The Past and Future of Debt Recharacterization

The bankruptcy doctrine of debt recharacterization, as developed in four federal circuits, uses multi-factor tests derived from tax cases involving solvent companies. Aspects of these tests make no sense when applied to debt of insolvent companies and the U.S. Treasury has determined that, even for the purpose originally intended, the tests produce "inconsistent and unpredictable results." The Ninth Circuit has now joined the Fifth Circuit in looking to state law as the basis for determining whether debt claims should be recharacterized as equity and disallowed in bankruptcy cases. This article examines these two approaches, analyzing arguments for and against application of a federal or a state law rule of decision for debt recharacterization. Drawing on U.S. Supreme Court precedents, statutory analysis, and policy, the article shows that state law provides the proper framework for determining whether debt should be recharacterized as equity in bankruptcy. State law offers consistency between state and federal courts and a higher degree of predictability concerning the enforcement of insider debt. The article predicts that the U.S. Supreme Court will ultimately resolve the circuit split in favor of a state law rule of decision. In anticipation of such a ruling, the article concludes by providing an overview of choice of law issues and state law approaches to debt recharacterization.