Recharacterization of Claims as Equity

"Recharacterization" refers to the equitable power exercised by bankruptcy courts to recast a purported claim or transaction according to its true economic nature and substance, regardless of its form or label. In bankruptcy, the two major types of recharacterization is of loans to be in actuality equity contributions and the recharacterization of sales as secured loans.

In the case of First NLC Financial Services, LLC, 396 B.R. 562 (Bkrtcy. S.D. Fla., 2008), a chapter 7 trustee brought an adversary proceeding against purported lenders and asserted that their claims based on loans should, inter alia, be recharacterized instead as equity. The bankruptcy court stated that at least five Circuit Courts of Appeal, including the Eleventh Circuit, recognize the power of bankruptcy courts to recharacterize debt as equity. The bankruptcy court further states that the purpose of recharacterization is to prevent equity investors from labeling their contributions as loans and thereby circumventing the Bankruptcy Code's priority system by obtaining a larger recovery and higher priority in the event of a bankruptcy. The court further distinguished recharacterization from equitable subordination in that recharacterization rests on the substance of the transaction while equitable subordination is based on the assessment of the creditor's behavior. The Bankruptcy Court noted that the determination of recharacterization is generally based on a number of factors, including the issue of undercapitalization, the names given to the certificates evidencing the debt, the presence of a fixed maturity date, the source of the payments, the right to enforce payments, participation in management, the status of the contribution in relation to regular corporate creditors, the intent of the parties, identity of interest between the creditor and stockholder, source of the 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, and the failure of the debtor to repay on the due date or seek a postponement.