The entitlement of creditors’ claims to distribution ahead of holders of equity interests in the debtor is inherent in the Bankruptcy Code. Treating an equity investor on a par with unsecured creditors disregards the principles underlying the absolute priority rule in a manner that undermines this basic bankruptcy concept.
Consequently, the similar, and sometimes overlapping, but distinct doctrines of recharacterization and equitable subordination were developed by case law. While equitable subordination has been incorporated into the Bankruptcy Code, recharacterization continues to be applied solely as a creation of case law.
Recharacterization and equitable subordination are doctrines aimed at different conduct and have different remedies (although sometimes based on the same facts). The recharacterization analysis generally involves determining whether a funding instrument labeled as debt is in fact an equity investment. Since the substance of the transaction governs over form, if a debt transaction was actually an equity infusion, the recharacterized claim will be treated as equity.
In contrast, equitable subordination is based on an assessment of the creditor’s behavior. It is used to remedy inequity or unfairness to the debtor’s other creditors by demoting the subordinated creditor’s right to repayment to the rights of other creditors or equity holders. Accordingly, while some courts have confused the doctrines or have mistakenly found that equitable subordination supplants recharacterization in the context of bankruptcy, the doctrines address distinct concerns and require bankruptcy courts to conduct different inquiries.
In Fitness Holdings International, Inc., the Ninth Circuit Court of Appeals addressed for the first time the question of whether bankruptcy courts have the power to recharacterize debt to equity.
The Fitness of Recharacterization
Los Angeles Lawyer Magazine, December 2013 edition