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By: Ira L. Herman, Blank Rome, LLP
To increase their share of a finite bankruptcy pie, creditors, debtors and other parties in interest in a case will seek to reduce or eliminate competing claims. This objective may be accomplished using various provisions of the Bankruptcy Code. Section 502(b)(1) is the statutory provision providing for the objection to, and disallowance of, claims based on the applicable laws and rules and by the enforcement of any agreement between or among the relevant parties. Section 510(c) is the statutory provision that governs the equitable subordination of claims where the claim arises from or is tainted by the inequitable conduct of a party as a result of such bad conduct. Subordination does not eliminate claims; rather, it results in the subordinated claim being removed from one class of claims and placed in a class that is afforded a lower priority in the pecking order of the payments to be made in a bankruptcy case. In many instances, a subordinated claim receives no distribution. By virtue of the subordination, the claimants remaining in the class formerly occupied by the subordinated claim may benefit essentially by receiving a proportionate share of a distribution that would otherwise have been paid to the now subordinated claim.
The Bankruptcy Code, however, is silent with regard to the recharacterization of a purported claim1 as something less (i.e., an equity security interest). Because no section of the Bankruptcy Code expressly provides for recharacterization, it has been left to the courts to determine whether or not they have the authority to recharacterize.
Most courts, when asked to consider recharacterization, have held that the bankruptcy courts have the authority to do so. A majority of the courts authorizing recharacterization, including the Third, Fourth, Sixth, and Tenth Circuits, have found that bankruptcy courts may recharacterize pursuant to the broad equitable powers granted by Section 105(a) of the Bankruptcy Code. In re SubMicron Sys., 432 F.3d 448, 454 (3d Cir. 2006); Dornier Aviation (North America), Inc. v. Official Comm. of Unsecured Creditors (In re Dornier Aviation), 453 F.3d 225, 231 (4th Cir. 2006); Sender v. Bronze Group, Ltd. (In re HedgedInvestments Assocs., Inc.), 380 F.3d 1292, 1297 (10th Cir. 2004); In re AutoStyle Plastics, Inc., 269 F.3d 726, 748, 750 (6th Cir. 2001). The “bankruptcy court’s equitable powers have long included the ability to look beyond form to substance.” In re Dornier Aviation (North America), Inc., 453 F.3d at 233. In fact, the equitable power of the court to recharacterize is viewed as essential to effectuating the Bankruptcy Code’s priority scheme. Id. at 233; In re AutoStyle Plastics, Inc., 269 F.3d at 748; In re Hedged-Investments Assocs., Inc., 380 F.3d at 1298.
The Fifth and Ninth Circuits have found that recharacterization is required in appropriate circumstances by Butner v. United States, 440 U.S. 48, 54 (1979), when applicable non-bankruptcy law would characterize something that at first glance may look like a loan as a contribution to capital. In re Lothian Oil, Inc., 650 F.3d 539, 542–43 (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, 1148 (9th Cir. 2013).
In Lothian Oil, the Fifth Circuit held that recharacterization of a purported debt as a capital contribution is permitted and that recharacterization is not limited to claims of insiders.2 As stated above, the Fifth Circuit’s approach to recharacterization differs from the several circuits that rely upon the equitable powers of a bankruptcy court as the basis for recharacterization. Rather than relying on the Section 105(a) “all writs” provision of the Bankruptcy Code, the Fifth Circuit applied state law to recharacterize a claim as an equity security interest by employing Section 502(b)(1) of the Bankruptcy Code—the Bankruptcy Code section that provides for the allowance and disallowance of claims. The Fifth Circuit reasoned that resorting to the general equitable powers of the bankruptcy court was inappropriate because it was unnecessary to do so, since Section 502(b)(1) explicitly grants authority to bankruptcy courts to allow and disallow claims. Thus, the Fifth Circuit’s analysis focused on the governing agreement and applicable state law, and not bankruptcy law, when deciding what rights were actually created by the agreement of the parties, despite any descriptive labels used by the parties (i.e., substance over form).
To read the full practice note in Lexis Practice Advisor, follow this link.
Ira L. Herman is a partner at Blank Rome, LLP. He concentrates his practice on distressed public debt issues, insolvency matters involving upstream and midstream oil and gas companies, and distressed M&A, in addition to traditional bankruptcy and insolvency matters.
For additional information on recharacterization, see
> UNDERSTANDING RECHARACTERIZATION
RESEARCH PATH: Bankruptcy > Case Administration and the Estate > Proofs of Claim > Practice Notes > Proofs of Claim
For additional information on subordination, see
> UNDERSTANDING SUBORDINATION
1. A “claim” under Section 101(5) of the Bankruptcy Code includes the “right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured.” 2. An “equity security” is defined as either “(A) share in a corporation, whether or not transferable or denominated ‘stock’, or similar security; (B) interest of a limited partner in a limited partnership; or (C) warrant or right, other than a right to convert, to purchase, sell, or subscribe to a share, security, or interest of a kind specified in subparagraph (A) or (B) of this paragraph.” 11 U.S.C. § 101(16).