In a recent decision, the Third Circuit Court of Appeals (which included now Supreme Court Justice Alito) issued the first appeals court decision on the standard of appellate review for a recharacterization determination. Specifically, the appeals court found that a recharacterization decision is one based in fact that cannot be overturned on appeal unless the findings by the lower court are clearly erroneous. Further, the court took great pains to distinguish equitable subordination from recharacterization and specifically recognized recharacterization as a cause of action that courts can address using the equitable powers granted to bankruptcy courts under the Bankruptcy Code.

The appeals court also hammered home the concept that each recharacterization determination is factually dependent, and no application of "magic factors" can churn out an easy broad-based finding. Parenthetically, it should be noted that the appeals court's decision also included a finding that a secured creditor can bid the full amount of its claim, not just the economic value, even if the collateral has no value at all and even if those claims are bid by an assignee of the secured creditors as part of a pre-packaged plan.

By way of brief background, recharacterization is an action where a party requests that a bankruptcy court disregard form over substance and "recharacterize" a transaction that was structured as debt into an equitable contribution which, by its nature, is behind the secured creditors in line for repayment. Recharacterization is different from equitable subordination in that there is no misconduct required and that it is not punitive in nature. Further, in equitable subordination the obligation is only subordinated to the extent of the harm, but in recharacterization the entire obligation is treated as junior to secured debt. Finally, while the power to determine cases of equitable subordination is specifically provided for under the Code pursuant to §510, bankruptcy courts have found the authority to recharacterize transactions from debt to equity based on the equitable powers contained in §105 of the Code. In cases that have been decided in the area of recharacterization, courts have sought to enumerate a list of factors to aid in the determination of whether an obligation was really intended to be a debt or an equity transaction—regardless of what it is structured as on its face. In another departure from the analysis that is conducted in the context of equitable subordination, the factors used by courts in recharacterization are for guidance only, and no one factor is controlling; each recharacterization case is factually dependent.² This article seeks to provide an update in the evolving area of recharacterization. For an in-depth discussion of the evolution of recharacterization and the case law to date, this author refers readers to her prior writings.³

In re Submicron Systems Corp.: The Lower Court Ruling

In 1997, 1998 and 1999, Submicron funded its operations through a series of notes that were issued in favor of several different lenders. By mid-1999, the business of Submicron continued to decline and a determination was made to sell the assets as soon as possible. Submicron negotiated with the lenders, and a buyer was found. Submicron filed a pre-packaged bankruptcy petition that was dependent upon the sale agreement with the buyer. The sale agreement provided that a new entity (which was a limited-liability corporation) would be set up to purchase the assets out of the bankruptcy and that the existing lenders would contribute new capital to the new entity as well as assign their claims against Submicron to the new buyer entity in exchange for equity in the new buyer entity. The sales agreement further provided that the new buyer entity would then credit-bid the full value of the lender's secured claims to purchase the assets of Submicron at the §363 sale. The practical reality was that the unsecured creditors would receive nothing.

In the bankruptcy case, the creditors' committee raised four objections to the §363 sale: (1) the notes were executed in 1999 (just prior to the financial downturn of Submicron and within months of the bankruptcy petition); (2) if not recharacterized, the 1999 notes should be treated as unsecured debt; (3) the new entity should not be allowed to credit bid the secured lender's claims to the full amount of the secured debt since the assets were fully encumbered and, for all intents and purposes, had no value; and (4) seeking equitable subordination of certain of the lender's claims was warranted. The bankruptcy court dismissed the creditors' committee's objections.

In 2003, the U.S. District Court in Delaware issued an opinion in which it affirmed the court's denial of the creditors' committee's request to recharacterize the various pre-petition fundings as equitable contributions.⁴ In its decision, the district court noted that the trial testimony was uncontradicted in that if the defendants had not made the 1999 funding to the debtor, Submicron would have been forced to close down and liquidate, leaving nothing for the unsecured creditors.⁵ In a lengthy opinion, the district court concluded that the 1999 fundings were properly characterized as debt, and that they would be treated as secured debt. The district court was persuaded that the parties intended the 1999 fundings to be secured debt, and stated that the defendants were protecting their past investments (secured debt) through the additional loans.⁶ The district court noted that while several factors leaned slightly toward equity, such as the absence of a sinking fund, the inadequacy of capitalization and collateral, the majority of the other factors weighed toward characterization as debt.⁷ The district court concluded that the plaintiff failed to show that under the debtor's financially distressed circumstances the defendant's 1999 fundings were irrational, improper or equity infusions disguised as debt.

Interestingly, the district court was not troubled that some of the defendant's 1999 fundings had notes while others did not, since the record was clear that the debtor's accounting department had made numerous mistakes and errors when generating notes. The fact that the notes were generated for some fundings and not for others was not sufficient in and of itself, in the district court's opinion, to recharacterize the 1999 fundings as equity.⁸ The district court also took note that (1) the committee had not proven that the defendants or their designees controlled or dominated Submicron in any way, (2) while undercapitalization lends itself for a court to be more skeptical of purported loans, under-capitalization of a loan is insufficient to justify the subordination of insider claims, and (3) the lender's participation on the board did not, in and of itself, provide support for equity characterization.⁹ The district court quoted In re Octagon Roofing and stated: "This is because 'any other analysis would discourage loans from insiders to companies facing financial difficulty, and that would be unfortunate because it is the shareholders who are most likely to have the motivation to salvage a floundering company.'"¹⁰ The district court also stated: "When a company is in distress, the only parties motivated to put new money in are those that already have a financial stake; this is the action of any reasonable lender under the circumstances at bar."¹¹

Submicron: Third Circuit Court of Appeals Decision

Recharacterization. The Third Circuit Court of Appeals reviewed the district court ruling and affirmed the district court's determination that the infusion of funds in 1999 should not be recharacterized as an equity investment.¹² The appeals court spent a great deal of time in its opinion explaining recharacterization and differentiating it from equitable subordination. Further, the appeals court explicitly stated that there can be no "Kabuki"-like outcome based on the application of some "mechanistic scorecard" of factors.¹³ While the opinion of the appeals court provides a summary of the factors used by other courts to aid in the evaluation of whether an obligation should be recharacterized as equity, the appeals court was clear that the outcome is overwhelmingly driven by the facts in each case. "Which course a court discerns is typically a common-sense conclusion that the party infusing funds does so as a banker (the party expects to be repaid with interest no matter what the borrower's 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."¹⁴

With the appeals court's emphasis on the factually dependent nature of recharacterization decisions, it predictably determined that the district court's findings were findings of fact and could not be overturned unless clearly erroneous.¹⁵ While the appeals court noted that there was no direct precedent on whether a recharacterization conclusion was a finding of fact or law, it found guidance from cases that were decided in the context of recharacterizing obligations for tax purposes. The appeals court's use of tax recharacterization cases by analogy was a logical leap and identical in analysis to the use of the Roth Steel factors, which were employed by the AutoStyle Plastics court in the early recharacterization cases.¹⁶ Ultimately, the appeals court reviewed the findings of the district court and determined that its findings were not clearly erroneous and could not be overturned.

Credit Bidding. The appeals court also affirmed a finding by the district court that the new buyer entity could credit-bid the face value of its claim (which had been assigned to it by the lenders as part of a pre-negotiated plan) and not only the economic value. The appeals court noted that it was well-settled under §363(k) that creditors can bid the full face value of their secured claims.¹⁷ An argument had been raised that because the claimant was not partially undersecured but fully undersecured (because the collateral was found to have no economic value), the established law under §363(k) did not apply. The appeals court found that nothing about the logic of allowing credit bids up to the full face value of the collateral changes if the collateral has no actual value.¹⁸ The appeals court concluded that the logical conclusion must be that a full credit bid must be allowed because §363 was designed to avoid the complexities and inefficiencies of valuing collateral altogether by substituting the theoretically preferable mechanism of a free-market sale to set the price.¹⁹ Further, the appeals court could find nothing in the language of §363(k) that limited a lender's ability to credit-bid its claim to the economic value of the claim.

Conclusion

The Submicron decision by the appeals court reiterates that no one factor is determinative in assessing recharacterization claims, and that all the facts must be viewed in light of the circumstances surrounding each case with no one factor given controlling or decisive weight. Further, the appeals court decision in Submicron provides the first precedent for the appropriate standard to be applied on appeal for recharacterization decisions. While many recharacterization disputes are likely to be settled by the parties because of the time and expense involved in litigating such a factually intense cause of action, those cases that are not settled generally involve large sums of money and provide the incentive to appeal the ruling of a lower court. Perhaps the Third Circuit's determination that recharacterization cases are not likely to be overturned on appeal, unless the findings of the lower court were clearly erroneous, will provide some greater finality to recharacterization decisions as well as a disincentive to pursue an appeal.

Finally, the court's discussion of credit-bidding is thought-provoking and sure to create further controversies concerning the applicability of §506 to §363 sales as well as the strategic use of credit-bidding in §363 sales in the future. Given the discussion of the purposes of §506 and §363, the appeals court decision can arguably be cited to support any argument to be made that §506 does not apply to asset sales under §363. Moreover, perhaps the committee pursued the wrong objections in attacking the sale. Perhaps the pre-packaged plan and the assignment of claims by the lenders with the full intent to allow the credit-bidding of its claims amounted to a sub rosa plan. Perhaps an argument could have been made that the "arrangement" between the lenders and the new buyer entity concerning the credit-bidding of its secured claims chilled the bidding process in some way or amounted to collusion in the sale process. While the focus was on the amount of the credit bid allowed by the assignee of the lenders' claims, it seems the focus should have been on the behind-the-scenes dealings between the parties that placed the buyer in the position to credit-bid the claims in the first place. While it can be argued that the unsecured creditors would not have received anything in a liquidation anyway, it appears they were the ones that were outwitted and outplayed in this case.

 

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Footnotes

1 The author would like to thank Jonathan P. Friedland of Kirkland & Ellis in Chicago for his insight, comments and collaboration on this article. Further, the author would like to thank her colleague J. Michael Booe for his continued role as a sounding board and for his input and ideas.

2 See, e.g., In re AutoStyle Plastics Inc., 269 F.3d 726 (6th Cir. 2001).

3 Brighton, Jo Ann J., "Is It a Capital Contribution or a Loan?," ABI Journal, Vol. XXI, No. 5, June 2002, p. 1; Brighton, Jo Ann J., "Is It a Capital Contribution or a Loan? Update: Recharacterization—Practical Pointers in an Evolving Arena," ABI Journal, Vol. XXII, No. 10, December/January 2004, p. 18; Sprayregen, James H.M., Friedland, Jonathan P., and Mayer, James R., "Recharacterization from Debt to Equity: Lenders Beware," ABI Journal, Vol. XXI, No. 9, November 2003; Sprayregen, James H.M., Friedland, Jonathan P., Brighton, Jo Ann J., and Bianca, Salvatore F., "Recharacterization of Debt to Equity: An Overview, Update and Practical Guide Using an Evolving Doctrine," 2004 Annual Survey of Bankruptcy Law, Thomson West.

4 In re Submicron Systems Corp., 291 B.R. 314 (D. Del. 2003).

5 Id. at 329.

6 Id. at 324-25.

7 Id. at 326.

8 Id.

9 Id. at 325-26.

10 Id. at 325; In re Octagon Roofing, 157 B.R. 852, 858 (N.D. Ill. 1993).

11 Id. at 324-25.

12 432 F.3d 438 (3rd Cir. 2006).

13 432 F.3d at 456.

14 Id.

15 Id. at 457.

16 The Roth Steel factors were formulated in the context of a tax court case. Roth Steel Tube Co. v. Commissioner of Internal Revenue Service, 800 F.2d 625 (6th Cir. 1986). The AutoStyle Plastics court determined that the Roth Steel factors provided a general framework for assessing recharacterization of tax claims and that it was also appropriate in the bankruptcy context in determining whether to recharacterize debt to equity. 269 F.3d at 750.

17 Id. at 459-60.

18 Id.

19 Id.