You can’t have your cake and eat it too: on debt as equity

Een post door gastblogger Simon Landuyt

Debt and equity have in common that they are both provided to a company by an investor in return for a claim on its assets. For the creditor, the claim and the repayment date are fixed. On the other hand, the shareholder is a residual claimant. He will, in principle, only receive from the company to the extent the company’s assets exceed its liabilities. As a consequence, the claim of the shareholder is subordinated to the claim of the creditor. Therefore, at least in certain jurisdictions, it often happens that creditors or bankruptcy trustees try to qualify or “recharacterize” a rather vague financial contract of (another) investor into equity once the company gets into difficulties.

This is exactly what happened in In re Province Grande Old Liberty, LLC, Case No. 15-1669, 2016 WL 4254917 (4th Cir. Aug. 12, 2016), a recent case before the United States Court of Appeals for the Fourth Circuit. The debtor, a corporation, defaulted on a bank loan. Debtor and bank agreed (under a settlement agreement) that another company, named PEM and owned by insiders of the debtor, would acquire the loan at a discount. Regardless, the debtor went bankrupt and PEM claimed 7.000.000 $ based on the purchased loan from the bankrupt estate. In order to increase their liquidation dividend, two other creditors of the debtor initiated proceedings to qualify the claim of PEM as equity.

The bankruptcy court ruled in favour of the claimants. It determined that with the settlement agreement, the bank loan was satisfied and the funds provided by PEM to pay back the loan were deemed equity contributions. As a consequence PEM could no longer share in the assets of the debtor as a creditor, but only as a subordinated equity holder (and most probably received nothing from the debtor’s estate). This decision went all the way up and was finally confirmed by the Court of Appeals for the Fourth Circuit. The full blog entry on this court opinion can be found here.

Recharacterisation of debt into equity is common all over the globe in cases initiated by the tax authorities (for example in Belgium under article 18, 4° of the income tax code 1992) because of the – often –  more favourable tax treatment of debt. In insolvency/corporate law cases, this is also a frequent occurrence in many jurisdictions, especially the United States which has a huge volume of cases. To my knowledge, in Belgium, debt granted to a corporation, contrary to debt provided to companies without limited liability, has never been requalified into equity for insolvency reasons. The reason for this might be that Belgian courts cling too much to the formal aspect (equity can only be provided to a corporation through a notarial deed) of a financial contract and not enough to the actual substance of the transaction.

The recharacterisation of debt into equity has to be distinguished from other doctrines like fault based subordination of debt and the automatic subordination of certain loans, which have the same practical outcome. Under fault based subordination, the claim of the creditor can be subordinated by a court if the creditor has not respected a certain legal norm. For example, under the equitable subordination doctrine in the United States, a debt claim can be subordinated when the creditor has acted inequitable. Automatic subordination, as it says, subordinates certain predefined claims by default, without taking the creditors’ actions into account. A prime example of this is the Recht der Gesellschafterdarlehen in Germany which automatically subordinates shareholder loans.

Under fault based- and automatic subordination, it is not questioned that the specific financial contract between the investor and the company is debt. Under recharacterisation, the court determines that the legal qualification given to the financial contract by the parties (or at least the investor) is not debt but equity. In the United States a number of criteria developed by subsequent case-law are therefore taken into account, such as the presence of a fixed maturity date, the existence of an interest rate or profit participation, the link between the investor and the company, etc.

All three doctrines can be viewed as functional equivalents to the traditional fraudulent conveyance law and the moral principles it safeguards, which have been described by Robert Clark in a seminal article as Truth, Respect, Evenhandedness and Non-Hindrance. According to Clark the fault based subordination doctrine complements fraudulent conveyance law where the obscure transactions by the creditor are numerous and complex and the transactions costs would be too high to dissect with the scalpel of fraudulent conveyance law. The recharacterisation doctrine can in turn be seen as a specific tool to enforce the principle of Truth. Recharacterisation and fault based subordination are both flexible ex post standards, which have to be worked out in practice by a court. Automatic subordination of certain loans, to the contrary, is an ex ante bright line rule which provides legal certainty. It has been argued by some law & economics scholars that the automatic subordination of shareholder loans is the preferred standard as it would decrease agency- and transaction costs.

In any case, none of the above doctrines are currently in the toolkit of a Belgian bankruptcy judge. Given the increasingly complex litigation, it might be time for the legislator to introduce one or more of them into Belgian law.


Simon Landuyt

Financial Law Institute (Ghent University)

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