In re Alternate Fuels: Tenth Circuit BAP Holds Recent Supreme Court Decisions Do Not Limit Power to Recharacterize Debt to Equity

Practical Law Legal Update 5-568-6502 (Approx. 7 pages)

In re Alternate Fuels: Tenth Circuit BAP Holds Recent Supreme Court Decisions Do Not Limit Power to Recharacterize Debt to Equity

by Practical Law Finance

Background

In 1999, William Karl Jenkins and his wife (the Claimants) purchased from John Warmack (Warmack) for $549,250:

All of the stock in Alternate Fuels, Inc. (AFI).
99% of the stock of AFI's operating company, Cimarron Energy Co. (Cimarron).
Cimarron's mining equipment, valued between $1 million to $2 million.
24 Certificates of Deposit in total face amount of $1,377,000 that were pledged to secure reclamation bonds guaranteeing AFI's obligations to the State of Missouri to reclaim, or restore, certain mining sites (Reclamation Bonds). The release of the Certificates of Deposit was contingent on AFI's satisfactory completion of its reclamation work.

Warmack used the sale proceeds to pay down secured debts on Cimarron's equipment, as required by the purchase agreement. Even though AFI received no benefit from the $549,250 payment, it executed a promissory note in the amount of $500,000 payable to Green Acres Farms, a business name the Claimants registered with the Missouri Secretary of State. The note had a five-year term, but repayment in full was due on the release of the Reclamation Bonds by the State of Missouri. AFI had no expected source of revenue and could only repay this note with the Certificates of Deposit. After the sale, AFI was left with only the permitted mining sites that were subject to reclamation and a $500,000 indebtedness to the Claimants. Any funds that the Claimants advanced to AFI were to finance the reclamation process, with the ultimate purpose of having the State of Missouri release the Certificates of Deposit.

AFI did not observe corporate formalities. Jenkins controlled all of AFI's operations, which were limited to reclamation efforts through Cimarron, and were funded through checks issued by Green Acres Farms. Before obtaining funds from the Claimants, AFI unsuccessfully attempted to obtain financing from at least six banks. AFI advanced the funds from Green Acre Farms to Cimarron, but there was no written agreement between AFI and Cimarron, no accounting connecting these funds to the promissory note and no documentary evidence that the funds were used for reclamation expenses. AFI executed another $500,000 five-year promissory note payable to Green Acres Farms in 2000 and a $1 million five-year note payable to Green Acres Farms in 2001. These notes had similar terms to the first note issued, were also to be repaid in full on the release of the Reclamation Bonds and were not supported by any contemporaneous or prior accounting. The Claimants knew that AFI would not be able to pay these notes, and claimed that each note was intended to be additional debt, not to supersede or replace the previous note.

In 2002, AFI filed a lawsuit against officers and employees of the Missouri Department of Natural Resources, alleging that the State of Missouri had unreasonably blocked and interfered with the reclamation. Since Jenkins controlled AFI, in 2003, he caused AFI to assign $3 million of its potential recovery from the litigation to the Claimants and to issue a fourth note in favor of Green Acres Farms and the Claimants in the amount of $2,370,761. This note stated that it was a renewal of the prior three notes, but made no reference to future advances. Like the three prior notes, it had a term of five years, was not supported by any contemporaneous or prior accounting and was to be paid in full on the release of the Reclamation Bonds. However, this note was also secured by the $3 million assignment of potential proceeds from the litigation.

The litigation resulted in a favorable judgment for AFI, which the State of Missouri satisfied in 2008 by paying a little over $7 million into the registry of the US District Court for the Western District of Missouri. This prompted creditors of AFI to make claims against the judgment proceeds. Because AFI needed court assistance in determining the priority of payment to its creditors, it filed a Chapter 11 bankruptcy petition in 2009 and a trustee was appointed.

The Claimants filed a proof of claim against AFI's estate for $4,336,813, which included, among other things, $3,823,862.92 for payment of the first three promissory notes and $487,298.62 for money related to reclamation. The trustee filed an adversary proceeding against the Claimants challenging their claim and seeking either to have the Claimants' loans recharacterized as an equity contribution, or have their secured claims equitably subordinated or disallowed entirely. Because the Bankruptcy Court found that the claims for the first three promissory notes and the claim for money related to reclamation should be recharacterized as equity, it set aside AFI's assignment of the litigation proceeds. Alternatively, the Court held that because the Claimants failed to prove the validity and amount of their claims, their claims should be disallowed. The Court further held that even if the Claimants' claims were not recharacterized as equity or disallowed, they should be treated as unsubordinated, unsecured claims for the amount of the transfers, but their secured claim on the litigation proceeds should be equitably subordinated.

The Claimants appealed the Bankruptcy Court's decision to the BAP.

Outcome

The BAP held that two recent US Supreme Court decisions, Travelers Casualty & Surety Co. of America v. Pacific Gas & Electric Co (549 U.S. 443 (2007)) and Law v. Siegel (134 S. Ct. 1188 (2014)), do not limit a bankruptcy court's authority to recharacterize claims, which is found in section 105 of the Bankruptcy Code.

Next, the BAP held that the Bankruptcy Court properly recharacterized the Claimants' claim in this case. In concluding that the Claimants' claims should be recharacterized, the Bankruptcy Court employed a 13-factor test identified by the US Court of Appeals for the Tenth Circuit in Sender v. Bronze Group, Ltd. (In re Hedged-Investments Assocs., Inc.) (see 380 F.3d 1292 (10th Cir. 2004)).

Recharacterization Not Precluded by Supreme Court Decisions

The Claimants argued that the US Supreme Court's decision in Travelers Casualty & Surety Co. of America v. Pacific Gas & Electric Co. precludes recharacterization unless recharacterization is allowed by applicable state law (see 549 U.S. 443 (2007)). In Travelers, the US Supreme Court stated that "we generally presume that claims enforceable under applicable state law will be allowed in bankruptcy unless they are expressly disallowed" (549 U.S. at 452). Therefore, the Claimants argued that the Travelers decision prohibits recharacterization of their claims because:

There is no prohibition in the Bankruptcy Code that disallows their claims.
Their claims are enforceable under Kansas law, which the Claimants alleged does not recognize recharacterization.

The Claimants also argued that the US Supreme Court's decision in Law v. Siegel prohibits recharacterization (see 134 S. Ct. 1188). In Law, the US Supreme Court stated that a bankruptcy court's equitable powers under section 105(a) "can only be exercised within the confines of the Bankruptcy Code" (134 S. Ct. at 1194). Therefore, the Claimants argued that because section 502(b) of the Bankruptcy Code, which deals with the disallowance of claims, does not give bankruptcy courts the discretion to grant or disallow claims under section 105(a) based on whatever considerations they deem appropriate, the Bankruptcy Court erred by applying recharacterization.

The BAP rejected both of these arguments. First, it noted that neither the Travelers case nor the Law case abrogated a bankruptcy court's ability to recharacterize a claim. Neither case dealt with recharacterization or even mentioned the In re Hedged-Investments decision.

Next, the BAP explained that recharacterization is based on establishing the true substance of a transaction, not on the enforceability of a claim. It is a determination on whether a claim should be treated as debt or equity, not whether a claim should be allowed or disallowed.

Finally, the BAP explained that the implementation of the Bankruptcy Code's priority scheme requires a determination of whether a particular obligation is debt or equity. Therefore, where there is a dispute, the BAP held that a bankruptcy court must have the authority to make this determination in order to preserve the Bankruptcy Code's priority scheme. Denying a bankruptcy court this ability 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."

As an aside, the BAP noted that it was not convinced that recharacterization is not permissible under Kansas law.

Therefore, the BAP affirmed that a bankruptcy court has the power under section 105(a) to recharacterize debt to equity, which it called "essential to the proper and consistent application of the Code."

Hedged-Investments Test

After finding that recharacterization is within a bankruptcy court's equitable powers, the BAP held that the Bankruptcy Court properly applied the 13-factor In re Hedged-Investments test and affirmed its recharacterization of the Claimants' claims. This test considers the following factors to help determine whether certain facts are more supportive of a loan or an equity transaction:

The names given to the certificates evidencing the indebtedness.
The presence or absence of a fixed maturity date.
The source of payments.
The right to enforce payment of principal and interest.
Participation in management flowing as a result.
The status of the contribution in relation to regular corporate creditors.
The intent of the parties.
"Thin" or adequate capitalization.
Identity of interest between the creditor and stockholder.
Source of interest payments.
The ability of the corporation to obtain loans from outside lending institutions.
The extent to which the advance was used to acquire capital assets.
The failure of the debtor to repay on the due date or to seek a postponement.

The Claimants argued that the multi-factor test found in In re Hedged-Investments compels treatment of their claims as loans. The Bankruptcy Court, however, considered the factors in light of the facts of the case and concluded that they supported the recharacterization of the Claimants' loans to equity. It concluded that two of the factors were inapplicable, three of the factors "superficially" supported recharacterization and the remaining seven factors "strongly" supported recharacterization.

The BAP agreed with the Bankruptcy Court's analysis of the factors and upheld its determination that recharacterization of the claims was appropriate. It was clear to the BAP that the Claimants' $549,250 payment to Warmack was a payment for an equity interest. AFI had no capital or funds to finance the reclamation, could not obtain outside financing for this purpose and had no economic benefit or incentive to reclaim the mining sites. The Claimants knew that AFI had no ability to pay the notes at the time they were signed and that they would be unable to enforce payment. Therefore, the notes and advances should be treated as equity contributions because the only purpose of AFI's reclamation was to benefit the Claimants, as the beneficial owners of AFI, by enabling them to obtain the Certificates of Deposit.

Practical Implications

The BAP's decision affirms that the authority to recharacterize claims is within the broad equitable powers of the bankruptcy court under section 105 of the Bankruptcy Code. Despite the fact that there is no provision in the Bankruptcy Code expressly authorizing recharacterization, the BAP declined to expand the US Supreme Court's holdings in Travelers and Law to limit this power. In doing so, the BAP emphasized that recharacterization is an essential tool for bankruptcy courts to preserve the Bankruptcy Code's priority scheme and prevent abuse by equity holders that try to disguise their true interests.

However, others are likely to make similar arguments that the US Supreme Court's recent decisions preclude relief not expressly permitted by the Bankruptcy Code, and it remains to be seen whether other Circuit courts will follow the BAP's ruling.

For more information on debt recharacterization and steps that can be taken to avoid a recharacterization claim, see Practice Note, The Risk of Debt Recharacterization in Bankruptcy.

In re Alternate Fuels: Tenth Circuit BAP Holds Recent Supreme Court Decisions Do Not Limit Power to Recharacterize Debt to Equity | Practical Law