equitably subordinate claims.18 Part III examines when and why some courts choose to recharacterize transactions from debt to equity instead of using sec 510(c) to subordinate claims in bankruptcy.19 Part IV takes a closer look at Pacific Express and the Ninth Circuit's prohibition of the recharacterization of claims in bankruptcy proceedings.20 Part V analyzes the reasons why bankruptcy courts choose to recharacterize certain transactions in bankruptcy.21 This Note ultimately concludes that bankruptcy courts should have the authority to recharacterize claims using the tax court factors. However, the bankruptcy courts should examine these factors as a group and avoid subordinating or recharacterizing claims based solely on the debtor's undercapitalization or inability to procure outside financing from disinterested lenders. II. The Doctrine of Equitable Subordination Bankruptcy courts are traditionally regarded as courts of equity.22 The doctrine of equitable subordination derives from this equitable jurisdiction.23 Although the substantive laws of bankruptcy normally achieve fair results for all interested parties, occasionally a narrow interpretation of the laws produces an unjust result. …