Equitable Subordination and Recharacterization

The doctrine of equitable subordination is based upon principles of equity, and allows a court to subordinate the claim of one creditor to the claims of other creditors. Section 510(c) of the Bankruptcy Code addresses equitable subordination of claims filed in bankruptcy cases. Subsection (c)(1) states “Notwithstanding subsections (a) and (b) of this section, after notice and a hearing, the court may—(1) under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or part or another secured interest[.]” 11 U.S.C. § 510(c)(1). The Sixth Circuit has adopted a three part test for determining whether equitable subordination of a claim is appropriate: “(1) the claimant must have engaged in some type of inequitable conduct; (2) this misconduct must have resulted in injury to the creditors of the bankrupt 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 Act.” Bayer Corp. v. MascoTech, Inc. (In re AutoStyle Plastics, Inc.), 269 F.3d 726, 744 (6th Cir.2001).

A related but distinct equitable remedy is “recharacterization.”  Recharacterization is appropriate where the circumstances show that a debt transaction was `actually [an] equity contribution [] ab initio.'” AutoStyle Plastics, 269 F.3d at 747-48)(quoting In re Cold Harbor Assocs., L.P., 204 B.R. 904, 915 (Bankr.E.D.Va.1997)). The issue to be determined in recharacterization is whether a “transaction created a debt or equity relationship from the outset.” Cold Harbor, 204 B.R. at 915; see also Cohen v. KB Mezzanine Fund II, LP, (In re SubMicron Sys. Corp.), 432 F.3d 448, 454 (3d Cir.2006) (“the focus of the recharacterization inquiry is whether `a debt actually exists.'”) (quoting AutoStyle Plastics, 269 F.3d at 748); Sender v. Bronze Group, (In re Hedged-Inv. Assocs., Inc.), 380 F.3d 1292, 1298  (10th Cir.2004) at 1298 (applying multi-factor test “to distinguish true debt from camouflaged equity”). Recharacterization prevents an equity investor from labeling its contribution as a loan, and subverting the Bankruptcy Code’s critical priority system by guaranteeing itself a higher priority-and a larger recovery-should the debtor file for bankruptcy. Fairchild Dornier GmbH v. Official Comm. of Unsecured Creditors, (In re Official Comm. of Unsecured Creditors for Dornier Aviation, Inc.), 453 F.3d 225, 231 (4th Cir.2006). Thus, the “exercise of th[e] power to recharacterize is essential to the implementation of the Bankruptcy Code’s mandate that creditors have a higher priority in bankruptcy than those with an equity interest.” Id. at 233. In determining whether a debt exists, the Sixth Circuit follows the test set out in Roth Steel Tube Co. v. Comm’r of Internal Revenue,  800 F.2d 625 (6th Cir. 1986).  Roth Steel sets forth the following eleven factors for consideration:

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

Id., at 630; See Autostyle Plastics, 269 F.3d at 747-48 (adopting Roth Steel factors for bankruptcy recharacterization).

By: Jamie L. Harris, Esq.

Jamie Harris is a member attorney with DelCotto Law Group PLLC. Her practice of law focuses on helping business owners hurdle financial obstacles. Jamie is best known for her experience in filing Chapter 7, 11, 12, and 13 bankruptcies. In her Chapter 11 cases, Jamie has represented companies from many different industries including healthcare, nonprofit, trucking, construction, commercial real estate and telecommunications.


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