A bankruptcy court, as a court of equity, is not bound by a party’s characterization of a transaction. This is particularly true with respect to an insider’s advance to a debtor that, while nominally structured as loan, is in essence a disguised equity contribution. In such cases, a bankruptcy court may acknowledge economic realities and recharacterize purported debt as equity. Some have argued that a court’s ability to grant relief not expressly authorized under the Bankruptcy Code, such as debt recharacterization, has been severely limited, if not extinguished, by recent Supreme Court decisions. That argument was recently rejected by the Bankruptcy Appellate Panel for the Tenth Circuit. Redmond v. Cimarron Energy Co. (In re Alternate Fuels , Inc.), No. KS-12-110 (B.A.P. 10th Cir. Mar. 18, 2014).
Background of the Dispute
In 1999, William Karl Jenkins and his wife became the indirect holders of (1) all of the stock in Alternate Fuels Inc. and (2) 99% of the interests in Cimmaron Energy Co. After acquiring AFI and Cimmaron, the Jenkinses advanced certain funds to AFI and, in exchange, received three promissory notes secured by an assignment of potential litigation proceeds. When AFI obtained a favorable judgment, it filed a voluntary petition under Chapter 11 to facilitate a distribution of the litigation proceeds to its creditors. A Chapter 11 trustee was thereafter appointed.
As a result of the Chapter 11 trustee’s challenge of the Jenkinses’ claims, the bankruptcy court, among other actions, recharacterized the Jenkinses’ purported loans as equity contributions. The Jenkinses appealed the bankruptcy court’s decision.
Tenth Circuit Bankruptcy Appellate Panel’s Analysis and Rationale
On appeal, the Jenkinses argued that a bankruptcy court’s power to recharacterize claims was limited by the Supreme Court’s decisions in Travelers Cas. & Sur. Co. v. Pac. Gas & Elec. Co., 549 U.S. 443 (2007) and Law v. Siegel, No. 12-5196, 2014 WL 813702 (Mar. 4, 2014). In Travelers, the Supreme Court stated that “we generally presume that claims enforceable under applicable state law will be allowed in bankruptcy unless they are expressly disallowed.” In Law, the Supreme Court stated that a bankruptcy court’s equitable powers “can only be exercised within the confines of the Bankruptcy Code.” Thus, according to the Jenkinses, because the Bankruptcy Code does not provide for the recharacterization of claims, their claims could only be recharacterized if applicable state law would permit it. In this instance, the Jenkinses’ claim was governed by Kansas law, which according to the Jenkinses, does not permit the recharacterization of claims to equity.
Noting that neither Supreme Court decision addressed a court’s ability to recharacterize claims, the Bankruptcy Appellate Panel concluded that “[i]t is not implicit, and clearly not explicit that Travelers or Law abrogated a bankruptcy court’s ability to recharacterize an alleged loan.” Moreover, the Panel noted that recharacterization is not a determination of the validity of a claim. Instead, it is a determination of “the true substance of the transaction.” If a court is bound to a party’s characterization and is not able to recharacterize debt as equity, the Bankruptcy Code’s priority scheme may be turned on its head to the detriment of holders of valid claims. On the other hand, if a purported claim is recharacterized as equity, a bankruptcy court will continue to recognize the relationship between the debtor and the claimant, albeit in a different form.
Ultimately, the Bankruptcy Appellate Panel affirmed the bankruptcy court’s decision finding that recharacterization was appropriate under the test previously adopted by the Tenth Circuit. Nevertheless, opponents of equitable relief, such as recharacterization and equitable disallowance of claims, may follow the lead of the Jenkinses and continue to argue that recent Supreme Court rulings preclude relief not expressly permitted by the Bankruptcy Code. Whether such future efforts prove to be successful remains to be determined.