Tenth Circuit: Recharacterization Remedy In Bankruptcy Is Alive And Well

In Redmond v. Jenkins (In re Alternate Fuels, Inc.), 789 F.3d 1139 (10th Cir. 2015), a panel of the U.S. Court of Appeals for the Tenth Circuit upheld bankruptcy courts' authority to recharacterize insider debt as equity. In so ruling, the court rejected an argument that recent U.S. Supreme Court precedent prevents bankruptcy courts from using section 105(a) of the Bankruptcy Code to recharacterize debt as equity. Nevertheless, after upholding the recharacterization doctrine, the Tenth Circuit panel split on the doctrine's application. The majority, stating that courts must "exercise caution" when determining whether recharacterization is appropriate, ultimately concluded that the insider's claims should not be recharacterized as equity. By contrast, the dissent contended that recharacterization was warranted.

Alternate Fuels

Kansas-based Alternate Fuels, Inc. (the "debtor") engaged in coal-mining operations through a subsidiary. In connection with these operations, the debtor was obligated to restore certain mining sites to their original condition, including mines located in Missouri. To assure the State of Missouri that reclamation would be performed, the debtor posted reclamation bonds which were secured by approximately $1.4 million in certificates of deposit.

Subsequent to the debtor's posting of security for the reclamation bonds, William Karl Jenkins and M. Earlene Jenkins (collectively, the "Insiders") acquired 100 percent ownership of the debtor and 99 percent ownership of the subsidiary. The Insiders, however, did not acquire the companies for the purpose of continuing mining operations. Rather, the Insiders believed that they could use their political connections to modify the debtor's reclamation arrangements, such that they could obtain the proceeds of the certificates of deposit. In furtherance of this goal, the Insiders succeeded in arranging for the certificates of deposit to be assigned to them personally.

During the years following the Insiders' acquisition of the debtor, which had ceased mining operations, the debtor executed three promissory notes evidencing in total approximately $4 million in funding provided by the Insiders. Each of the notes stated that it would mature in a period of years, while also providing that "[t]his note shall be paid in full upon reclamation bond release from the State of Missouri." Because the debtor had no operations or income of its own, the Insiders' only anticipated source of repayment was the certificates of deposit.

Several years after the Insiders had acquired the debtor, the debtor temporarily ceased its reclamation efforts when it filed suit against third parties, alleging tortious interference with its reclamation process. Realizing that their likelihood of recovering the certificates of deposit was diminishing, the Insiders agreed to continue funding the debtor only after receiving, as security for their loans, a partial assignment of the debtor's reclamation suit recovery. On the same date as that assignment, the debtor executed a new promissory...