Focusing on Intent in Recharacterization Analysis, Delaware Bankruptcy Court Ruling Indicates that Creditors Seeking Derivative Standing Face High Hurdle

Focusing on Intent in Recharacterization Analysis, Delaware Bankruptcy Court Ruling Indicates that Creditors Seeking Derivative Standing Face High Hurdle

In In re Mobile Steel Co., 563 F.2d 692 (5th Cir. 1977), the Fifth Circuit articulated what has become the most commonly accepted standard for equitable subordination of a claim.Under this standard, a claim can be subordinated if the claimant engaged in some type of inequitable conduct that resulted in injury to creditors (or conferred an unfair advantage on the claimant) and if equitable subordination of the claim is consistent with the provisions of the Bankruptcy Code. Courts have refined the test to account for special circumstances.For example, many courts make a distinction between insiders (e.g., corporate fiduciaries) and noninsiders in assessing the level of misconduct necessary to warrant subordination.

A related but distinct remedy is "recharacterization."Like equitable subordination, the power to treat a debt as if it were actually an equity interest is derived from principles of equity.It emanates from the bankruptcy court’s power to ignore the form of a transaction and give effect to its substance.  However, because the Bankruptcy Code does not expressly empower a bankruptcy court to recharacterize debt as equity, some courts disagree as to whether they have the authority to do so and, if so, the source of such authority.

Four circuits have held that a bankruptcy court’s power to recharacterize debt derives from the broad equitable powers set forth in section 105(a) of the Bankruptcy Code, which provides that "[t]he court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of [the Bankruptcy Code]."  See Committee of Unsecured Creditors for Dornier Aviation (North America), Inc., 453 F.3d 225 (4th Cir. 2006); Cohen v. KB Mezzanine Fund, II, LP (In re SubMicron Systems Corp.), 432 F.3d 448 (3d Cir. 2006); Sender v. Bronze Group, Ltd. (In re Hedged-Invs. Assocs., Inc.), 380 F.3d 1292 (10th Cir. 2004); Bayer Corp. v. MascoTech, Inc. (In re AutoStyle Plastics, Inc.), 269 F.3d 726 (6th Cir. 2001).  In Grossman v. Lothian Oil Inc. (In re Lothian Oil Inc.), 650 F.3d 539 (5th Cir. 2011), the Fifth Circuit adopted a nuanced approach to the question, ruling that a bankruptcy court’s ability to recharacterize debt as equity is part of the court’s authority to allow and disallow claims under section 502 of the Bankruptcy Code.  In Official Committee of Unsecured Creditors v. Hancock Park Capital II, L.P. (In re Fitness Holdings International, Inc.), 714 F.3d 1141 (9th Cir. 2013), the Ninth Circuit ruled that "a court has the authority to determine whether a transaction creates a debt or an equity interest for purposes of § 548, and that a transaction creates a debt if it creates a ‘right to payment’ under state law," as required by section 101(5)(A) of the Bankruptcy Code.

In some jurisdictions that recognize the doctrine of recharacterization, uncertainty exists regarding the legal standard for determining when recharacterization is appropriate.  In AutoStyle Plastics, the Sixth Circuit applied an 11-factor test derived from federal tax law.  Among the enumerated factors are the labels given to the alleged debt; the presence or absence of a fixed maturity date, interest rate, and schedule of payments; whether the borrower is adequately capitalized; any identity of interest between the creditor and the stockholder; whether the loan is secured; and the corporation’s ability to obtain financing from outside lending institutions.  Under this test, no single factor is controlling.  Instead, each factor is to be considered in the particular circumstances of the case.

In SubMicron, however, the Third Circuit questioned the utility of the Autostyle test, cautioning against the application of the test as a "mechanistic scorecard."   According to the Third Circuit, although such multifactor frameworks "undoubtedly 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."  SubMicron has given rise to uncertainty regarding whether courts in the Third Circuit, which have traditionally applied the Autostyle test, will continue to do so.  This was one of the issues addressed by the bankruptcy court in Optim Energy.

Optim Energy

In 2007, Optim Energy, LLC ("Optim Energy")—which, together with certain affiliates, owned and operated three Texas power plants—entered into a $1 billion credit facility with a lender.  The credit facility was guaranteed by Cascade Investments, L.L.C. ("Cascade").  Optim Energy also entered into a guaranty reimbursement agreement with Cascade whereby Optim Energy agreed to reimburse Cascade for any payments made by Cascade to the lender.  That agreement stated that Optim Energy’s reimbursement obligations "constitute indebtedness of [Optim Energy] and shall not, in any event, constitute or be treated as an equity or capital contribution by the Guarantors."  As security for its reimbursement obligations, Optim Energy granted Cascade a lien on substantially all of its assets.  At the time of these transactions, Cascade owned 50 percent of Optim Energy’s equity.

Pursuant to a 2011 restructuring, Cascade made a $5 million payment to the lender on behalf of Optim Energy.  In exchange, Cascade increased its ownership interest in Optim Energy to 99 percent.  In the documents effectuating these transactions, Cascade’s $5 million payment to the lender on behalf of Optim Energy was described as a capital contribution. 

In early 2014, as Optim Energy and certain of its affiliates were preparing to file for bankruptcy, Cascade paid the lender the full amount outstanding on Optim Energy’s credit facility. That payment triggered certain obligations under the 2007 agreements between Optim Energy and Cascade, which had the effect of making Cascade the senior secured creditor of the debtors.

Optim Energy and its affiliates filed for chapter 11 protection in the District of Delaware in February 2014. Walnut Creek Mining Company ("Walnut Creek")—a coal supplier to Optim Energy and the debtors’ largest non-insider unsecured creditor—filed a motion seeking derivative standing to prosecute claims against Cascade for recharacterization, breach of fiduciary duty and equitable subordination. Walnut Creek argued that, beginning in 2007 with Cascade’s agreement to guarantee repayment of Optim Energy’s obligations to the lender, Cascade engaged in a series of inequitable transactions designed to transform Cascade from an equity interest holder to a senior secured lender. 

The Bankruptcy Court’s Ruling

The bankruptcy court denied Walnut Creek’s motion for derivative standing.  The court initially explained that, in the Third Circuit, a party seeking derivative standing must establish that the debtor:  (i) has "unjustifiably refused" to pursue an estate claim itself or to allow the moving party to pursue such a claim on its behalf; and (ii) that the movant has alleged "colorable claims."  The court focused its analysis on the second element.

In examining whether the recharacterization claim was colorable, the court did not rely on the Autostyle factors.  Instead, citing SubMicron, the court wrote that "the overarching inquiry with respect to recharacterizing debt as equity is whether the parties to the transaction in question intended the loan to be a disguised equity contribution."  According to the bankruptcy court, such 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."

Applying this analysis, the court concluded that "the many transactions and financial arrangements that give rise to [Cascade’s] secured claims were structured and intended as debt obligations and are not susceptible to being recharacterized as equity contributions."  The court rejected six principal arguments asserted by Walnut Creek, as follows:


  • Walnut Creek argued that the debtors were inadequately capitalized when Cascade guaranteed Optim Energy’s line of credit.  The court rejected this argument, finding that the timing of the guarantee agreement and the capital structure of Optim Energy supported the conclusion that Optim Energy’s obligations to Cascade were intended to be debt.
  • Walnut Creek argued that no prudent, bona fide lender would have entered into the 2007 guarantee agreement because Optim Energy was newly-formed and insufficiently capitalized in 2007.  The court found that Walnut Creek failed to plead any facts supporting this inference.
  • Walnut Creek asserted that Optim Energy granted security interests to Cascade at a time when Optim Energy had no debt.  The court held that this argument failed because the 2007 credit facility transaction between the lender and Optim Energy was contingent upon the granting of such security interests, and that such arrangements are not unusual.
  • Walnut Creek alleged that Cascade’s waiver of certain fees as part of the reimbursement agreement indicated that Cascade’s claims should be recharacterized as equity.  The court disagreed, noting that Cascade and Optim Energy later entered into a forbearance agreement that was indicative of a "true creditor relationship."
  • Walnut Creek pointed to the fact that, under various agreements, Optim Energy’s obligations to Cascade were subordinated to Optim Energy’s obligations under its bank credit facility.  The court acknowledged that, under Autostyle, "subordination to all other claims may be an indication that the claims are capital contributions, not loans."  Even so, the court rejected this argument because Cascade’s claims for reimbursement were subordinated to the lender’s claims only until the lender was paid in full, and because such subordination clauses are typical.
  •  Walnut Creek argued that the parties treated certain capital contributions made by Cascade as equity because Cascade never demanded reimbursement from Optim Energy pursuant to the 2007 reimbursement agreement.  The court disagreed.  It found that the reimbursement agreement was separate and distinct from the capital contributions cited by Walnut Creek, and that the guarantee was never triggered because Optim Energy never defaulted on its obligations under the credit facility agreement.

The court also briefly addressed Walnut Creek’s arguments regarding potential equitable subordination and breach of fiduciary duty claims.  The court ruled that Walnut Creek failed to allege a colorable claim for equitable subordination because Walnut Creek failed to allege any inequitable conduct.  The court also held that Walnut Creek had not stated a colorable claim for breach of fiduciary duty because Optim Energy’s operating agreement expressly provided that "that no fiduciary duties were owed" by Cascade to Optim Energy.


Optim Energy indicates that, at least in the Delaware, creditors seeking derivative standing to pursue estate claims face a high bar in alleging facts sufficient to support colorable claims.  The ruling should provide some assurance to lenders that, absent evidence of misconduct, their claims will not be equitably subordinated, and that a lender can structure an equity position in a borrower in a way that minimizes the risk that a debt obligation will later be recharacterized as equity by a bankruptcy court.

Taking its cue from the binding precedent of SubMicron, the bankruptcy court in Optim Energy focused its inquiry on the parties’ intent, rather than performing an Autostyle factor-based analysis, in assessing whether a debt should be recharacterized as equity.  Although this might appear to be a significant departure from the approach used by the vast majority of courts, it appears to be largely a case of form over substance.  As with "badges of fraud" in the context of fraudulent transfer litigation, the Autostyle factors merely provide a roadmap for courts in assessing whether the parties intended a transaction to create a credit or equity relationship.  As the Optim Energy court noted, slavish reliance on the factors as a "scorecard" for applying the remedy of recharacterization should be viewed as consistent neither with Autostyle nor the rulings of the majority of courts that employ the Autostyle approach.