Recharacterisation risk in modern finance
August 2014 | EXPERT BRIEFING | BANKING & FINANCE
As investors continue to chase yield in an historically low interest rate environment, they are using increasingly complicated structures to unlock value. The quest for better returns is not without risk. Thus, capital providers will be well served not only to consider the means to enhance their potential return on investment, but also to plan ahead by considering the downside risk and taking steps to manage that risk.
One risk investors must consider is that a transaction structured as a loan will be deemed to be something else by a court -- an equity investment or contribution to capital. Courts in the United States are facing the issue of ‘loan recharacterisation’ with greater frequency than ever, as capital providers use hybrid structures, i.e., structures with characteristics both of traditional loans and of equities, to increase their return on investment. The recharacterisation risk is especially high when a financially distressed borrower enters bankruptcy, and the assets and liabilities of that entity are subjected to heightened scrutiny by competing stakeholders.
As recharacterisation is a judicially created doctrine based solely on case law precedent, the law in this area is less than clear due to inconsistent decision making by the courts. The case law is particularly fractured where the courts have had to deal with so called rescue financing provided to a financially distressed business by an insider or other nontraditional lender.
In the main, however, the courts have analysed transactions where recharacterisation is at issue by looking past labels and determining whether the instrument before the court reflects the existence of a loan transaction or of something else. Presently, there are two chief rationales used by bankruptcy courts to recharacterise. The first rationale, which has been adopted by the Third, Fourth, Sixth, and Tenth Circuits, is that courts may recharacterise claims in a bankruptcy case pursuant to the broad equitable powers granted to them by Bankruptcy Code section 105(a). These circuits apply a multi-factor test developed at the federal level.
Other courts, including the Fifth and Ninth Circuits, find that bankruptcy courts have the authority to recharacterise debt as equity only if applicable non-bankruptcy law would recharacterise such debt as equity. These courts base their reasoning on the Supreme Court opinion of Butner v. United States (440 U.S. 48, 54 (1979)), which held that “Congress has generally left the determination of property rights in the assets of a bankrupt’s estate to state law”. Thus, in these circuits, the analysis will depend on applicable state law.
Despite the circuit split as to rationale, there are factors all of the courts appear to consider in a recharacterisation analysis. Factors that courts have considered in recharacterising purported debt as equity include: (i) the names given to the instruments, if any; (ii) the presence or absence of a fixed maturity date and schedule of payments; (iii) the presence or absence of a fixed rate of interest or interest payments; (iv) the source of repayment; (v) the adequacy or inadequacy of capitalisation in relation to debt; (vi) the identity of interests between creditors and shareholders; (vii) the presence or absence of security for the amount advanced; (viii) the ability of the corporation to obtain funds from outside sources; (ix) the extent to which the advances were subordinated to claims of outside creditors; (x) The extent to which the advances were used to acquire capital assets; and (xi) the presence or absence of a sinking fund to provide repayments. Courts also look to the formal indicia of the arrangement, including the stated intent of the parties or any stated contingency on the obligation to repay. Additionally, courts review facts surrounding the financing such as: (i) the extent of participation in management by or voting power of the holder; (ii) the relative position of the obligees as to other creditors regarding the payment of interest and principal; (iii) the timing of the advance with reference to the organisation of the corporation; and (iv) the failure of the debtor to repay on the due date or to seek a postponement versus the creditor’s response to non-payment.
While no one factor is typically considered controlling, the various factors are not of equal significance and the analysis is very case-specific. Although some of these factors cannot be altered at the front end of a deal – e.g., the identity of creditors with the shareholder and the participation of the creditor in management – other factors can indeed be controlled. As a practical matter, an insider making a loan should: (i) back up the loan with formal documentation, including a standard promissory note; (ii) make the loan on normal business terms, including an interest rate comparable to what could be obtained from a non-insider lender; and (iii) avoid terms that are red flags for claim recharacterisation, such as a contingency on the obligation to repay, redemption provisions, or provisions granting voting power to the instrument holder.
When a financing complies with the formalities for a valid loan agreement and advances are treated as a loan in the debtor’s business records, courts typically are reluctant to recharacterise, even when the borrower was undercapitalised at the time funds were advanced. On the other hand, when the transaction lacks formalities, especially when the party advancing funds is an insider, courts are more likely to recharacterise. Circumstances such as the lack of a fixed maturity date, repayment contingent on profitability (in particular where the borrower has a history of not being profitable), the borrower’s liabilities (even after the financing) far exceeding its assets, and the purported creditor assuming the borrower’s losses, all militate toward recharacterising debt as equity.
Even where a transaction is evidenced by a ‘promissory note’ such instrument may be recharacterised if the parties to the transaction do not act like the transaction is a loan. For instance, where payment is dependent on the profitability of the borrower, the instrument may not be considered evidence of a debt, but rather of an equity investment. For a transaction to be characterised as a loan transaction, there must be a reasonable expectation of repayment that does not depend solely on the success of the borrower’s business.
In essence, a bankruptcy court performing a recharacterisation analysis is determining whether the facts presented demonstrate that the capital provider has funded as a banker (i.e., the party expects to be repaid with interest, no matter the borrower’s fortunes) and the funds are therefore debt, or as an investor (i.e., the funds infused are repaid based on the borrower’s fortunes) and therefore the funds are equity.
No matter the test applied, the recharacterisation analysis is intended to turn on facts rather than equitable principles, even though the effect of recharacterisation invariably will seem inequitable to capital providers, as recoveries on account of equity investments are structurally subordinated to payments on account of debts. The difference in treatment is particularly impactful on a capital provider that goes from having what it believes is a secured position to being in the position of equity – which is frequently out of the money in a bankruptcy case.
Based on the potential harsh realities of recharacterisation, would-be lenders, especially insiders, should look carefully at the financing transaction they are considering against the backdrop of the recharacterisation risk to manage the downside risk and enhance the likelihood of payment even if things do not work out for the borrower as intended.
Ira L. Herman and Katharine Battaia Clark are partners at Thompson and Knight LLP. Mr Herman can be contacted on +1 (212) 751 3045 or by email: firstname.lastname@example.org. Ms Clark can be contacted on +1 (214) 969 1495 or by email: email@example.com.
© Financier Worldwide
Ira L. Herman and Katharine Battaia Clark
Thompson and Knight LLP