(1) the Intent of the Parties;

Recharacterization

A bankruptcy court may “recharacterize” a debt instrument as an equity instrument in certain circumstances. Because creditors must be repaid in full before equity holders receive anything, the economic consequence of recharacterization can be dramatic. If a debtor is insolvent (which many debtors are), recharacterization will eliminate any distribution of assets to the holder of the recharacterized instrument.

Recharacterization focuses on the economic substance of a transaction at the time the parties entered into that transaction. Courts recognize that, at times, an investor may attempt to disguise a capital contribution as a loan in order to improve the investor’s position if the company later fails. In such a circumstance, the investor would be permitted to share in the profits of a company while simultaneously obtaining a priority return as a creditor in a bankruptcy.

There is no firm test to determine whether a court will recharacterize a debt as equity. Rather, a court will look to the facts and circumstances that existed when the investor made the investment. Factors that a court will consider in determining whether to recharacterize a debt as equity include the following:

(1) the intent of the parties;

(2) the identity between creditors and shareholders;

(3) the extent of participation in management by the holder of the instrument;

(4) the ability of the corporation to obtain funds from outside sources;

(5) the ‘thinness’ of the capital structure in relation to debt;

(6) the risk involved;

(7) the formal indicia of the arrangement;

(8) the relative position of the obliges as to other creditors regarding the payment of interest and principal;

(9) the voting power of the holder of the instrument;

(10) the provision of a fixed rate of interest;

(11) a contingency on the obligation to repay;

(12) presence of sinking fund to provide repayments;

(13) the source of the interest payments;

(14) the presence or absence of a fixed maturity date;

(15) a provision for redemption by the corporation;

(16) a provision for redemption at the option of the holder; and

(17) the timing of the advance with reference to the organization of the corporation.

Unlike some similar doctrines, recharacterization does not require a finding by the court that the parties involved acted inequitably or improperly in any way. The focus in a recharacterization analysis is on the economic substance of a transaction at the time of the transaction, not the conduct (or misconduct) of the parties to it. Recharacterization typically occurs in scenarios where the transaction does not bear the characteristic of an arm’s length transaction.

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