Subordination and Recharacterization


Summary

This practice note discusses how a bankruptcy court may recharacterize documents that purport to create a loan transaction and determine that the transaction, despite labels, is something else—a transaction providing for a contribution to the debtor's capital. Although lawyers can structure a transaction to look like debt, most appellate courts agree that bankruptcy courts have the authority to determine what a transaction really is despite nomenclature used by the parties to an agreement. A true lender will always want to ensure that a transaction is treated as debt by a bankruptcy court, and therefore must structure the transaction in a way that will reduce the recharacterization risk. Private equity investors in a project who take back paper at different levels of the capital stack, will have carefully consider the structure of a transaction and determine their tolerance for the recharacterization of the portion of their investment that they have intended to be debt.