In our last article[i], we discussed the judicial recharacterization of loans as equity interests. As we described, a court will recharacterize a lender’s debt claim as equity if it determines the “loan” actually was intended to be, and was treated by the parties as, an equity investment. Recharacterization is a powerful tool for creditors and trustees because, under the Bankruptcy Code’s priority scheme, debt claims (and all general unsecured claims) must be repaid in full before equityholders can receive any distribution on account of their (equity) interests. Because many, if not most, bankruptcy cases result in little or no recovery for equityholders, the recharacterization of a creditor’s debt claim as equity can be catastrophic to the affected party. At the same time, if the recharacterized claim is large enough, the recovery to remaining creditors may increase dramatically.
If the debtor is still holding (or already has spent) loan proceeds when it files for bankruptcy, then effectuating recharacterization is relatively straightforward: the debtor’s estate keeps (or does not have to repay) the “loan” and the “lender” is sent to the back of the line with the other equityholders.
But what happens if, before bankruptcy, the debtor already repaid a “loan” that actually was an equity investment? Does the bankruptcy court have the power to compel the “lender” to disgorge that “repayment” to the estate? Can the court recharacterize the loan after it is “repaid” and, by doing so, deprive the “lender” of even a claim in the debtor’s bankruptcy case? In most cases, the answer to both questions is yes.
When a debtor or trustee seeks to recover — or “claw back,” in the colorful language of practitioners — funds “repaid” on account of a purported “loan,” it must commence a lawsuit (called an adversary proceeding, in bankruptcy-speak) against the putative lender. The complaint will assert that the debtor gave the alleged lender something (cash) for nothing, thereby reducing the debtor’s assets and depriving other creditors of a more robust recovery from the bankruptcy estate.
This “something for nothing” cause of action is known as a “constructive fraudulent transfer.” While the Bankruptcy Code uses the word “fraudulent” (which is fraught with ugly connotations), the statue covers any transfer in which the debtor gave someone something for nothing, including transfers that have nothing to do with “fraud” at all.[ii] In fact, constructive fraudulent transfers generally arise by mere happenstance. So in our example, if, at the time of, and after giving effect to, the “loan repayment,” the debtor was insolvent or rendered insolvent, or was left with unreasonably small capital or unable to pay its debts as they mature, and did not receive reasonably equivalent value in exchange for the “loan repayment,” then the transfer will be deemed a constructive fraudulent transfer, regardless of the parties’ intent.[iii]
The Bankruptcy Code provides that a debtor or trustee may, as a matter of federal law, avoid any fraudulent transfer that occurred during the two years immediately before the debtor filed its case. This “look back period” generally is longer, however, if the trustee uses state fraudulent transfer law to prosecute its claim (for example, the statute of limitations to recover fraudulent transfers in New York is six years).
Once proven, fraudulent transfers may be “avoided,” meaning that the transaction may be unwound, set aside, or deemed retroactively ineffective. In our example, if the “loan” repayment is avoided, then the party who received the repayment from the debtor will be deemed to have acquired no rights to that cash.
The Bankruptcy Code provides that the transferred property itself (or upon court order, the value of the transferred property) may be recovered (that is, clawed back) from the initial transferee or a subsequent transferee[iv] to the extent that the transfer is avoided.[v] The “value” of the recovered property means the fair market value at the time of the transfer. Thus, even if the property declines in value between the time of the transfer and the time of the lawsuit, the debtor or trustee still may recover the fair market value of the property at the time of the transfer. In our example, the value of the cash is static, but in cases involving other forms of property (e.g., stock or real property), this concept is important because it places the burden of negative value fluctuations on the transferee, not the debtor’s estate.[vi] Further, the recovery of the property must be for the benefit of all of the debtor’s unsecured creditors, not simply a discreet subset of creditors, or the estate itself. In our case, the return of cash would plainly benefit the debtors’ unsecured creditors (assuming they were not otherwise being paid in full under the debtor’s plan).
Once the property (or its value) is returned to the debtor’s estate, the transferee is typically granted a claim in the bankruptcy case in an amount equal to the consideration it paid for the returned property.[vii] So, the next time you purchase a two million dollar Ming vase at a garage sale for $100, you will recognize that if the seller files for bankruptcy the next day, you almost certainly will be required to return the vase (or its value), and will get a $100 (unsecured) claim in the case (not a two million dollar claim). The analysis is easier when the property is cash and, in our example, the lender would be required to return the entire “repayment” – the lender should get a claim for the entire amount returned.
So what does all of this have to do with recharacterization? Well, let’s first assume that debtor or trustee suing a “lender” for constructive fraudulent transfer can prove that the debtor was insolvent when it repaid its putative “loan.” How does it prove the second part of the constructive fraudulent transfer test, i.e., that the debtor did not receive reasonably equivalent value? This is where recharacterization comes in—if the debtor can show that the loan was really an equity investment, then by definition (as we’ll see below) it did not receive reasonably equivalent value.
Otherwise stated, if the transfer was a legitimate repayment of an actual loan, then it cannot be a fraudulent transfer. By definition, repayment of a loan constitutes “reasonably equivalent value” because it relieves the debtor of a contractual obligation on a dollar-for-dollar basis. But if the transfer by the debtor was in repayment of a phony “loan” that is subject to recharacterization, then it is actually a dividend made while the debtor was insolvent that did not the relieve the debtor of any actual obligation. The debtor, then, would have received no value for the cash it paid. In that case, the “loan repayment” would satisfy the second prong of the constructive fraudulent transfer analysis (and likely violate state corporate laws to boot)[viii] because the debtor would not have received reasonably equivalent value in exchange for the transfer.
This very scenario was recently addressed by the Ninth Circuit Court of Appeals in In re Fitness Holdings International, Inc., 714 F.3d 1141 (9th Cir. 2013). In Fitness, the plaintiff moved for a declaratory judgment that a loan from the debtor’s sole shareholder was actually an equity investment, and sought to have the debtor’s repayment of that “loan” avoided as a constructively fraudulent transfer. The lower court dismissed the complaint, holding that as a matter of law, courts in the Ninth Circuit were barred from recharacterizing debt as equity. The Ninth Circuit reversed, overruling the precedent relied on by the lower court, and held that a court does have the authority to recharacterize debt as equity.[ix] Thus, in the Ninth Circuit courts have the authority to recharacterize debt as equity in the context of proving that a debtor received less than reasonably equivalent value in a constructive fraudulent transfer analysis.
Once the “loan” is recharacterized, it only gets worse for the transferee. As we pointed out earlier, if a transferee gives the property (or its value) back to the debtor’s estate, then it typically receives a claim in the debtor’s case in an amount equal to the value of the disgorgement by the transferee. On the other hand, if a loan is recharacterized as an equity contribution, then the “lender” has to return the “repayment” and gets not a claim, but rather an equity interest. And, as we mentioned earlier, equityholders rarely recover anything.
In short, when constructive fraudulent transfer meets recharacterization, a perfect storm may descend upon the transferee, washing away both its recovery and even its claim. Whether you think justice is served in such a scenario likely depends on whether you are the transferee whose claim is recharacterized, or the debtor who gets to claw the money back, or the creditors’ committee anticipating enhanced recovery for unsecured creditors.
[i] This article is the second in a series of three articles by the authors on recharacterization. The first article, “How Unsecured Creditors Push Ahead of Lenders Who in Fact Invested, Part I – What is Recharacterization?”, is also posted on commercialbankruptcyinvestor.com.
[ii] To differentiate between the truly fraudulent scenarios in which a bad actor intends to commit fraud (e.g., the debtor transferred away property to keep it out of the reach of creditors), and those scenarios that may not involve fraud (e.g., the debtor mistakenly sold property for less than its value), the Bankruptcy Code breaks fraudulent transfers into two categories: (i) actual fraudulent transfers, and (ii) constructively fraudulent transfers. An actual fraudulent transfer requires proof that the debtor made the transfer with the actual intent to hinder, delay, or defraud either present or future creditors. Debtors rarely leave a note in the file indicating that they actually intended to defraud their creditors, so courts permit the use of circumstantial evidence to prove the intent element. Even so, actual fraudulent transfers remain difficult for a plaintiff to prove. Payments made under a Ponzi scheme are a prime example of actual fraudulent transfer.
[iii] Note that proof of debtor-transferor’s insolvency is required in a constructive fraudulent transfer action, but is not an element of actual fraudulent transfer cause of action.
[iv] The ability to recover from the initial transferee and any subsequent transferee is intended to discourage the initial transferee from hiding the transferred assets by immediately reconveying them to someone else; however, the debtor or trustee may only recover the total value transferred one time (in other words, the debtor cannot recover the entire value of the transfer from each transferee). Mere conduits, such as the post office that delivers the property to the transferee, don’t count as “transferees” for this analysis.
[v] 11 U.S.C. § 550. Generally, if the value of the property transferred by the debtor exceeds the value provided by the transferee, then the transaction is avoidable only to the extent of that excess.
[vi] Fraudulent transfer law and jurisprudence are vast and complex, and an in-depth discussion of fraudulent transfers is beyond the scope of this post. However, the statute expressly provides that the debtor cannot recover the property from a subsequent transferee who took the property from the initial transferee for value, in good faith, and without knowledge of the voidability of the transfer. Thus, unlike the transfer from the debtor to the initial transferee, the price that the subsequent transferee pays to the initial transferee for the same property does not need to be the fair market or reasonably equivalent value of that property. Finally, if the transferee improves the property, he or she is entitled to a lien on the property in an amount equal to the value of the improvement.
[vii] 11 U.S.C. § 502(h).
[viii] Under most state laws, dividends may be made only if the company has adequate capital remaining once the dividend is paid. In Delaware, for example, a company only may pay a dividend from a capital “surplus,” which is defined as: (1) the fair value of a corporation’s total assets less its stated liabilities, less (2) the corporation’s stated capital (which is generally defined as the aggregate par value of the company’s equity).
[ix] Because the lower courts believed that they could not recharacterize the loan in any event, they did not analyze whether the loan was, in fact, an equity investment, so the Ninth Circuit remanded the case for further consideration. Regardless of how the lower court ultimately rules on the issue of whether the sole shareholder’s loan should be recharacterized, the Ninth Circuit’s Fitness decision stands as an affirmation that pre-bankruptcy transfers by debtors can be subject to recharacterization. The simple lesson is that transferees can be compelled to disgorge money “repaid” years before a debtor files for bankruptcy.
Lawrence V. Gelber is a partner in the Business Reorganization group of Schulte Roth & Zabel LLP, practicing in the areas of distressed M&A and financing, corporate restructuring, creditors’ rights, debt and claims trading, and prime brokerage insolvency/counterparty risk, with a focus on representation of investment funds and other financial institutions in distressed situations. His…
James is special counsel Schulte Roth and Zabel's Business Reorganization practice. He has significant experience in bankruptcy and out-of-court restructurings. James assists clients with acquisitions and divestitures of distressed companies and their assets, financing and use of cash collateral, and identifying exit strategies. He also litigates various disputes including labor issues, preference and fraudulent claim…
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In Fitness Holdings, the Ninth Circuit held that recharacterization is available only if state law provides for it, and that section 105 of the Bankruptcy Code is not a source of authority for recharacterization. Therefore, if state law provides for retroactive recharacterization, the trustee would presumably be able to employ it to avoid a fraudulent transfer. You say that retroactive recharacterization is available in the Ninth Circuit, but isn’t that only if the applicable state law provides for retroactive recharacterization? My assumption is that there are few states where this is the case. Michigan, for example, does not so provide. Do all of the states within the Ninth Circuit recognize retroactive recharacterization?