Tenth Circuit: Recharacterization Remedy in Bankruptcy Is Alive and Well
In Redmond v. Jenkins (In re Alternate Fuels, Inc.), 789 F.3d 1139 (10th Cir. 2015), a panel of the U.S. Court of Appeals for the Tenth Circuit upheld bankruptcy courts’ authority to recharacterize insider debt as equity. In so ruling, the court rejected an argument that recent U.S. Supreme Court precedent prevents bankruptcy courts from using section 105(a) of the Bankruptcy Code to recharacterize debt as equity. Nevertheless, after upholding the recharacterization doctrine, the Tenth Circuit panel split on the doctrine’s application. The majority, stating that courts must “exercise caution” when determining whether recharacterization is appropriate, ultimately concluded that the insider’s claims should not be recharacterized as equity. By contrast, the dissent contended that recharacterization was warranted.
Kansas-based Alternate Fuels, Inc. (the “debtor”) engaged in coal-mining operations through a subsidiary. In connection with these operations, the debtor was obligated to restore certain mining sites to their original condition, including mines located in Missouri. To assure the State of Missouri that reclamation would be performed, the debtor posted reclamation bonds which were secured by approximately $1.4 million in certificates of deposit.
Subsequent to the debtor’s posting of security for the reclamation bonds, William Karl Jenkins and M. Earlene Jenkins (collectively, the “Insiders”) acquired 100 percent ownership of the debtor and 99 percent ownership of the subsidiary. The Insiders, however, did not acquire the companies for the purpose of continuing mining operations. Rather, the Insiders believed that they could use their political connections to modify the debtor’s reclamation arrangements, such that they could obtain the proceeds of the certificates of deposit. In furtherance of this goal, the Insiders succeeded in arranging for the certificates of deposit to be assigned to them personally.
During the years following the Insiders’ acquisition of the debtor, which had ceased mining operations, the debtor executed three promissory notes evidencing in total approximately $4 million in funding provided by the Insiders. Each of the notes stated that it would mature in a period of years, while also providing that “[t]his note shall be paid in full upon reclamation bond release from the State of Missouri.” Because the debtor had no operations or income of its own, the Insiders’ only anticipated source of repayment was the certificates of deposit.
Several years after the Insiders had acquired the debtor, the debtor temporarily ceased its reclamation efforts when it filed suit against third parties, alleging tortious interference with its reclamation process. Realizing that their likelihood of recovering the certificates of deposit was diminishing, the Insiders agreed to continue funding the debtor only after receiving, as security for their loans, a partial assignment of the debtor’s reclamation suit recovery. On the same date as that assignment, the debtor executed a new promissory note, which renewed the first three promissory notes but also included an additional source of repayment: the proceeds of the reclamation suit.
Ultimately, after recovering $5 million from the reclamation suit, the debtor filed for chapter 11 protection in the District of Kansas in January 2009. The Insiders filed secured proofs of claim in the amount of $4.3 million based on, among other things, the promissory notes.
A chapter 11 trustee was appointed in the debtor’s case, and the trustee filed a complaint against the Insiders, seeking to recharacterize the Insiders’ promissory note debt as equity or, in the alternative, to equitably subordinate the Insiders’ claims under section 510(c) of the Bankruptcy Code. Applying the factors articulated by the Tenth Circuit in Sender v. Bronze Grp., Ltd. (In re Hedged-Investments Assocs., Inc.), 380 F.3d 1292 (10th Cir. 2004) (discussed below), the bankruptcy court ruled, among other things, that the Insiders’ claims should be recharacterized as equity contributions. In the alternative, the court ruled that the claims should be equitably subordinated due to the Insiders’ breach of fiduciary duties and other misconduct. After a Tenth Circuit bankruptcy appellate panel affirmed the ruling, the Insiders appealed to the Tenth Circuit.
Recharacterization Generally and in the Tenth Circuit
Recharacterization is a tool used by bankruptcy courts to ensure that the Bankruptcy Code’s payment priority scheme is properly implemented. When a court recharacterizes putative debt as equity, the court essentially ignores the label attached to the relevant transaction and instead recognizes its true substance. A claim that has been recharacterized as equity is moved to a lower rung on the bankruptcy priority ladder and generally is paid only after all claims have been satisfied in full.
In Hedged-Investments, the Tenth Circuit implicitly recognized section 105(a) of the Bankruptcy Code as a basis for recharacterization. Section 105(a) provides, in relevant part, that a bankruptcy court “may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of [the Bankruptcy Code].” The Third, Fourth, and Sixth Circuits have also relied on section 105(a) to provide authority for recharacterization. See Cohen v. KB Mezzanine Fund, II, LP (In re SubMicron Systems Corp.), 432 F.3d 448 (3d Cir. 2006); Comm. of Unsecured Creditors for Dornier Aviation (North America), Inc., 453 F.3d 225 (4th Cir. 2006); Bayer Corp. v. MascoTech, Inc. (In re AutoStyle Plastics, Inc.), 269 F.3d 726 (6th Cir. 2001).
The Fifth and Ninth Circuits have taken a different approach, holding instead that section 502(b)(1) of the Bankruptcy Code, which provides that “the court . . . shall allow [a] claim . . . except to the extent that . . . such claim is unenforceable against the debtor and property of the debtor, under any agreement or applicable law,” is the proper statutory authority for recharacterization. See Grossman v. Lothian Oil Inc. (In re Lothian Oil Inc.), 650 F.3d 539 (5th Cir. 2011); Official Comm. of Unsecured Creditors v. Hancock Park Capital II, L.P. (In re Fitness Holdings Int’l, Inc.), 714 F.3d 1141 (9th Cir. 2013).
In Hedged-Investments, the Tenth Circuit instructed bankruptcy courts, when analyzing whether to recharacterize debt as equity, to examine the following 13 nonexclusive 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 other corporate creditors;
(7) the intent of the parties;
(8) “thin” or adequate capitalization;
(9) the identity of interest between the creditor and stockholder;
(10) the source of interest payments;
(11) the ability of the corporation to obtain loans from outside lenders;
(12) the extent to which funds were used to acquire capital assets; and
(13) the failure of the debtor to repay on the due date or to seek a postponement.
Hedged-Investments, 380 F.3d at 1298 (citation omitted).
In Alternate Fuels, the Tenth Circuit reaffirmed a bankruptcy court’s authority to recharacterize a debt as equity under section 105(a) in accordance with the multifactor test set down in Hedged-Investments.
The Tenth Circuit’s Ruling
The Insiders argued to the Tenth Circuit that Hedged-Investments was abrogated by two recent Supreme Court decisions—Travelers Cas. & Surety Co. of America v. Pac. Gas & Electric Co., 549 U.S. 443 (2007), and Law v. Siegel, 134 S. Ct. 1188 (2014).
In Travelers, the Supreme Court reversed a circuit court ruling that an unsecured creditor could not recover attorneys’ fees that were authorized by a pre-petition agreement but incurred post-petition. The Supreme Court stated that, when applying section 502(b), “we generally presume that claims enforceable under applicable state law will be allowed in bankruptcy unless they are expressly disallowed.” Travelers, 549 U.S. at 452. The Insiders argued that the Court thereby abrogated the Hedged-Investments test by holding that “a court may not fashion a test ‘solely of its own creation’ in determining what constitutes a ‘claim’ for purposes of bankruptcy."
In Law, the Supreme Court reversed a bankruptcy court’s order under section 105(a) that expressly contravened another provision of the Bankruptcy Code (section 522, which specifies exempt property). The Supreme Court explained that although section 105(a) allows a bankruptcy court to issue orders “necessary or appropriate” to carry out the provisions of the Bankruptcy Code, it is “hornbook law” that section 105(a) does not allow a bankruptcy court to “override explicit mandates of other sections of the Bankruptcy Code.” Law, 134 S. Ct. at 1192. Citing this analysis, the Insiders argued that recharacterization under section 105(a) is not permissible where it conflicts with section 502(b).
In Alternate Fuels, the Tenth Circuit rejected these arguments. First, the court noted that neither Travelers nor Law considered the doctrine of recharacterization or expressly overruled Hedged-Investments.
Next, the Tenth Circuit explained that the Insiders’ expansive reading of Travelers and Law improperly conflates disallowance with recharacterization. According to the Tenth Circuit, the two concepts, although related, require different inquiries and serve different functions. Whereas disallowance of a claim under section 502(b) is appropriate “when the claimant has no rights vis-à-vis the bankrupt,” recharacterization is an inquiry into the nature of the transaction underlying an asserted claim. Unlike disallowance, recharacterization of a loan as equity does not ultimately relieve the debtor from its obligation to repay the claimant. Rather, the Tenth Circuit emphasized, recharacterization simply moves the claimant’s right to payment to a lower position in the priority scheme.
The Tenth Circuit panel thus unanimously reaffirmed section 105(a) as an appropriate statutory authority for recharacterizing debt as equity.
However, the Tenth Circuit panel split on whether the Insiders’ claims should be treated as equity under the Hedged-Investments multifactor test.
The majority emphasized that the Insiders were “engaged in a venture with substantial risk,” highlighting factors that weighed against recharacterization. For example, the majority explained that the first factor had been met because the instruments at issue were labeled “promissory notes.” Here, the majority rejected the argument that this factor’s inquiry is controlled by the sufficiency of consideration furnished to the debtor for incurring the indebtedness or that the consideration furnished in this case was insufficient. With regard to the fifth and 12th factors of the test, the majority noted that: (i) the Insiders did not increase their participation in the debtor’s management following the loans; and (ii) the debtor used the Insiders’ advances to fund operating expenses.
The majority also disagreed with the bankruptcy court’s conclusions regarding a number of the other Hedged-Investment factors. For example, the majority stated that a court should not place too much emphasis on the eighth factor—the debtor’s undercapitalization—as it would create an “unhealthy deterrent effect,” disincentivizing business owners from providing capital to save their struggling businesses. Regarding the ninth factor—the identity of interest between the creditor and stockholder—the majority explained that this factor cannot be weighed too heavily in a single equity holder situation. “Otherwise,” the court wrote, “this factor would militate against finding true debt in any situation involving a single stockholder.”
While finding that some of the factors weighed in favor of recharacterization, the majority counseled that courts should “exercise caution in this arena” and held that, on balance, the factors weighed against recharacterizing the Insiders’ claims as equity.
The dissent highlighted the Insiders’ self-interested business purpose: the Insiders “made a business gamble—[they] bet that [they] would spend less helping [the debtor] reclaim the coal land than [they] would make from . . . collecting 24 certificates of deposit.”
Although the dissenting judge agreed with the majority that certain of the factors signaled debt in “name and form,” he went on to analyze the other factors concerning the “real-world backdrop” of the transaction. In the end, he concluded that four factors weighed against recharacterization, three factors were neutral, and six factors weighed in favor of recharacterization. On balance, the dissenting judge concluded that the Hedged-Investments test supported recharacterization.
Finally, emphasizing that equitable subordination is “an extraordinary remedy to be employed by courts sparingly,” the Tenth Circuit panel unanimously ruled that the remedy did not apply because the Insiders had not engaged in inequitable or unfair conduct.
The Tenth Circuit stated the rationale for its ruling in Alternate Fuels as follows: “Recharacterization under [section] 105(a) is essential to a court’s ability to properly implement the priority scheme of the Bankruptcy Code.” In reaffirming its recharacterization precedents, the Tenth Circuit declined to read recent Supreme Court precedent as invalidating section 105(a) as a source of authority for the remedy. Even so, the Tenth Circuit panel split on whether that remedy should be employed in the case before it. Thus, while Alternate Fuels may provide a road map for rebutting similar attacks on the use of section 105(a) as authority for recharacterization, it is also a reminder that the recharacterization analysis itself is difficult to apply and may be subject to different applications by different judges.
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