Tenth Circuit Upholds Recharacterization of Debt to Equity

While not expressly authorized by the Bankruptcy Code, it is generally well-established that a bankruptcy court, as a court of equity, is not bound by a party’s characterization of a transaction and, instead, may recharacterize the nature of the transaction, acknowledging the economic realities involved.  The prime example occurs in instances where an insider purports to loan money to a debtor, but the loan is in essence a disguised equity contribution.  Based on case law in most jurisdictions, a bankruptcy court may recharacterize such a loan as an equity contribution.

In Redmond v. Cimarron Energy Co. (In re Alternate Fuels , Inc.), No. KS-12-110 (B.A.P. 10th Cir. Mar. 18, 2014), the Bankruptcy Appellate Panel (“BAP”) for the Tenth Circuit Court of Appeals recently upheld a bankruptcy court’s authority to recharacterize, notwithstanding arguments that the U.S. Supreme Court recently curbed a bankruptcy court’s authority to act outside the confines of the express language of the Bankruptcy Code.

Loan versus Equity

A “loan” is a sum of money advanced to a borrower for a specified period and repayable with agreed interest.  Typically, the amount loaned, the terms of repayment, and the interest are agreed up front when the money is loaned. Advances, interest rates, and repayment terms are not customarily left to the discretion of the lender.  The lender’s right to receive repayment is supported by consideration (money loaned) and accounted for with contemporaneous records. In short, the amount loaned and the amount to be repaid are readily calculable at the beginning of the transaction, and the obligation to repay is not conditional.

On the other hand, “equity” is an investment – an expenditure of money – in order to earn a financial return.  The amount of financial return is unknown and the entitlement to receive payment is conditional.   The amount of payment received may be unrelated to the amount advanced or may be received in exchange for little consideration.

The characterization of a transaction as a loan or equity contribution is important in bankruptcy because of the priority scheme set forth in the Bankruptcy Code.  Pursuant to that priority scheme, equity is generally not entitled to a recovery from a bankruptcy estate unless all creditor claims are satisfied.  See 11 U.S.C. § 1129(b).


In 1999, a husband and wife (the “Insiders”) became the indirect holders of all of the stock in Alternate Fuels Inc. (AFI).  The acquisition of these interests apparently was a strategic move to realize the value of the assets of AFI and an affiliated entity (Cimmaron), without being subject to all of the liabilities of AFI.  After acquiring AFI, the two Insiders purported to loan certain funds to AFI and, in return, received three promissory notes eventually secured by an assignment of potential litigation proceeds.  When AFI obtained a favorable judgment, it filed chapter 11 bankruptcy to facilitate a distribution of the litigation proceeds to its creditors.  A chapter 11 trustee was thereafter appointed.

In order to obtain a larger recovery to non-insider creditors, the chapter 11 trustee challenged the Insiders’ claims, arguing that the Insider loans were disguised equity contributions.  The bankruptcy court agreed with the trustee, finding, among other things, that there was insufficient documentation of the loan terms and the loans provided no benefit to AFI and instead were intended to obtain a recovery on the Insiders’ investment.  As a result, the loans (or equity contributions) became subordinate to the claims of other unsecured creditors of AFI.  The Insiders appealed this decision to the Tenth Circuit BAP.

Read the Text

On appeal, the Insiders argued that two recent U.S. Supreme Court opinions limited the bankruptcy court’s ability to recharacterize.  They first cited to Travelers Casualty & Surety Company of America v. Pacific Gas & Electric Company, 549 U.S. 443 (2007), where the Supreme Court held that “we generally presume that claims enforceable under applicable state law will be allowed in bankruptcy unless they are expressly disallowed,” pursuant to section 502(b) of the Code.  The Insiders contended that Travelers precludes recharacterization unless recharacterization is allowed by applicable state law.  Because in this instance applicable state law (Kansas) does not recognize recharacterization, the Insiders argued that their claim was enforceable under applicable state law and therefore could not be disallowed by an equitable federal doctrine (recharacterization), which is not expressly found in the Bankruptcy Code.

The Insiders next cited to the more recent opinion of Law v. Siegel, No. 12-5196, 571 U.S.___, 2014 WL 813702 (Mar. 4, 2014) (slip opinion), where the Supreme Court held that a bankruptcy court’s inherent powers pursuant to section 105(b) of the Code could not contravene express provisions of the Code.  For a recent discussion of the Siegel decision, see SCOTUS Restricts Inherent Bankruptcy Authority.

BAP Decision

The Tenth Circuit BAP rejected the Insiders’ arguments.  The BAP first distinguished the recharacterization remedy from the allowance or disallowance of claims proscribed in the Travelers and Siegel cases.  According to the BAP, recharacterization is not based on the enforceability of a claim; rather it is based on establishing the true substance of a transaction.  In other words, recharacterization is not a determination of whether a claim should be allowed or disallowed; it is a determination of whether a claim should be treated as a claim or an equity interest.  On the other hand, when a claim is disallowed under section 502 of the Code, it is essentially not recognized in the bankruptcy case.  If a claim is recharacterized, however, it is still recognized in the bankruptcy case, but is simply treated as an equity interest.

The BAP then reasoned that the Travelers and Siegel decisions did not deal with recharacterization of transactions and therefore neither opinion implicitly or expressly abrogated this equitable doctrine.  In doing so, the BAP found some support from the Fourth Circuit Court of Appeals’ opinion in In re Official Committee of Unsecured Creditors for Dornier Aviation (North America), Inc., 453 F.3d 225 (4th Cir. 2006).  There the Fourth Circuit held that:

[D]enying a bankruptcy court the ability to recharacterize a claim would have the effect of subverting the Code’s critical priority system by allowing equity investors to jump the line and reduce the recovery of true creditors. In light of the broad language of § 105(a) and the larger purpose of the Bankruptcy Code, we believe that a bankruptcy court’s power to recharacterize is essential to the proper and consistent application of the Code.

The BAP ultimately applied the thirteen factors announced by the Tenth Circuit in Sender v. Bronze Group, Ltd. (In re Hedged-Investments Associations., Inc.), 380 F.3d 1292 (10th Cir. 2004).  These nonexclusive factors include:

  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 regular corporate creditors;
  7. the intent of the parties;
  8. “thin” or adequate capitalization;
  9. identity of interest between the creditor and stockholder;
  10. source of interest payments;
  11. the ability of the corporation to obtain loans from outside lending institutions;
  12. the extent to which the advance was used to acquire capital assets; and
  13. the failure of the debtor to repay on the due date or to seek a postponement.

The purpose of these factors is to “distinguish true debt from camouflaged equity” by determining whether certain facts are more supportive of a loan or equity transaction.  However, the Tenth Circuit recognizes that these factors are not dispositive and their applicability and weight depend on the circumstances.

The BAP’s detailed and lengthy application of the Hedge-Investments factors is best explained in Redmond opinion itself.  To summarize that opinion, the BAP found that the totality of circumstances surrounding the Insiders’ loans supported recharacterization, as the Insider loans were either used to (a) acquire interests in AFI or (b) allow AFI to meet certain obligations that would release encumberances in certain assets that otherwise were available to AFI’s equity owners.  Thus, the BAP concluded that AFI received no economic benefit from the loans and the only purpose of the loans was to benefit the beneficial owners of AFI (i.e., the Insiders).


Because of the particular facts in Redmond, the BAP appeared reluctant to expand the holdings in Travelers and Siegel to abolish the equitable doctrine of recharacterization, even though such doctrine is not codified in the Bankruptcy Code. The BAP seemed focused on preserving the priority scheme set forth by the Bankruptcy Code and preventing abuse by equity owners attempting to take advantage of their unique positions with a debtor by disguising their true interests.

Whether other Circuit Courts will agree with the analysis remains to be seen.  In the future, however, the Siegel holding should raise less concerns, because that case involved a bankruptcy court order that directly contravened a Bankruptcy Code provision; namely, surcharging an exempt asset, in violation of section 522 of the Code.  Recharacterization, however, is not expressly proscribed by the Bankruptcy Code.  The holding in Travelers presents a more difficult question, because there the Supreme Court seems to suggest that section 502 allows any claim enforceable under state law unless expressly prohibited by the Code.  Significantly, section 502 of the Code–or any other provision–does not expressly prohibit a claim on recharacterization grounds.

Nonetheless, even if Travelers presents an obstacle in the future, there may exist multiple other state law arguments, like fraud, misrepresentation, or, in certain jurisdictions, recharacterization, that would still preserve the ability to disallow disguised transactions by insiders.