90 Second Lesson: What is the Difference Between Recharacterization and Equitable Subordination?

Discerning Similar Methods to Lower the Order of Priority of Creditors’ Claims

Question:

Jeff P. from Los Angeles asked us to explain the interplay between recharacterization and equitable subordination.

Though both doctrines are used to reduce the order of priority of creditor claims, they do have important differences that can affect those priorities. Here is our response.

Answer:

What are recharacterization and equitable subordination? Recharacterization is the act of recategorizing debt as an equity interest rather than a loan, which would then put the equity claim at a lower priority than the debt claim. Equitable subordination allows the bankruptcy court to lower payment priority of a claim made by a creditor that is guilty of inequitable conduct, such as fraud.

While recharacterization and equitable subordination are often mentioned in the same breath, the underlying purposes of these doctrines—and the analysis conducted by courts in evaluating claims asserted thereunder—are quite different. While the doctrine of equitable subordination authorizes a court to subordinate a creditor’s claim based on the conduct of the creditor, a recharacterization requires no such finding. Typically, recharacterization is based on the evaluation of the substance of the original transaction—does a debt actually exist?¹ Conversely, a claim of equitable subordination generally assumes that the subject debt is legitimate, but the priority of that debt should be adjusted based on the bad acts of the creditor.²

Recharacterization vs Equitable Subordination: Which Results in Lower Priority?

While the underlying purposes of these doctrines differ, their results often look similar—both have the effect of reducing the order of priority of creditor claimS. Recharacterization, however, typically results in much lower payment priority because, in these instances, courts convert debt claims into equity interests, and equity interests have the lowest payment priority possible (holders of equity interests receive nothing until all claims are paid in full). By contrast, even if a court subordinates a claim to the lowest possible payment priority, that claim still must be paid in full before holders of equity interests receive any payment at all.

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[Editors’ Note: This 90 Second Lesson is part of our irregular series in which we answer readers’ questions. If you have a question, submit it to [email protected] and we will try to answer it. This 90 Second Lesson is based, in substantial part, in material reprinted from Commercial Bankruptcy Litigation 2d and Strategic Alternatives For And Against Distressed Businesses, with permission of Thomson Reuters. For more information about these publications, please visit www.legalsolutions.com

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This is an updated version of an article originally published on April 26, 2016 and previously updated June 17, 2020.]

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1. In re AutoStyle Plastics, Inc., 269 F.3d 726, 748 (6th Cir. 2001); In re Official Committee of Unsecured Creditors for Dornier Aviation (North America), Inc, 453 F.3d 225, 232 (4th Cir. 2006).
2. In re SubMicron Systems Corp., 432 F.3d 448, 454 (3d Cir. 2006).