Opinion ID: 3024056
Heading Depth: 1
Heading Rank: 3

Heading: Recharacterization as Equity

Text: Cohen argues that the District Court erred by failing to recharacterize the infusion of the 1999 Fundings as an equity investment. To succeed with this argument, he must demonstrate that the District Court abused its discretionary authority or premised its determination on clearly erroneous findings of fact. Because he has failed to do so, we affirm the District Court’s recharacterization holding. A. Recharacterization / Equitable Subordination At the outset, it is important to distinguish recharacterization from equitable subordination. Both remedies 11 are grounded in bankruptcy courts’ equitable authority6 to ensure “that substance will not give way to form, that technical considerations will not prevent substantial justice from being done.” Pepper v. Litton, 308 U.S. 295, 305 (1939). Yet recharacterization and equitable subordination address distinct concerns. Equitable subordination is apt when equity demands that the payment priority of claims of an otherwise legitimate creditor be changed to fall behind those of other claimants. See, e.g., Citicorp Venture Capital, Ltd. v. Comm. of Creditors Holding Unsecured Claims, 160 F.3d 982, 986–87 (3d Cir. 1998); Bayer Corp. v. MascoTech, Inc. (In re Autostyle Plastics, Inc.), 269 F.3d 726, 749 (6th Cir. 2001). In contrast, the focus of the recharacterization inquiry is whether “a debt actually exists,” In re Autostyle Plastics, 269 F.3d at 748 (internal 6 Bankruptcy courts’ general powers of equity are codified at 11 U.S.C. § 105(a), which states that a “court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of [the Bankruptcy Code].” The power of equitable subordination is specifically codified at 11 U.S.C. § 510(c), which states that, after notice and a hearing, the court may (1) under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or part of another allowed interest; or (2) order that any lien securing such a subordinated claim be transferred to the estate. 12 quotation marks omitted) or, put another way, we ask what is the proper characterization in the first instance of an investment.7 For these reasons, we agree with those courts that have determined that “the issues of recharacterization of debt as equity capital and equitable subordination should be treated separately.” Blasbalg v. Tarro (In re Hyperion Enters., Inc.), 158 B.R. 555, 560 (D.R.I. 1993); see, e.g., In re Autostyle Plastics, 269 F.3d at 749 (explaining that “[b]ecause both recharacterization and equitable subordination are supported by the Bankruptcy Code and serve different purposes, we join those courts that have concluded that a bankruptcy court has the power to recharacterize a claim from debt to equity” and collecting cases); Aquino v. Black (In re AtlanticRancher, Inc.), 279 B.R. 411, 433 (Bankr. D. Mass. 2002) (stating that “while once considered solely in conjunction with the doctrine of equitable s u b o r d i n a ti o n , b a n k r u p t c y c o u r t s n o w c o n s i d e r 7 In this context, the label “recharacterization” is misleading. See Citicorp Real Estate, Inc. v. PWA, Inc. (In re Georgetown Bldg. Assocs. Ltd. P’ship), 240 B.R. 124, 137 (Bankr. D.D.C. 1999) (“The debt-versus-equity inquiry is not an exercise in recharacterizing a claim, but of characterizing the advance’s true character.” (emphases in original)); In re Cold Harbor Assocs., L.P., 204 B.R. 904, 915 (Bankr. E.D. Va. 1997) (“Rather than recharacterizing the exchange from debt to equity, or subordinating the claim for some reason, the question before this Court is whether the transaction created a debt or equity relationship from the outset.”). 13 recharacterization a separate cause of action”). Cohen advances both arguments. He argues that the infusion of the 1999 Fundings is most accurately characterized as an equity investment—a recharacterization argument—and, in the alternative, that if the infusion is deemed a debt investment, the Lenders’ claims should be equitably subordinated. We turn first to the recharacterization argument, as “[d]etermining [an] equitable subordination issue prior to determining whether [an] advance is a loan or [an equity investment] is similar to taking the cart before the horse.” Diasonics, Inc. v. Ingalls, 121 B.R. 626, 630 (Bankr. N.D. Fla., 1990). If a “particular advance is a capital contribution, . . . . then equitable subordination never comes into play.” In re Georgetown Bldg. Assocs., 240 B.R. at 137. B. Recharacterization Framework In defining the recharacterization inquiry, courts have adopted a variety of multi-factor tests borrowed from nonbankruptcy caselaw.8 While these tests undoubtedly 8 In Roth Steel Tube Co. v. Comm’r, 800 F.2d 625 (6th Cir. 1986), the Court of Appeals for the Sixth Circuit laid out eleven factors to determine whether an investment was debt or equity in the context of assessing income tax liability. Id. at 630. In re Autostyle Plastics extended the use of those factors to the recharacterization context. 269 F.3d at 749–50. They are: 14 (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 Tube Co., 800 F.2d at 630. The Courts of Appeal for the Eleventh and Fifth Circuits also employ a multi-factor test in the tax context. They have identified the following thirteen factors: (1) the names given to the certificates evidencing the indebtedness; (2) the presence or absence of a fixed maturity date; (3) the source of payments; (4) the right to enforce payment of principal and interest; (5) participation in management flowing as a result; (6) the status of the contribution in relation to regular corporate creditors; (7) the intent of the parties; (8) “thin” or adequate capitalization; (9) identity of interest between 15 creditor and stockholder; (10) source of interest payments; (11) the ability of the corporation to obtain loans from outside lending institutions; (12) the extent to which the advance was used to acquire capital assets; and (13) the failure of the debtor to repay on the due date or to seek a postponement. Stinnett’s Pontiac Serv., Inc. v. Comm’r, 730 F.2d 634, 638 (11th Cir. 1984) (citing Estate of Mixon v. United States, 464 F.2d 394, 402 (5th Cir. 1972)). In re Cold Harbor Assocs., L.P., 204 B.R. at 915, discussed both of the above tests in the recharacterization context and applied the factors relevant to that case, and In re Georgetown Bldg. Assocs., 240 B.R. at 137, cited with approval Cold Harbor’s use of these factors in the recharacterization context (but found it unnecessary to adopt formally a specific set of factors). In this case, the District Court applied a seven-factor test used in an unpublished District of Delaware case that was bankruptcy related, Official Comm. of Unsecured Creditors of Color Tile, Inc. v. Blackstone Family Inv. P’ship (In re Color Tile, Inc.), No. Civ. A. 98-358-SLR, 2000 WL 152129 (D. Del. Feb. 9, 2000) (Robinson, J.). Those factors are (1) the name given to the instrument; (2) the intent of the parties; (3) the presence or absence of a fixed maturity date; (4) the right to enforce payment of principal and interest; (5) the presence or absence of voting rights; (6) the status of the contribution in relation to regular corporate 16 include pertinent factors, they devolve to an overarching inquiry: the characterization as debt or equity is a court’s attempt to discern whether the parties called an instrument one thing when in fact they intended it as something else. That intent may be inferred from what the parties say in their contracts, from what they do through their actions, and from the economic reality of the surrounding circumstances. Answers lie in facts that confer context case-by-case. No mechanistic scorecard suffices. And none should, for Kabuki outcomes elude difficult fact patterns. While some cases are easy (e.g., a document titled a “Note” calling for payments of sums certain at fixed intervals with market-rate interest and these obligations are secured and are partly performed, versus a document issued as a certificate indicating a proportional interest in the enterprise to which the certificate relates), others are hard (such as a “Note” with conventional repayment terms yet reflecting an amount proportional to prior equity interests and whose payment terms are ignored). Which course a court discerns is typically a commonsense conclusion that the party infusing funds does so as a banker (the party expects to be repaid with interest no matter the borrower’s contributors; and (7) certainty of payment in the event of the corporation’s insolvency or liquidation. In re SubMicron Sys., 291 B.R. at 323 (citing In re Color Tile, 2000 WL 152129, at ). 17 fortunes; therefore, the funds are debt) or as an investor (the funds infused are repaid based on the borrower’s fortunes; hence, they are equity). Form is no doubt a factor, but in the end it is no more than an indicator of what the parties actually intended and acted on. C. Review of the D istrict Court’s Recharacterization Holding i) Standard of Review We must first determine whether the District Court’s recharacterization conclusion is a finding of fact we review for clear error or a conclusion of law over which we exercise plenary review. Direct precedent on this issue is lacking,9 but several courts have considered this issue in the tax context. In tax cases addressing whether for tax purposes a 9 Research has uncovered only one bankruptcy case discussing whether the capital contribution versus loan determination question is primarily one of law or fact. There the Court concluded that “[t]he issue of classification of an advance presents a question of law subject to de novo review.” Celotex Corp. v. Hillsborough Holdings Corp. (In re Hillsborough Holdings Corp.), 176 B.R. 223, 248 (M.D. Fla. 1994) (citing Lane v. United States (In re Lane), 742 F.2d 1311 (11th Cir. 1984), a tax refund case). 18 contribution should be treated as debt or equity, courts of appeal are split. The United States Courts of Appeals for the Sixth and Ninth Circuits have concluded the issue is one of fact to be reviewed for clear error. Roth Steel Tube, 800 F.2d at 629 (citing Smith v. Comm’r, 370 F.2d 178, 180 (6th Cir. 1966)); Bauer v. Comm’r, 748 F.2d 1365, 1367 (9th Cir. 1985) (citing A.R. Lantz Co. v. United States, 424 F.2d 1330, 1334 (9th Cir. 1970)). The Fifth and Eleventh Circuit Courts of Appeals, on the other hand, have held the issue to be primarily one of law subject to de novo review. Lane v. United States (In re Lane), 742 F.2d 1311, 1315 (11th Cir. 1984); Estate of Mixon v. United States, 464 F.2d 394, 402–03 & n.13 (5th Cir. 1972).10 In our Court, we were called upon to review a debt versus equity determination in the tax context in Geftman v. Comm’r, 154 F.3d 61 (3d Cir. 1998), but we eschewed entering the thicket of deciding whether we were reviewing a finding of fact or a conclusion of law. See id. at 68 n.9. As discussed above, the determinative inquiry in 10 Of course, it could be argued that the Eleventh Circuit did not reach this conclusion of its own accord. When the former Fifth Circuit was split into the Fifth and Eleventh Circuits on October 1, 1981, the Eleventh Circuit adopted as precedent the decisions of the Fifth Circuit handed down as of September 30, 1981. Bonner v. City of Prichard, 661 F.2d 1206, 1209 (11th Cir. 1981). Thus, Mixon was binding precedent for the Lane Court. 19 classifying advances as debt or equity is the intent of the parties as it existed at the time of the transaction. So framed, we agree with our Sixth and Ninth Circuit colleagues that this is a question of fact that, “once resolved by a district court, cannot be overturned unless clearly erroneous.” A.R. Lantz Co., 424 F.2d at 1334. ii) The District Court’s Determination Was Not Clearly Erroneous The District Court’s opinion includes ample findings of fact to support its recharacterization determination. Because these findings are not clearly erroneous and overwhelmingly support the Court’s decision to characterize the 1999 Fundings as debt (under any framework or test), we affirm its factual determination. The District Court set out numerous facts to support a debt characterization. Looking to the lending documents, it found “beyond dispute in the record that . . . the name given to the 1999 fundings was debt . . . and . . . the 1999 fundings had a fixed maturity date and interest rate.” In re SubMicron Sys., 291 B.R. at 325. The Court also found evidence of the parties’ intent to create a debt investment outside the lending documents. For example, it noted that “[t]he 1999 notes were recorded as secured debt on SubMicron’s 10Q SEC filing and UCC-1 financing statements.” Id. at 319. 20 The District Court could not find, on the other hand, convincing evidence to support an equity investment characterization of the 1999 Fundings. It rejected Cohen’s argument that the dire financial circumstances surrounding the infusion of the 1999 Fundings supported an equity characterization. Instead, it concluded, with reference to the conflicting testimony and relative credibility of witnesses presented by both parties, that Cohen “failed to prove that[,] under SubMicron’s dire circumstances, [the Lenders’] transactions were improper or unusual [as debt investments].” Id. at 325. Recognizing that “‘[w]hen a corporation is undercapitalized, a court is more skeptical of purported loans made to it because they may in reality be infusions of capital,’” id. (quoting In re Autostyle Plastics, 269 F.3d at 746–47), the District Court also noted that “when existing lenders make loans to a distressed company, they are trying to protect their existing loans and traditional factors that lenders consider (such as capitalization, solvency, collateral, ability to pay cash interest and debt capacity ratios) do not apply as they would when lending to a financially healthy company,” id. Weighing these competing considerations, it did not find SubMicron’s undercapitalization greatly supported an equity characterization. Id. Similarly, the Court found the Lenders’ participation on the SubMicron Board did not, in and of itself, provide support for an equity characterization. Again relying on expert testimony, it emphasized that it is “not unusual for lenders to 21 have designees on a company’s board, particularly when the company [is] a distressed one.” Id. at 325–26. After reviewing conflicting evidence on the issue, the Court concluded that Cohen “[did] not prove[] that [Lenders] or their designees controlled or dominated SubMicron’s Board in any way.” Id. at 326. Based on these factual determinations, the conclusion was inevitable that the Lenders’ representation on SubMicron’s Board did not necessarily support an equity characterization. Lastly, the Court found unpersuasive Cohen’s argument that SubMicron’s failure to issue notes for the 1999 Tranche Two Funding should be understood as evidence of the parties’ understanding that the 1999 Fundings were, in effect, equity investments. It noted that “[t]he record is clear that SubMicron’s accounting department made numerous mistakes and errors when generating notes,” concluding that “[t]he fact that notes were generated for some fundings and not others is not sufficient, in and of itself, to recharacterize the 1999 fundings as equity.” Id. at 326. In short, the District Court found ample evidence to support a debt characterization and little evidence to support a characterization of equity infusion. On the basis of these findings, which comport with the record, it was hardly clear error for the Court to conclude that “[Cohen] ha[d] not proven by a preponderance of the evidence that the 1999 [F]undings should be recharacterized as equity.” Id. at 325. 22