Focusing On Intent In Recharacterization Analysis, Delaware Bankruptcy Court Ruling Indicates That Creditors Seeking Derivative Standing Face High Hurdle

In In re Mobile Steel Co., 563 F.2d 692 (5th Cir. 1977), the Fifth Circuit articulated what has become the most commonly accepted standard for equitable subordination of a claim.Under this standard, a claim can be subordinated if the claimant engaged in some type of inequitable conduct that resulted in injury to creditors (or conferred an unfair advantage on the claimant) and if equitable subordination of the claim is consistent with the provisions of the Bankruptcy Code. Courts have refined the test to account for special circumstances.For example, many courts make a distinction between insiders (e.g., corporate fiduciaries) and noninsiders in assessing the level of misconduct necessary to warrant subordination.

A related but distinct remedy is "recharacterization."Like equitable subordination, the power to treat a debt as if it were actually an equity interest is derived from principles of equity.It emanates from the bankruptcy court's power to ignore the form of a transaction and give effect to its substance. However, because the Bankruptcy Code does not expressly empower a bankruptcy court to recharacterize debt as equity, some courts disagree as to whether they have the authority to do so and, if so, the source of such authority.

Four circuits have held that a bankruptcy court's power to recharacterize debt derives from the broad equitable powers set forth in section 105(a) of the Bankruptcy Code, which provides that "[t]he court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of [the Bankruptcy Code]." See Committee of Unsecured Creditors for Dornier Aviation (North America), Inc., 453 F.3d 225 (4th Cir. 2006); Cohen v. KB Mezzanine Fund, II, LP (In re SubMicron Systems Corp.), 432 F.3d 448 (3d Cir. 2006); Sender v. Bronze Group, Ltd. (In re Hedged-Invs. Assocs., Inc.), 380 F.3d 1292 (10th Cir. 2004); Bayer Corp. v. MascoTech, Inc. (In re AutoStyle Plastics, Inc.), 269 F.3d 726 (6th Cir. 2001). In Grossman v. Lothian Oil Inc. (In re Lothian Oil Inc.), 650 F.3d 539 (5th Cir. 2011), the Fifth Circuit adopted a nuanced approach to the question, ruling that a bankruptcy court's ability to recharacterize debt as equity is part of the court's authority to allow and disallow claims under section 502 of the Bankruptcy Code. In Official Committee of Unsecured Creditors v. Hancock Park Capital II, L.P. (In re Fitness Holdings International, Inc.), 714 F.3d 1141 (9th Cir. 2013), the Ninth Circuit ruled that "a court has the authority to determine whether a transaction creates a debt or an equity interest for purposes of § 548, and that a transaction creates a...