United States: Dealing With Companies In Financial Distress (Part 2)

This article is part of a series: Click Dealing With Companies In Financial Distress (Part I) for the previous article.

State Law

In evaluating whether or not an option contract is executory and can be rejected in bankruptcy the role of state law can be key. In the case of In re Plascencia, although the court stated that an unexercised option is not executory, the court went on to say that this does not wholly answer the question of whether the trustee is bound to the contract and questioned whether under Virginia law a recorded option is merely a contract right or whether it rises to the level of a property interest. In re Plascencia, 354 B.R. 774,780 (Bankr. E.D. Va. 2006). That court held that in Virginia an option to purchase is in the "nature of an interest in real estate which may be recorded and by that recordation protect the optionee's interest in the real estate," such that the option could not be treated simply as a contingent claim subject to discharge or compromise in the case. Id.

Optionees in Possession

Section 365 of the Bankruptcy Code which governs the assumption and rejection of the executory contracts and unexpired leases contains a special provision for executory contracts for sales of real estate. It provides:

  • (i)(1) If the trustee rejects an executory contract of the debtor for the sale of real property under which the purchaser is in possession, such purchaser may treat such contract as terminated, or, in the alternative, may remain in possession of such real property . . .
  • (2) If such purchaser remains in possession –
    • (A) such purchaser shall continue to make all payments due under such contract, but may, offset against such payments any damages occurring after the date of the rejection of such contract caused by the nonperformance of any obligation of the debtor after such date, but such purchaser does not have any rights against the estate on account of any damages arising after such date from such rejection, other than such offset; and
    • (B) the trustee shall deliver title to such purchaser in accordance with the provisions of such contract, but is relieved of all other obligations to perform under such contract.
  • (j) A purchaser that treats an executory contract as terminated under subsection (i) of this section, or a party whose executory contract to purchase real property from the debtor is rejected and under which such party is not in possession, has a lien on the interest of the debtor in such property for the recovery of any portion of the purchase price that such purchaser or party has paid. (emphasis added)

If a Non-Debtor gives notice it is exercising the option to purchase the physical assets and a contract provides it is in possession of the real estate at that point, a Non Debtor may be able to rely on Section 365(i) to force the Debtor to transfer title.


Because of the lack of consistent treatment in the case law, a Non Debtor can best secure its option contract by recording its option in the real property records, and by formulating the contract in a way that makes the exercise of the option extremely simple, with as few steps or restrictions as possible for exercise, payment, and delivery of documentation. The recordation would implicate state law, heightening the possibility that the Debtor would not be able to reject the contract. The simplicity of the contract would reduce the likelihood that the Debtor would file bankruptcy after the Non Debtor had announced its intention to exercise the option, or had in fact exercised it, but had not completed the deal, as that situation leads to the murkiest waters under bankruptcy interpretation and provides the greatest possibility that the contract would be dischargeable.


The Bankruptcy Code and case law do not provide a clear answer whether rights of first refusal will be enforceable in a bankruptcy case. The Non-Debtor's ability to enforce its rights of first refusal in a bankruptcy of the Debtor will hinge upon the rationale applied by the court in which the bankruptcy is filed. Bankruptcy courts such as Delaware have held that property rights created under operating agreements such as LLC agreements, partnership agreements and bylaws that becomes property of the bankruptcy estate remain subject to a preexisting ROFR because the debtor does not have greater rights in the property of the estate than the debtor had before filing for bankruptcy. Other courts have held that rights of first refusal, including rights in operating agreements, are executory contracts that the debtor can reject under the Bankruptcy Code.

Joint Ownership Agreements as Property of the Estate: ROFR Enforceable

In Northrop Grumman Tech. Services, Inc. v. The Shaw Group, Inc. (In re IT Group Inc.), 302 B.R. 483 (D. Del. 2003), the debtor sought bankruptcy court approval to transfer its rights under a limited liability company agreement in which the debtor was a member. The other non-debtor members of the LLC objected to the transfer because the other members did not consent to the transfer, and unanimous member consent was required under the LLC operating agreement to approve a transfer of the membership interest. The bankruptcy court held that the debtor could transfer the bare economic interest in the LLC, but the transfer was subject to the ROFR in favor of the non-debtor members contained in the LLC operating agreement. The proposed transferee appealed the bankruptcy court's decision. The transferee argued that the bankruptcy court erred in holding that the assumption and assignment of the debtor's bare economic interest was subject to the ROFR because the ROFR impermissibly restricted the assignment of the membership interests and was unenforceable pursuant to section 365 of the Bankruptcy Code which allows a bankruptcy court to approve the assumption and assignment of an executory contract from the debtor to a third-party regardless of the existence of a contractual restriction on such assignment. Id. at 486.

The district court analyzed the transferee's argument that the ROFR was unenforceable under section 365(f) because it impermissibly prohibited, restricted or conditioned the assignment of the contract. The district court noted that a bankruptcy court has discretion in determining whether a contractual provision that does not expressly prohibit assignment qualifies as a de facto anti-assignment provision. The court agreed with the bankruptcy court that the ROFR was not an unenforceable restraint on assignment because the court was not persuaded that enforcing the ROFR would hamper the debtor's ability to assign the property or foreclose the estate from realizing the full value of the debtor's interest in the LLC. Id. The court also dismissed the transferee's argument that public policy militates against enforcement of the ROFR because the procedure implicated by the exercise of the ROFR regarding allocation of the purchase price was too onerous. The court stated that "the holder of a ROFR is entitled to an allocation of the purchase price when the asset subject to the ROFR is part of a package, and to conclude that allocation procedures render the ROFR unenforceable would be to usurp a cognizable property right set forth by state law, a result which the Court believes would be counter to sound public policy." Id. at 489.

ROFR as an Executory Contract Subject to Rejection

Courts which have refused to enforce ROFR have focused on the contractual nature of the right—rather than the scope and nature of the debtor's property interest. These courts have applied either Section 365(a) or (f) of the Bankruptcy Code to avoid enforcement. Section 365 of the Bankruptcy Code permits a debtor to reject burdensome contracts. In In re Fund Raiser Products Co, Inc., 1996 WL 515504 (E.D. Pa. Aug. 30, 1996), the district court affirmed the bankruptcy court's order approving the sale of stock owned by the debtor free of a ROFR provision contained in the company's bylaws. The court analyzed the "matching rights clause" and determined that it was executory in nature. The party objecting to the rejection of the ROFR—relying on the property-interest cases discussed above—argued that the trustee can only sell what its owns, and it owns the stock subject to the matching right.

The district court dismissed the argument: "This argument ignores the powers given to a Trustee under the specific, central provision of 11 U.S.C. § 365, including the right to reject executory contacts. The Trustee may sell stock free and clear of a matching right provision under § 365." Id. at *2. The court further held that that the rejection of the matching right did not terminate the bylaws because the bylaws themselves expressly stated that the remaining provisions would be valid. "Article I, section 3(c) states that '[t]he invalidity of any portion of the by-laws shall not affect any other portion thereof that can be given effect without such invalid portion.' Thus, the matching right could be severed from the bylaws without rejection of the remainder. See In re Fleishman, 138 B.R. 641, 645 (Bankr. D. Mass. 1992) (severing analogous ROFR provision form)."

The Southern District of New York has also relied upon Section 365 to avoid the enforceability of a ROFR in a franchise agreement. Adelphia Comm. Corp., 359 B.R. 65, 85-90 (Bankr. S.D.N.Y. 2007). However, the Adelphia court acknowledged that they applied a "facts and circumstances" test and not aper se rule to reach their conclusions and stated that the considerations applied in Adelphia may not necessarily be the same in every ROFR case. Id. at 86. The Adelphia case dealt with a multi-asset sale/auctions where the court believed that enforcing rights of first refusal with respect to a subset of those assets would be destructive to maximizing value, and have a chilling effect on future bankruptcy auctions. Id. at 87. Because the assets were shared or used for the benefit of multiple contract counterparties, the court reasoned that the exercise of a ROFR by one contract counterparty would affect other entities, some of whom would be prejudiced by the loss of assets needed to serve them, and would at least require efforts to decouple the interlocking operations. Id. at 88.

Effect of Rejecting ROFR

Even if the Debtor is successful in rejecting the ROFR in bankruptcy, any asset sale must be in compliance with Section 363 of the Bankruptcy Code. A Section 363 sale is much like a traditional controlled auction. An initial bidder, known as a "stalking horse," reaches an agreement to purchase assets from the chapter 11 debtor. The buyer and the debtor negotiate an asset purchase agreement which rewards the stalking horse for investing the effort and expense to sign a transaction that will be exposed to "higher and better" bids. The protections afforded to a stalking horse generally include a combination of a break-up fee averaging 3% of the sale price, expense reimbursement up to a negotiated cap, minimum increments for overbids, qualification requirements for competing bidders, strict deadlines for competing bids and dates for the run-off auction, final court approval and closing.


Anytime a debtor files bankruptcy, any sale or other transfer of its assets is subject to review under Sections 544 and 548 of the Code providing for recovery of fraudulent conveyances. The most basic fraudulent conveyance concern is that a bankruptcy court, with hindsight, will make a determination that the debtor did not receive a reasonably equivalent value in exchange for the transfer of its assets. This is a factual determination to be based on the preponderance of the evidence. An acquiror can attempt to insulate itself from subsequent attack by amassing evidence, including valuation opinions, that the price paid at the time of the transaction was fair. Note also that the remedy for a fraudulent conveyance may be either the recovery of the value of the property transferred or the property itself. Thus, a debtor that prevails on a fraudulent conveyance claim will seek recovery of the assets transferred if the value of that asset has increased subsequent to the time of the transfer; otherwise, it will seek recovery of the value existing at the time of the transfer. A completely different fraudulent conveyance risk is posed by a situation where the acquiror pays value to one debtor affiliate in exchange for assets from a different debtor affiliate. In such a situation, the transaction is vulnerable to attack on the grounds that the debtor that transferred its assets received nothing in exchange for such transfer. Note that simply having one debtor affiliate book an intercompany debt to another debtor affiliate does not provide sufficient "value" to the debtor whose assets are being transferred where the intercompany debt is not ultimately going to be paid in full because of an insolvency.

Lookback Period

The Code allows avoidance of fraudulent transfers within two years prior to the bankruptcy filing. See 11 U.S.C.A. § 548. State Uniform Fraudulent Transfer Acts permitting transfer avoidances up to four years or more may also be used to avoid transfers occurring more than two years before the bankruptcy filing. 11 U.S.C.A. § 544(b).

Elements of Claim

The debtor may avoid a transfer of the debtor's property, or an obligation incurred by the debtor, if the debtor received less than "reasonably equivalent value" in exchange and the debtor:

  • was or became insolvent as a result of the transfer;
  • was engaged in business, and was left with unreasonably small capital after the transfer; or
  • intended to incur debts after the transfer, or believed he or she would incur debts after the transfer, that would be beyond his or her ability to pay as they matured. See 11 U.S.C.A. § 548(a)(1)(B).

If the following elements exist a constructive fraudulent transfer has taken place. Alternately, the Debtor can recover transfers made with the intent to hinder, delay or defraud creditors.

Transactions Commonly Attacked as Fraudulent Transfers

Several types of transactions are particularly susceptible to fraudulent conveyance attack. These include affiliate guaranties and third party pledges of collateral, intercompany dividends, asset transfers between affiliates and contractual obligations to third parties undertaken for the benefit of affiliates.

  • Guarantees and Third Party Pledges of Collateral. A guarantee is an undertaking by one person to answer for the payment of a debt or for the performance of some obligation of another person who is primarily liable for such payment or performance. Guarantees and third-party pledges of collateral are often attacked in bankruptcy as fraudulent transfers. The execution of the guaranty is a transfer within the meaning of the Code. Reasonably equivalent value for this purpose means consideration which benefits the guarantor. Reliance by the creditor will not suffice. There are three types of corporate guarantees: upstream, downstream, and cross-stream.
    • Upstream Guarantees. An upstream guarantee occurs when a subsidiary guarantees a loan made to its parent corporation. The Code allows a debtor to avoid an upstream guarantee given one year prior to the filing of the bankruptcy petition if the guarantor did not receive adequate consideration (i.e., "reasonable equivalent value") and the giving of the guarantee rendered the guarantor "insolvent" or, in certain other ways, adversely affected the financial condition of the guarantor.
    • Cross-Stream Guarantees. A cross-stream guarantee occurs when one corporation guarantees a loan made to another corporation which is owned by the same parent corporation. These guarantees are subject to the same fraudulent conveyance problems as upstream guarantees.
    • Downstream Guarantees. A downstream guarantee occurs when a parent corporation guarantees a loan made to one of its subsidiaries. Generally, these guarantees are not challenged as fraudulent conveyances because of the obvious benefit which the guarantee affords to the parent's investment in the subsidiary. However, where the parent and subsidiary have distinct creditors and the subsidiary is insolvent, the parent company's creditors may attack the guarantee. While a transfer to a wholly-owned solvent subsidiary is often for reasonably equivalent value because the value of the parent's stock interest in the subsidiary may be correspondingly increased, that is never the case when the subsidiary is hopelessly insolvent, because the value of those shares is zero both before and after the transfer. See, e.g., In re Duque Rodriguez, 77 B.R. 937, 939 (Bankr. S.D. Fla. 1987) aff'd, 895 F.2d 725 (11th Cir. 1990); In re Chase & Sandborn Corp., 68 B.R. 530, 533 (Bankr. S.D. Fla. 1986), aff'd, 848 F.2d 1196 (11th Cir. 1988); Robert K. Rasmussen, Guarantees and Section 548(A)(2) of the Bankruptcy Code, 52 U. CHI. L. REV. 194, 215-216 & n.69 (1985).
  • Other Transactions. There is no reasonably equivalent value for corporate dividends or distributions as a matter of law because only the payee, not the transferor, receives value. See Pereira v. Equitable Life Ins. Society (In re Trace Int'l Holdings, Inc.), 259 B.R. 548, 560-61 (Bankr. S.D.N.Y. 2003). Recovering a dividend as a constructive fraudulent transfer is easier than proving it was an illegal dividend. Dividends can be in the form of cash or assets. Thus asset transfers to a parent or affiliated corporation are critically analyzed.

Managing Risk

There are several ways to minimize the risk of fraudulent conveyance attack.

  • Valuation/Solvency Opinions. As counterparty you may wish to obtain a valuation opinion on the asset or a solvency opinion from a third party expert such as an investment banker. In order for a bankruptcy judge to give such an opinion much credibility, the expert opining must not be receiving any compensation based on the outcome of the valuation. Thus, an investment banker receiving a fee based on whether a sales transaction occurs may not be especially helpful in a subsequent court proceeding. Carefully drafted certificates of the chief financial officer are also helpful. Accounting firms are precluded from rendering solvency opinions.
  • Allocation of Purchase Price. As to the risk posed by a transaction involving multiple debtor affiliates, a counterparty should take care to ensure that each debtor affiliate receives fair value for its assets in any transaction. Thus, if a subsidiary's assets are being sold, the payment for such asset should be made to the subsidiary, not to the subsidiary's parent. Obviously, the counterparty cannot control whether a debtor affiliate subsequently transfers assets received to a parent corporation. However, by ensuring that its own transaction with each debtor affiliate was fair from that debtor affiliate's standpoint, the counterparty should be able to insulate itself from a fraudulent conveyance claim. Note: The problem in one debtor affiliate receiving payment for another debtor affiliate's assets stems from the possibility that the various debtor corporations have different creditor bodies and insufficient assets to pay off such creditors. Where a particular debtor affiliate has no creditors or has ample assets to pay such creditors, that debtor affiliate may have an identity of interest with its parent corporation such that there is no fraudulent conveyance risk in making payment directly to the parent corporation. Ample due diligence may allow an acquiror to satisfy itself that a particular debtor affiliate has no creditors or contingent creditors such that the transaction could not be subject to subsequent attack as a fraudulent conveyance.
  • Credit for Value Given. The transferee of a transfer is protected if he or she acted in good faith and gave value to the debtor. Such transferee may retain any property transferred to the extent of the value given in return. A good faith transferee from whom the trustee recovers property also has a lien against the property recovered to secure the lesser of (i) the transferee's cost of improvements to the property made after the transfer, less the amount of any profits earned by the transferee from the property and (ii) any increase in value of the property as a result of action by the transferee. 11 U.S.C.A. § 550(e)(1).
  • Calculating the Benefit. If it is intended that the parent downstream (whether by loan, advance, capital contribution or otherwise) some of the loan proceeds to the subsidiary, then the subsidiary obviously stands to benefit (albeit indirectly) from the guarantee. In that situation, the issue would turn on the sufficiency of the benefit. The amounts should be well documented. Where (i) the subsidiary guarantees the entire amount of the loan to the parent and (ii) it is clear that, at most, only a portion of the loan proceeds will be made available to the subsidiary, a serious question will exist as to the adequacy of the consideration.
  • Limitation of Guaranty. It may be advisable to limit the subsidiary's obligation under the guarantee. For example, the guarantee might limit the subsidiary's liability under the guarantee to the amount of loan proceeds actually downstreamed to it by the parent. Provisions should be included in the guarantee limiting the liability of the subsidiary under the guarantee in such a way as to minimize the risk that the guarantee will render the subsidiary insolvent.


Section 547 of the Bankruptcy Code (the "Code") provides that a transfer of property to an entity that is a creditor of a debtor can be "recovered" if the transfer can be characterized as a payment in satisfaction of such creditor's antecedent debt. Such transfers are termed "preferences." See 11 U.S.C.A. § 547. Section 547 and its accompanying provisions are worded very broadly so that any payment that can be characterized as a payment on account of an antecedent debt can be recovered, even where the transfer was not made directly to the creditor. Thus, transfers are subject to recovery as preferences if the creditor was a direct or indirect transferee or even where the creditor was not a transferee at all, but was "benefited" by the transfer. Any transfer of a debtor's assets occurring in the time period 90 days prior to that debtor's bankruptcy filing is subject to attack under Section 547. Note that if a creditor can be characterized as an "insider" by virtue of its control over the debtor or other relationship with the debtor, the preference period is extended from 90 days prior to bankruptcy to one year before bankruptcy.

Elements of Preference

All of the following elements must be present to avoid a transfer as a preference. There must be:

  • a transfer (of property valued at $5,475 or more)
  • of property of the debtor
  • to or for the benefit of a creditor
  • on account of an antecedent debt
  • made while the debtor was insolvent (the debtor is rebuttably presumed to be insolvent during the 90 days before a bankruptcy petition is filed, see 11 U.S.C.A. § 547(f))
  • within 90 days prior to filing of the petition (or within one year if the transferee was an "insider" as defined in 11 U.S.C.A. § 101(31))
  • which allows the creditor receiving the transfer to receive more than the creditor would receive in a liquidation of the debtor's assets. See 11 U.S.C.A. § 547(b); In re El Paso Refinery, L.P., 178 B.R. 426, 432 (Bankr. W.D. Tex. 1995), rev'd on other grounds, 171 F.3d 249 (5th Cir. 1999).
    • "Transfer" Broadly Defined. "Transfer" includes "every mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with property or with an interest in property, including retention of title as a security interest and foreclosure of the debtor's equity of redemption." 11 U.S.C.A. § 101(54). The creation and perfection of a contractual lien (e.g., taking and recording a trust deed on real estate, or a security interest in personal property) is a "transfer."
    • Transfer Must "Prefer" Creditors. A transfer is not preferential unless it enables the creditor to receive more than it would have received in a hypothetical Chapter 7 case if the transfer had not occurred. 11 U.S.C.A. § 547(b)(5) (issuance of letter of credit to supplier to pay off antecedent unsecured debt to supplier was preferential transfer). A creditor with a security interest in a "collateral mass" (e.g., inventory or accounts receivable) is subject to preference attack to the extent it improves its position during the 90-day period before the bankruptcy petition is filed. 11 U.S.C.A. § 547(c)(5).
    • Intercompany Guarantees. "Insiders" who guarantee their company's debts automatically benefit from preferential transfers made by the debtor company to reduce such debts. Every reduction of a guaranteed debt reduces the "inside" guarantor's liability for payment thereon. Thus, an insider may be liable for payments made on guaranteed debts up to one year before the case was commenced.


There are several defenses to a preference attack which allow the risk to be managed.

  • Ordinary Course of Business Transactions. The most important exception to the preference rule shelters transfers made in the ordinary course of business. The debtor may not avoid a transfer that was:
    • in payment of a debt incurred by the debtor in the "ordinary course of business" or financial affairs of the debtor and transferee
    • made in the ordinary course of business or financial affairs of the debtor and transferee
    • made according to ordinary business terms. See 11 U.S.C.A. § 547(c)(2); In re El Paso Refinery, L.P., 178 B.R. 426, 432 (Bankr. W.D. Tex. 1995), rev'd on other grounds, 171 F.3d 249 (5th Cir. 1999). In determining whether a challenged transfer is "ordinary," courts employ an "objective industry" test. The transfer must comport with the prior dealings between the debtor and transferee, and the transfer must also comport with practices common to businesses similarly situated. See In re Roblin Indus., Inc., 78 F.3d 30 (2d Cir. 1996). If you notice a change in the debtor's conduct (such as late payments indicating cash flow problems), consider options such as requiring prepayment or cash terms or not allowing the debtor to have more than one outstanding invoice.
  • No Antecedent Debt. There can be no preference without an "antecedent debt." An antecedent debt is incurred before the transfer (i.e. payment). Requiring prepayment for delivery of goods or services eliminates the antecedent debt element.
  • Contemporaneous Exchange for New Value. The trustee may not avoid a transfer to the extent it was: (i) intended by the parties to be a substantially contemporaneous exchange for new value given to the debtor; and (ii) in fact was a substantially contemporaneous exchange; See 11 U.S.C.A. § 547(c)(1). Requiring cash on delivery is a contemporaneous exchange.
  • Enabling Loans. Also shielded from preference attack are certain transfers that create a security interest similar to a purchase money security interest (defined in UCC § 9.103). The security interest must secure new value that was given to enable the debtor to acquire particular property, and in fact be used to acquire such property. See 11 U.S.C.A. § 547(c)(3). Funding directly to the vendor and obtaining a PMSI eliminates the preference risk.
  • New Value. A transfer may be protected from preference attack to the extent the creditor gave new value to the debtor after the transfer. See 11 U.S.C.A. § 547(c)(4); the "subsequent advance" exception allows a creditor to claim a credit against preferential transfers for subsequent advances of "new value" made after transfer.
  • After Acquired Property Security Interests in Inventory/Receivables. Some creditors have "floating" perfected liens in the debtor's inventory and/or receivables and the proceeds therefrom. To the extent such creditors do not improve their net positions in the collateral during the avoidance period, perfected liens on new inventory and/or receivables (and their proceeds) are not avoidable as preferences. 11 U.S.C.A. § 547(c)(5).


Section 510(c) of the Code authorizes a court to equitably subordinate all or part of an allowed claim to all or part of another allowed claim for purposes of distribution. Additionally, a court may order that any lien securing such subordinated claim be transferred to the bankruptcy estate. The majority of circuits employ a three prong test in determining whether a claim should be equitably subordinated:


The claimant must have engaged in some type of equitable misconduct. Inequitable conduct directed against the bankrupt or its creditors may be sufficient to warrant equitable subordination of a claim irrespective of whether it was related to the acquisition or assertion of the claim. There are generally three categories of misconduct which may constitute inequitable conduct: (i) fraud, illegality, and breach of fiduciary duties; (ii) claimant's use of the debtor as a mere instrumentality or alter ego; and (iii) undercapitalization. Capitalization is inadequate if in the opinion of a skilled financial analyst, it would definitely be insufficient to support a business of the size and nature of the bankruptcy in light of the circumstances existing at the time the bankruptcy was capitalized. Once it is established that the Debtor was undercapitalized, a showing of additional inequitable conduct may be required. The majority of cases reviewed require misconduct in addition to undercapitalization. A minority of some courts have held that it is possible to have "no fault subordination." In re Virtual Network Services Corp., 902 F.2d 1246 (7th Cir. 1990); In re Burden, 917 F.2d 115 (3rd Cir. 1990).

Injury to Other Creditors

The misconduct resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant. Claim(s) should only be subordinated to the extent necessary to offset the harm which the bankrupt and its creditors suffered on account of the inequitable misconduct; and

Consistent With Code

Equitable subordination of the claim must not be inconsistent with the provisions of the Code. See Benjamin v. Diamond (Matter of Mobile Steel Company), 563 F.2d 692, 699 700 (5th Cir. 1977).

Managing Risk

When dealing with affiliates, care should be taken to ensure that intercompany contracts are in line with terms negotiated between third parties and that the creditor does not use its position to improve the likelihood that its claims against the debtor will be paid while others will not. For nonaffiliates the creditor should not become involved in the day-to-day management of the debtor.


It is not uncommon for a parent corporation or major shareholder(s) to advance money to a company. In bankruptcy these loans are often subject to attack. Courts consider various factors in determining whether advances to a corporation constitute a loan or a capital contribution. The test most widely followed is that articulated in Roth Steel Tube Co. v. Comm'r. of Internal Revenue, 800 F.2d 265 (6th Cir. 1986).


The goal of the recharacterization inquiry is deciding whether what the parties called a loan was in reality an equity contribution. Debt recharacterization merely involves the question: "what is the proper characterization in the first instance of an investment"? Cohen v. KB Mezzanine Fund II, LP (In re Submicron Sys. Corp.), 432 F.3d 448, 454 (3d Cir. 2006) (internal quotations and citations omitted). The power to recharacterize debt into equity stems from the bankruptcy court's authority to test the validity of debts, particularly shareholder loans to undercapitalized debtors. Diasonics, Inc. v. Ingalls, 121 B.R. 626, 630 (Bankr. N.D. Fla. 1990) (citing Taylor v. Standard Gas & Elec. Co., 306 U.S. 307 (1939) which created the so-called "Deep Rock" doctrine, under which a shareholder loan will be recharacterized as a capital contribution when either: (1) there is initial undercapitalization or (2) the loans were made when no disinterested lender would have extended credit.


Though courts have developed numerous factors to consider, "they devolve to an overarching inquiry: the characterization as debt or equity is a court's attempt to discern whether the parties called an instrument one thing when in fact they intended it as something else. That intent may be inferred from what the parties say in their contracts, from what they do through their actions, and from the economic reality of the surrounding circumstances." Id. at 456. Though the courts have articulated a 13-factor analysis, they really are just using inductive reasoning—sometimes called the duck test ("If it quacks like a duck..."). The 13 factors consistently considered by courts are as follows:

  • Is the contribution labeled debt?
  • Does the contribution have a maturity date, like debt?
  • Is the contribution repaid independent of the business' success, like debt?
  • Is repayment enforceable with appropriate safeguards, like debt?
  • Is the contribution given independent of management control, like debt?
  • Does the contribution have the subordination status of general creditors, like debt?
  • Did the parties objectively intend to create debt?
  • Was the debtor securely capitalized, like those who can take on debt?
  • Was the contribution given independent of equity interests, like debt?
  • Is the contribution primarily given in order to earn interest, like debt?
  • Could the contribution have been obtained from outside lenders, like other debt?
  • Was the contribution used to fund operations (not grow capital), like debt?
  • Did the debtor repay the contribution, or seek postponement if he cannot, like debt?

"Which course a court discerns is typically a common sense conclusion that the party infusing funds does so as a banker (the party expects to be repaid with interest no matter the borrower's fortunes; therefore, the funds are debt) or as an investor (the funds infused are repaid based on the borrower's fortunes; hence, they are equity). Form is no doubt a factor, but in the end it is no more than an indicator of what the parties actually intended and acted on." Id. The factors used to recharacterize debt as equity have been adopted from the factors used outside the bankruptcy context, primarily the tax context. In re Submicron Sys., 432 F.3d at 455 & n.8.

Minimizing Risk

Recharacterization is a fact intensive inquiry. A thorough understanding of the factors courts consider in determining whether an advance is debt or equity is key. Intercompany transactions should be well documented. Loans should be evidenced by promissory notes which set forth payment terms, interest rates and maturity. Collateralized loans with properly perfected liens are preferred along with evidence of the company's adequate capitalization.


Each of the identified risks is best managed by becoming and remaining informed about the financial condition of the relevant company and thoroughly documenting transactions with that company.


1. Section 761 of the Bankruptcy Code defines a commodity contract in part as "with respect to a futures commission merchant, contract for the purchase or sale of a commodity for future delivery on, or subject to the rules of, a contract market or board of trade." 11 U.S.C. § 761(4)(A). Other types of commodity contracts relate to foreign futures commission merchants, leverage transaction merchants, and clearing organizations.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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This article is part of a series: Click Dealing With Companies In Financial Distress (Part I) for the previous article.
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Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions