Restructuring

Contributed by Charles Persons

“I love the truth.  It’s the facts I’m not a fan of.”  — Stephen Colbert

While the fact is that Stephen Colbert was not answering a question about bankruptcy recharacterization issues when he made the statement quoted above, the truth is he probably was thinking about them—or at the very least, he should have been.  Recharacterization—the process by which a bankruptcy court may use equitable principles to recharacterize a debt as an equity contribution—is premised on the ability of the bankruptcy court to ascertain the “truth” about a transaction by reviewing the facts.  Was the transaction a true loan the lender intended to be repaid, or was it merely a capital contribution for the benefit of the business?  How was the transaction documented?  What expectations did the parties have about the transaction?  These are some of the questions a reviewing court asks when determining whether to recharacterize debt as equity.
Bankruptcy disputes seeking to recharacterize debt as equity require fact-intensive inquiries, and like any fact-intensive inquiry, courts don’t always see eye-to-eye when weighing which facts are the most important in determining the “truth” about a transaction.  Making recharacterization matters more difficult, the various circuits use different multi-factor tests for recharacterization and don’t even agree if those tests should be based in federal law or state law.  In short, recharacterization fights are unpredictable.  The United States Bankruptcy Court for the Northern District of Texas recently offered up one such surprise in In re Borger Hospitality, Inc., reviewing a recharacterization dispute under the expected factual rubric, but reaching a seemingly unexpected result.
Background
Borger Hospitality, Inc. was created for the purpose of constructing and operating two hotels in West Texas.  BHI was primarily owned by two groups—members of the Patel family, led by Harish Patel, and members of the Stiles family.  In an all too familiar story, BHI had troubles with its original general contractor that led to increased construction costs, unpaid subcontractors, and a slew of mechanics’ and materialmans’ liens.  These problems caused significant delay and forced the as-yet non‑operational hotelier to seek a new general contractor, as well as additional money to cover the cost of completing the construction, while it brought lawsuit against the original contractor.
Unable to obtain traditional loans, Patel used money from an unrelated venture in which he was owner, president, and a director—New Fredericksburg, Inc—to write $274,000 worth of checks in 2009 to BHI’s new general contractor and construction lender.  The $274,000 was carried on BHI’s ledger as “shareholder loans,” though New Fredericksburg was not a shareholder in the BHI venture.  However, there was no documentation to accompany the “shareholder loans,” no definite time established for their repayment, no evidence that any interest was being charged with respect to the “loans,” no formal resolutions adopted at either BHI or New Fredericksburg authorizing the “loans,” and no income stream available to BHI to indicate it would be able to repay the loans.
Despite the cash infusion from New Fredericksburg (at Patel’s direction), the additional money was not enough to save BHI, and the company filed for bankruptcy in the Bankruptcy Court for the Northern District of Texas (Amarillo division) in 2010.  On behalf of New Fredericksburg, Patel filed a proof of claim asserting a general unsecured claim for the $274,000.  Stiles objected to the allowance of the claim to the extent BHI possessed one or more chapter 5 claims against New Fredericksburg, but recast its objection at the hearing, arguing the New Fredericksburg “loans” should be recharacterized as equity investments or capital contributions.
Analysis
The Fifth Circuit allows recharacterization of a claim as an equity interest by bankruptcy courts, and any such recharacterization must be done in accordance with applicable state law.  Courts interpreting Texas law, the applicable state law in Borger, have employed various fact-intensive, factor-driven tests to assess whether debt should be treated as equity, including a 16-factor test, a 13-factor test, and an 11-factor test.  The Borger court elected to follow the 16-factor test, which considered:

(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 obligees 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) the source of the interest payments; (13) the presence or absence of a fixed maturity date; (14) a provision for redemption by the corporation; (15) a provision for redemption at the option of the holder; and (16) the timing of the advance with reference to the organization of the corporation.

Rather than conduct a straightforward application of the facts to the rubric of the chosen test, the Borger court contemplated additional factors and considerations with respect to recharacterization.  First, the court incorporated a factor from the 11-factor test and another from the 13-factor test into its analysis, recognizing the importance of (i) the name given the instrument evidencing the transaction (if any) and (ii) the right of the creditor to enforce payment of principal and interest.  However, the Borger court noted that the eighteen factors it reviewed were only to be considered aids in answering the ultimate question of whether the New Fredericksburg investment constituted risk capital subject to the fortunes of the BHI venture or whether there was a strict—even if undocumented—debtor-creditor relationship.  Further, despite its discussion of the eighteen factors and their importance in determining the true nature of the transactions, the court also emphasized a simpler, less factor‑oriented analysis, holding, “creditors and investors are distinguishable in the way they each view the solvency or insolvency of the enterprise with which they are dealing . . . if the enterprise prospers, a creditor expects nothing more than repayment of its fixed debt . . . . Investors, however, look to share in the profits to the exclusion of creditors.” 
Applying the facts of the case to the factors revealed that a third-party affiliate of an equityholder ostensibly made undocumented transfers of funds at that equityholder’s sole direction with no specified interest or repayment terms at a time when the borrower had no available capital for repayment.  These facts could lead to the conclusion that “debt” was really an equity contribution.  But the Borger court also discussed the importance of reviewing evidence in light of all factors, stated that no one factor was controlling, and held that the various factors are not of equal importance.  With these principles in mind, after reviewing the facts, the court refused to recharacterize the New Fredericksburg loans as equity contributions, notwithstanding the lack of documentation evidencing the nature of the transactions and other indicia of equity contributions.  In explaining its decision, the Borger court held (i) the assertion by New Fredericksburg that the transactions were always intended to be loans; (ii) the books of BHI documenting the transactions as a shareholder loans; and (iii) that BHI did not transfer or purport to transfer any equity interest in the company to New Fredericksburg were “basic facts” that “subsume the factor-driven analysis.”  On the strength of these facts, the court determined the transaction was a true loan between the parties and allowed the New Fredericksburg claim.
Whether Borger represents an analytical departure from the multi-factor Fifth Circuit recharacterization considerations in the Northern District of Texas or whether it is simply an aberrant, fact‑specific decision remains to be seen.  Most importantly, the case illustrates that the factor-driven recharacterization tests serve only as rough guidelines for ascertaining the “truth” behind a transaction, and no specific quantity of equity indicia will provide certain results in a recharacterization dispute.