Fear And Lothian Oil: Are Unsecured Creditors Under Greater Threat From Insider Loans?

Johnny White, Esq.

Johnny White, Esq.

The following article appeared in the Fall 2011 issue Blakeley & Blakeley's Trade Creditor's Quarterly.

The controversial doctrine of recharacterization empowers bankruptcy courts to ignore the formal labels of a loan and, looking instead to a transaction's substance, reclassify a lender's claim as equity instead of debt. The primary goal of the doctrine is to stop shareholders retaining assets of a bankrupt estate at the expense of creditors simply by dressing up their capital investments as loans. Recharacterization can have significant impact on the treatment of unsecured creditors in many bankruptcies. Its practical consequence is that the newly recharacterized loans fall down the ladder of priority (below the trade creditors) in the scheme of distribution at the end of the case. In large Chapter 11 cases where the debtor is carrying millions, perhaps hundreds of millions, in mezzanine bond debt for example, relegating the bondholders could be the difference between zero and hundred cent dollars for the trade.

A recent decision from a federal appeals court in Texas on the topic of recharacterization -- Grossman v. Lothian Oil Inc. (In re Lothian Oil Inc.), 650 F.3d 539 (5th Cir. 2011) -- piqued the interest of commentators for rejecting the rule that a lender must be an "insider" of the debtor before its debt can be recharacterized. Though this aspect of the decision is important, the attention has distracted somewhat from a more fundamental departure from precedent within the opinion -- one bearing on the very source of authority for recharacterization. The court in Lothian Oil determined that state, as opposed to federal, law governs whether a debt should be recharacterized. If widely followed, this could have profound implications, as discussed below.

How and When Recharacterization Can Be Invoked: A Split of Authority

After Lothian Oil, a four-way split exists among federal circuits that have interpreted the place of recharacterization in the Bankruptcy Code. Whether this circuit split could be resolved by the U.S. Supreme Court and, if so, how, is far beyond the scope of this article. It suffices to say that the law is unsettled, and the Texas opinion, which is well-reasoned, could gain currency going forward.

The four approaches to recharacterization are:

1. Recharacterization is incompatible with the Bankruptcy Code and no longer exists;

2. Recharacterization is allowed where it is an insider loan and the company was undercapitalized to begin with, or when no disinterested lender would have made a comparable loan;

3. Recharacterization is allowed when the totality of the circumstances and terms of the loan reveal that it was intended as a capital contribution at the time it was made; or

4. Recharacterization of a loan is al-lowed where applicable state law authorizes recharacterization.

The first two approaches are minority approaches that have failed to win any wide-spread support.1 The third approach, a case by case review of all the surrounding circumstances, has been favored by most courts. This test was imported from tax court decisions analyzing how transactions should be treated for tax purposes, and looks to a list of factors. The factors most commonly cited2 are:

1. the names given to the instruments, if any, evidencing the loan;
2. the presence or absence of a fixed maturity date and schedule of payments;
3. the presence or absence of a fixed interest rate and interest payments;

   Recharacterization would only be allowed if there is a basis for it in state law

4. the source of repayments;
5. the adequacy or inadequacy of capitalization;
6. the identity of interests between the creditor and stockholder;
7. the security, if any, for the advances;
8. the corporation's ability to obtain financing from outside lending institutions;
9. the extent to which the advances were subordinated to the claims of outside creditors;
10. the extent to which the advances were used to acquire capital assets; and
11. the presence or absence of a sinking fund to provide repayments.

As with any such test, no one factor controls, and ultimately the judge is left to make a highly subjective "I know it when I see it" judgment. The approach suffers criticism for its inherent uncertainties, and potential for discouraging bona fide insider loans that might otherwise keep a struggling business afloat -- anathema to the values of U.S. business law.

The Threat of State Law and Choice-of-Law Clauses

If the lender is sophisticated, the loan will contain a well thought-out choice-of-law clause

The reason Lothian Oil's approach -- i.e. leave it to the states -- presents a credible alternative to the multi-factor Autostyle test is because of Autostyle's awkward reliance on an unfashionable provision of the Bankruptcy Code. Courts taking the multi-factor approach have always cited section 105(a) of the Bankruptcy Code as supporting the doctrine of recharacterization. This is the provision of the Bankruptcy Code that enables the court to issue "any order, process, or judgment that is necessary or appropriate to carry out the provisions of [the Bankruptcy Code]." In other words, it is the "when all else fails, and justice requires it, we'll do whatever we want"-provision, and the default argument of bankruptcy lawyers everywhere that are badly stuck for an argument. It has come to be used sparingly.

Takeaways Although this debate takes place in a realm of theory well divorced from the day-to-day decisions of most credit managers, it is nonetheless worth considering whether you are doing everything you can to guard against being burned by insider loans. Here are some good practices: Request detailed financial statements when extending credit to better understand the customer's capital structure. Consider inserting a provision in your credit application to the effect that: As of the date of execution of this application, Customer has no outstanding debt obligations whatsoever to any of its directors, officers, shareholders, or any individual or entity meeting the definition of insider under 11 U.S.C. § 101(31). Customer further warrants and represents that it will promptly notify Supplier if Customer incurs any indebtedness to its shareholders, directors, officers or insiders in an aggregate amount greater than $20,000. Review UCC filings against the company when first approving a credit line and set up reminders for quarterly reviews thereafter to catch subsequent filings against the customer. Remember, a shareholder can lend money on an unsecured or secured basis. It is harder to cry foul and claim a loan should be recharacterized, when the creditor has been on notice, or should have been on notice, of the loan because of a publicly-filed UCC-1 statement.

Lothian Oil, on the other hand, finds authority in section 502(b)(1) of the Bankruptcy Code, which requires the Bankruptcy Court to hold a hearing to determine the amount of a creditor's claim if there is an objection to it, and disallow it if "such claim is unenforceable … under any agreement or applicable law." The key language is "applicable law," which is another way of saying "state law." By finding authority in this provision, Lothian Oil sidesteps the problem of using section 105(a), which most courts disfavor, and arguably creates a sounder theoretical basis for recharacterization.

The knock-on effect though is that recharacterization would only be allowed if there is a basis for it in state law. In the Lothian Oil case, the court looked to Texas law, which, as it happened, applied a similar multi-factor test to Autostyle, imported from federal tax law. In other states, such as Massachusetts and Wisconsin, recharacterization would be allowed only where there has been some inequitable conduct by the lender. What of New York, Delaware and California law, one of which will usually govern interpretation of a loan contract? The answer, unfortunately, is unclear. The law of these jurisdictions on this issue appears to be surprisingly underdeveloped.

Though it is praised for potentially bringing certainty to a very convoluted area of the law, would Lothian Oil be a net positive or net negative for the trade if widely adopted? The answer is probably a net negative. If the lender is sophisticated, the loan will contain a well thought-out choice-of-law clause. It is easy to see a lender-friendly jurisdiction such as Delaware adopting, by legislation if necessary, a framework for recharacterization that requires lender misconduct, and raises the bar for unsecured creditors seeking to recharacterize loan transactions. By simply choosing this as the governing law of the contract, lenders could stack the odds against later recharacterization.

Whether Lothian Oil takes off outside its circuit, or ultimately becomes a footnote, we have not heard the last word on recharacterization. So watch this space.

Johnny White, Esq. can be reached at jwhite @ blakeleyllp.com.

Footnotes

1. The first approach was endorsed in 1986 by the 9th Circuit Bankruptcy Appellate Panel - In re Pacific Express, 69 B.R. 112 (9th Cir. B.A.P. 1986) -- a decision which has been roundly criticized for conflating and confusing the concepts of re-characterization and "equitable subordination," a related doctrine, that can be invoked as a remedy in similar settings, but one that focuses on the fairness of the lender's conduct rather than on the formal and circumstantial attributes of the loan. The second approach, adopted by the 11th Circuit in Estes v. N & D Props., Inc. (In re N&D Props., Inc.), 799 F.2d 726, 733 (11th Cir. 1986) has also been acidly criticized as "invented without citation to relevant precedent." James M. Wilton & Stephen Moeller-Sally, Debt Recharacterization Under State Law, The Business Lawyer; Vol. 62, p. 1257 (2007)

2. See Bayer Corp. v. MascoTech, Inc. (In re Autostyle Plastics, Inc.), 269 F.3d 726, 747--53 (6th Cir. 2001)

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