It is well established that the bankruptcy court, as a court of equity, may "look through form to substance" in determining the true nature of a transaction relating to the rights of parties against a bankruptcy estate. In re Omne Partners II, 67 B.R. 793 (Bankr. D. N.H. 1986).

The Bankruptcy Code does not expressly provide for the re-characterization of debt to equity. However, bankruptcy courts can consider whether to recharacterize a claim of debt as equity. In re AutoStyle Plastics Inc., 269 F.3d 726 (6th Cir. 2001). Bankruptcy courts that have applied a recharacterization analysis have stated that their power to do so stems from the authority vested in the bankruptcy courts to use their equitable powers to test the validity of debt. AutoStyle Plastics, 269 F.3d at 747.2 The source of the court's general equitable powers is in §105 of the Code, which states that bankruptcy judges have authority to "issue any order, process or judgment that is necessary or appropriate to carry out the provisions of the Code." 11 U.S.C. §105(a).³ There is a line of cases where courts have determined that bankruptcy courts do not have any authority to recharacterize a claim based principally on the fact that there is no specific provision of the Code that allows courts to recharacterize claims. See, e.g., Pacific Express Inc., 69 B.R. 112, 115 (9th Cir. B.A.P. 1986); In re Pine Tree Partners Ltd., 87 B.R. 481, 491 (Bankr. N.D. Ohio 1988) (following In re Pacific Express). However, almost all other courts have disagreed with this line of cases. See In re Herby's Foods, 2 F.3d at 133; In re Midtown Product Terminal Inc., 599 F.2d 389, 393 (10th Cir. 1979); In re Hyperion Enterprises, 158 B.R. at 561-62; Diasonics Inc. v. Ingalls, 121 B.R. 626, 630 (Bankr. N.D. Fla. 1990).

The effect of the bankruptcy court's recharacterization of a claim from debt to equity may be similar to the court's subordination of a claim through equitable subordination in that in both cases, the claim is subordinated below that of other creditors. However, there are important differences between a court's analysis of recharacterization and equitable subordination issues, and recharacterization is actually a distinct cause of action.⁴ 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.⁵

Recharacterization cases turn on whether a debt actually exists, not on whether the claim should be equitably subordinated. AutoStyle Plastics, 269 F.3d at 748.⁶ In a recharacterization 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. AutoStyle Plastics, 269 F.3d at 748.⁷ In an equitable subordination analysis, the court is reviewing whether a legitimate creditor engaged in inequitable conduct, in which case the remedy is subordination of the creditors' claim to that of another creditor only to the extent necessary to offset injury or damage suffered by the creditor and his favored equitable doctrine, may be affected. AutoStyle Plastics, 269 F.3d at 747.⁸

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 Building Assoc., 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 requirements of equitable subordination. In re Hyperion Enterp., 158 B.R. 555, 561 (D. R.I. 1993). Some of the confusion between the doctrines is caused by the fact that undercapitalization is a factor in an equitable subordination analysis and often is a factor in a recharacterization analysis leading some courts to equitably subordinate claims that other courts would recharacterize as equity contributions. In re AutoStyle Plastics, 269 F.3d 726 at 748.⁹

Recharacterization of Debt to Equity

Courts generally focus on several different criteria to determine if they should characterize a claim as a loan or equity transaction. Recharacterization of loans as contributions to capital is suggested when the contributors are not only shareholders, but insiders or fiduciaries as well.¹⁰ The court's primary consideration appears to be whether the transaction reflects the characteristics of an arm's length negotiation. Courts are more likely to characterize a transaction made at arm's length as a loan and will use a variety of factors to determine whether claimant made the transaction at arm's length.¹¹

Factors for courts to consider generally fall into three critical groups: (1) the formality of the alleged loan agreement, (2) the financial situation of the company when the creditor made the purported loan and (3) the relationship between the creditor and the debtor.¹² Generally, courts measure the formality of the alleged loan by how specific and complete the parties made the agreement.¹³ One court has stated that the ultimate issue is whether the transaction had the substance and character of an equity transaction or of a loan.¹⁴ Courts generally weigh the relevant factors as a group so that no single factor will result in recharacterization of an advance. The many different factors employed to determine if courts should treat an alleged loan as a capital contribution make it difficult for both lenders and corporate borrowers to predict how the court will view individual transactions.¹⁵

The Roth Steel Factors

In evaluating the general categories stated above, bankruptcy courts generally look to 11 factors, commonly referred to as the Roth Steel Factors, when analyzing whether debt should be recharacterized as equity.¹⁶ No one factor is controlling or decisive.¹⁷ The factors must be construed within the particular circumstances of each case.¹⁸ The factors are the:

1. names given to the instruments, if any, evidencing the indebtedness;
2. presence or absence of a fixed maturity date and schedule of payments;
3. presence or absence of a fixed rate of interest and interest payments;
4. source of repayment;
5. adequacy or inadequacy of capitalization;
6. identity of interests between the creditor and stockholders;
7. security, if any, for the advances;
8. corporation's ability to obtain financing from outside lending institutions;
9. extent to which the advances were subordinated to the claims of outside creditors;
10. extent to which the advances were used to acquire capital assets; and
11. presence or absence of a sinking fund to provide repayment.¹⁹

1. The Names Given to the Instruments. The absence of notes or other instruments of indebtedness is a strong indication that the advances were capital contributions and not loans. AutoStyle Plastics, 269 F.3d at 750.²⁰ Additionally, courts will examine the names given to the documents and whether or not the labels accurately reflect the nature of the document and the substance of the transaction. Id.

2. The Presence or Absence of a Fixed Maturity Date and Schedule of Payments. The absence of a fixed maturity date and a fixed obligation to repay is an indication that the advances were capital contributions and not loans. AutoStyle Plastics, 269 F.3d at 750. The bankruptcy court in AutoStyle Plastics noted that the absence of a set schedule of repayment of principal weighs in favor of equity, but is not dispositive. However, the district court noted that the participation agreements used demand notes as well as a fixed interest rate and regular interest payments, which the district court believed was indicative of a loan. Moreover, the district court stated that a rigid application of a rule that the lack of a fixed maturity date and fixed payment schedule is indicative of equity "would create a per se rule that use of a demand note by an insider would always be indicative of an equity contribution rather than a loan."²¹ The appellate court agreed with the district court, and therefore concluded that the use of the demand note with a fixed rate of interest and interest payment is more indicative of debt than equity. AutoStyle Plastics, 269 F.3d at 750.

3. The Presence or Absence of a Fixed Rate of Interest and Interest Payments. The absence of a fixed rate of interest and interest payments is a strong indication that the advance is for capital contributions rather than loans. AutoStyle Plastics, 269 F.3d at 750.²² In the AutoStyle Plastics case, the defendants provided for interest, but subsequently agreed to defer interest payments. At best, the court determined that an argument can be made that this factor cuts both ways since the deferral of interest payments indicates the possibility that during the course of the transaction the lender never expected to get repaid and converted it back to equity. However, the court stated that it does not change the fact that initially at least, there was a fixed rate of interest and interest payments indicating that the transaction was originally intended to be debt and not equity.²³ Moreover, the deferral of interest payments does not by itself mean that the parties converted a debt transaction to equity, since the defendants still expected to be repaid. AutoStyle Plastics, 269 F.3d at 750.

4. The Source of Repayment. If the expectation of repayment depends solely on the success of the borrower's business, the transaction has the appearance of a capital contribution.²⁴ However, if various measures are taken to provide security for performance of the obligations, the repayment becomes less dependent on the success of the venture. L.I. Lighting Co. v. Bokum Resources Corp., 40 B.R. 274, 297 (Bankr. D. N.M. 1983).²⁵

5. The Adequacy or Inadequacy of Capitalization. Thin or inadequate capitalization is strong evidence that the advances are capital contributions rather than loans.²⁶ The undercapitalization analysis is particularly relevant when "a corporation is started by the shareholders with a minimal amount of capital who then make a large loan of money to the newly formed corporation. In re Cold Harbor, 204 B.R. 904, 917 (Bankr. E.D. Va. 1997). The district court in AutoStyle Plastics concluded that undercapitalization was adequate because the company had operated for more than 20 years before the loans at issue were made. However, the appellate court agreed that capitalization is not only assessed at initial capitalization. The appellate court determined, as did the court in Roth Steel, that a court must look at the capitalization at the time the transfer was made. AutoStyle Plastics, 269 F.3d at 751.²⁷ Certain courts have determined that when a debt is incurred when the debtor is undercapitalized and the prospect for repayment is poor, such advances are a capital contribution and not a loan. In re Transystems Inc., 569 F.2d 1364, 1369-71 (5th Cir. 1978). However, the inquiry concerning undercapitalization is highly factual and may vary substantially with the industry, company, size of the debt, accounting methods employed and like factors. See U.S. v. Colorado Invesco Inc., 902 F. Supp. 1339 (D. Colo. 1995). Additionally, some other conduct must also be found for undercapitalization to constitute a basis for recharacterizing debt to equity lest insiders and others shy away from lending to a corporation in financial distress or a venture at higher than usual risk. Kids Creek, 212 B.R. at 931.²⁸

6. The Identity of Interest Between the Creditor and the Stockholder. If stockholders make advances in proportion to their respective stock ownership, an equity contribution is indicated. AutoStyle Plastics, 269 F.3d at 751. On the other hand, a sharply disproportionate ratio between a stockholder's percentage interest in stock and in debt is indicative of a bona fide debt. Id. "Where there is an exact correlation between the ownership interest in the equity holders and their proportionate share of the alleged loan...this evidence standing alone is almost...overwhelming." Cold Harbor, 204 B.R. at 919.

7. The Security for the Advances. The absence of security for an advance is a strong indication that the advance is for capital contributions rather than loans. AutoStyle Plastics, 269 F.3d at 751.²⁹ The fact that a lender incurred the cost and invested the time to collateralize and perfect the advance makes the advance look more like a loan than equity.

8. The Corporation's Ability to Obtain Outside Financing. When there is no evidence of the availability of other outside financing, the fact that no reasonable creditor would have acted in the same manner is strong evidence that advances were capital contributions rather than loans. AutoStyle Plastics, 269 F.3d at 751. However, a per se application of this factor alone would prevent any shareholder or insider from ever loaning money to a company experiencing distress. Accordingly, this factor must be viewed broadly and in the factual context in which it is being applied. See Octagon Roofing, 157 B.R. at 858.

9. The Extent to Which Advances Were Subordinated to Claims of Outside Creditors. Subordination of advances to claims of all other creditors indicates that the loans were capital contributions and not loans. AutoStyle Plastics, 269 F.3d at 751.³⁰

10. The Extent to Which Advances Were Used to Acquire Capital Assets. Use of advances to meet the daily operating needs of the corporation rather than to purchase capital assets is indicative of bona fide indebtedness. AutoStyle Plastics, 269 F.3d at 752.³¹ It should be noted, however, that at least one court found it persuasive that a debtor needed working capital—specifically, "necessary turnaround cash" to provide for payroll and other current expenses—and that the company was on the verge of closing down or filing a chapter 11 petition.³² That court determined that such a dire need of cash was persuasive in finding that the obligation was a contribution to capital. However, the Transystems court clearly stated: "This court does not hold that the above circumstances preclude the possibility that [the] advance was a loan. However, taken in conjunction with the fact that there were no indicia of a loan presented [to the court], beyond the labels affixed to the documents themselves...[the shareholder's] intent was to provide a contribution to capital." Transystems, 569 F.2d at 1369.

11. The Presence or Absence of a Sinking Fund to Provide Repayments. The failure to establish a sinking fund for repayment is evidence that the advances were capital contributions rather than loans. The AutoStyle Plastics court noted that if the loans are secured by liens, it obviates any need for a sinking fund. 269 F.3d at 752.³³

Other Factors to Be Considered

Additionally, the intent of the parties will probably be examined by the court. Some courts have expressly stated that the "intent of the advancing party must be examined." Transystems Inc., 569 F.2d at 1366.³⁴ See, also, Omne Partners, 67 B.R. at 794 (the court found support for the position that the intent of the parties must be closely examined when analyzing whether sale leaseback transactions should be recharacterized). Further, the court must investigate the manner in which the circumstances, under which the advance was consummated in order to determine whether the bona fides of indebtedness, had been established. Transystems, 569 F.2d at 1366.

There are also a couple of additional factors that have been looked at by bankruptcy courts in analyzing whether debt should be recharacterized as equity, including the degree of shareholder control and how the obligation was treated in the business records. See Hyperion, 158 B.R. at 561.³⁵

Finally, in a bankruptcy case, each claimant has the ultimate burden to prove the validity of its claims. Practically, the noteholders have the burden of establishing that the bridge loan was valid and was, in fact, a loan.³⁶

Equitable Subordination

A second stage of the analysis must also be included concerning the standards for equitable subordination of the noteholders' claims. Should the bridge loan not satisfy the requirements for recharacterization of debt to equity, all or part of the bridge loan may be subject to a claim for equitable subordination to the claims of unsecured creditors (or possibly the claims of shareholders who did not participate in the bridge loan). Section 510(c) of the Code grants a bankruptcy judge the power to equitably subordinate the claim of a creditor whose conduct has caused injury to other parties or has afforded a creditor an unfair advantage over other creditors.³⁷ While §510(c) does not define the conduct that triggers equitable subordination, courts have developed established common law in this area. Equitable subordination is remedial, not penal, and should be used sparingly. In the Matter of U.S. Abatement Corp., 39 F.3d 556, 560 (5th Cir. 1994). The doctrine of equitable subordination should not be used punitively to take away anything to which a creditor is justly entitled as a result of the liquidation of the debtor's assets, and bestow it upon others who have no right to it. In re Cumberland Farms Inc., 81 B.R. 678, 681 (Bankr. D. Mass. 1995). It should also be noted that an equitable subordination complaint, even if successful, may not result in total subordination. The claim will only be subordinated to the extent necessary to offset the unfair advantage or harm which the creditors suffered on account of the inequitable conduct.³⁸ However, if conduct is so egregious that it affects the validity of the claim under applicable law, the debtor can ask the court to disallow it in full as part of the claims avoidance process. In the Matter of Mobile Steel, 563 F.2d, 692, 699 n. 10 (5th Cir. 1977).

The First Circuit has established that the following elements are necessary to equitably subordinate a claim. The trustee/ DIP must show that:

1. The claimants have engaged in some type of inequitable conduct;
2. The misconduct must have resulted in injury to creditors or conferred an unfair advantage on the claimant; and
3. Equitable subordination of the claim must not be inconsistent with the provisions of the Bankruptcy Code.

Hyperion, 158 B.R. at 562.³⁹

While the general three-prong test appears to be quite broad, courts have largely confined equitable subordination of claims to three general paradigms: (1) when a fiduciary of the debtor misuses his position to the disadvantage of other creditors; (2) when a third party controls the debtor to the disadvantage of other creditors; and (3) when a third party actually defrauds other creditors.⁴⁰

Insider Status and Its Effect on Equitable Subordination

Initially, it should be stated that a claim arising from the dealings between a debtor and an insider is to be rigorously scrutinized by the courts. Hyperion, 158 B.R. at 562.⁴¹ However, the mere fact of an insider relationship is insufficient to warrant subordination. Hyperion, 158 B.R. at 562. "The reason that transactions of insiders will be closely studied is because such parties usually have greater opportunity for such inequitable conduct, not because the relationship itself is somehow grounds for subordination."⁴² Such claims are not automatically subordinated because insiders are the persons most interested in restoring and reviving the debtor, and such bona fide effort should be viewed with approval.⁴³

Section 101(31) defines the term "insider." If the debtor is a corporation, the term insider includes "(1) an officer or director of the debtor; (2) a person in control of the debtor; (3) a partnership in which the debtor is a general partner; (4) a general partner of the debtor; or (5) a relative of the general partner, director, officer or person in control of the debtor." 11 U.S.C. §101(31). Mere stock ownership, with nothing more, does not constitute an insider relationship to the debtor. A lender can also be an insider if it generally acted as a joint venturer or prospective partner with the debtor rather than as an arm's-length creditor. Pan Am Corp. v. Delta Air Lines Inc., 175 B.R. 438, 500 (S.D.N.Y. 1994).

Insider status goes only to determining the standard under which the creditor's conduct is reviewed. Insider status alone is insufficient and cannot provide a sufficient basis for subordination. In re Astroline Communic. Co. L.P., 226 B.R. 324, 329 (Bankr. D. Conn. 1998); In re Beverages Int'l. Ltd., 50 B.R. 273, 281 (Bankr. D. Mass. 1985). Where a creditor is a non-insider, the trustee must show that the creditor's conduct was "egregious and severely unfair in relation to other creditors." Hyperion, 158 at B.R. 562. In the context of insiders, the standard is one of simple unfairness. Id. Furthermore, the burden of proof shifts in insider transactions. Once the trustee has met its initial burden of going forward with factual evidence to overcome the validity of the claimant's proof of claim, the burden shifts to the claimant/insider to demonstrate its good faith and the fairness of its conduct. In order to shift the burden, the trustee must provide a "substantial factual basis to support its allegation of impropriety."⁴⁴

Inequitable Conduct

The initial requirement is that the claimant must have engaged in an equitable conduct; an inequitable result is not enough on its own. See U.S. v. Noland, 517 U.S. 535, 539 (1996).⁴⁵ Courts have divided the varieties of inequitable conduct into three broad categories: (1) fraud, illegality or breach of fiduciary duties; (2) under-capitalization; or (3) control of the debtor through use of the debtor as the creditor's alter ego or instrumentality.⁴⁶

Additionally, certain courts have granted requests for equitable subordination, even though the party whose claim is being subordinated has not engaged in any inequitable conduct. This procedure has been described as "no fault" equitable subordination. Many of the recent decisions have focused on the issue of tax penalties and priority to be accorded such penalties. However, in 1996, the U.S. Supreme Court rendered two important decisions in this area. U.S. v. Noland, 517 U.S. at 535, and U.S. v. Reorganized CF&I Fabricators of Utah Inc., 518 U.S. 213 (1996). Those two decisions essentially eliminated the imposition of subordination in the absence of inequitable conduct. The only area in which courts continue to recognize subordination absent inequitable conduct concerns stock redemption claims. The inequitable conduct prong is generally the most difficult to apply.⁴⁷ The inequitable conduct and the claim at issue do not need to be related to warrant subordination. The inequitable conduct may arise out of any unfair act by the cre