Court: Bankruptcy Appellate Panel of the Tenth Circuit; March 18, 2014; Us Bankruptcy; United States Bankruptcy Court
Recharacterization allows courts to disregard how a transaction is labeled and instead focus on its actual substance, particularly in bankruptcy cases where a loan might be reclassified as an equity investment. William and Earlene Jenkins are appealing a bankruptcy court ruling that funds they provided to Alternate Fuels, Inc. (AFI) should be treated as an equity investment rather than a loan. The court affirmed this conclusion due to the unique circumstances of the case. Additionally, the Jenkinses challenged the bankruptcy court's findings that they failed to prove the validity and amount of their claims, and that any secured claims should be equitably subordinated; these findings were also upheld.
The factual background highlights Jenkins’ familiarity with coal mining and his involvement with AFI, which filed for Chapter 11 in 1992 but struggled to operate successfully, ultimately ceasing mining operations in 1996. Following abandonment of AFI’s assets by the Chapter 11 trustee, secured creditors foreclosed on equipment, leaving AFI with only mining permits. John Warmack acquired AFI’s stock, subsequently forming Cimarron Energy Co. to continue mining operations, while securing reclamation bonds with certificates of deposit that insulated them from AFI's creditors. In 1999, Jenkins learned Warmack wanted to liquidate his interest in AFI and Cimarron. To circumvent regulatory restrictions preventing Jenkins from owning stock, he arranged for the AFI stock to be registered under Michael Christie, who acted merely as a proxy.
The purchase included the assignment of Certificates of Deposit valued at $1,377,000, with the Jenkinses paying Warmack $549,250. Warmack utilized these funds to reduce secured debts on Cimarron's equipment. Although AFI received no advantage from the payment, it executed a $500,000 promissory note to Green Acres Farms, a business registered by Jenkins, with a five-year term that would be settled upon the release of reclamation bonds from the State of Missouri. At trial, Jenkins provided checks dating back to 2000 but failed to produce documentation supporting the loan. He admitted that AFI could not repay the note without the Certificates of Deposit. The funds advanced by Jenkins were intended for reclamation, aiming for the Certificates' release. Following the transaction, the Jenkinses owned 100% of AFI and 99% of Cimarron, which possessed all mining equipment. AFI was burdened by a $500,000 debt to the Jenkinses and did not intend to conduct mining operations. The Warmack transaction aimed to secure proceeds from equipment valued between $1 to $2 million and the Certificates' release upon reclamation. Although release depended on AFI's successful reclamation efforts, the Jenkinses began receiving interest payments on the Certificates immediately. AFI did not adhere to corporate formalities and was solely controlled by Jenkins, who delegated daily operations to Pommier. AFI lacked income and was financed through checks from Green Acres Farms, which were issued to AFI and then endorsed to Cimarron without any formal agreement or documentation regarding reclamation expenses. The funds advanced never entered an AFI account, thus evading claims from AFI's creditors. On November 6, 2000, AFI issued another $500,000 promissory note to Green Acres Farms at a 9% interest rate, with similar terms regarding reclamation bond release. Jenkins again failed to connect these advances to the second note or provide necessary documentation.
Pommier asserted that the second promissory note aimed to replace the first note at a lower interest rate, a claim Jenkins contested. Jenkins was aware that AFI could not pay this note, with repayment reliant solely on Certificates of Deposit. A third note for $1,000,000, executed on October 11, 2001, similarly lacked supporting accounting and was meant to replace the second note, a claim Jenkins also denied while knowing AFI's inability to pay. During reclamation efforts, Cimarron received a $170,000 arbitration award against Mackie Clemmons Coal Company, which was used to pay Girard National Bank to release a lien on Cimarron’s equipment. Jenkins did not dispute that recovery claim, and a check corroborated Pommier’s testimony. The mining equipment, valued between $1,000,000 and $2,000,000, was liquidated, with Pommier claiming Jenkins retained the proceeds, which Jenkins did not contest or account for. In 2002, both Jenkins and Pommier believed the reclamation was nearly complete, but AFI filed a lawsuit against Missouri Department of Natural Resources employees, believing they were obstructing the process. Jenkins, controlling AFI, assigned $8,000,000 from this litigation to himself and Pommier on March 1, 2003, and executed a fourth note for $2,370,761, which renewed the prior notes without referencing future advances or accounting. This fourth note, like the earlier ones, was also contingent on the release of reclamation bonds or lawsuit proceeds. AFI eventually won a judgment against Cabanas, which was partially satisfied by the State of Missouri in September 2008. Following this, Pommier filed for Chapter 11 bankruptcy for AFI on January 28, 2009, and a trustee was appointed. The Jenkinses filed a claim against AFI’s estate for $4,336,813.
The Jenkinses’ claim comprises three components: (1) $3,823,862.92 for the first three promissory notes, plus interest, backed by a $3,000,000 assignment from the Cabanas lawsuit; (2) $487,298.62 for reclamation-related funds; and (3) accounts for Dan Card ($7,676.00) and Pat Miller ($17,975.56). The Trustee initiated an adversary proceeding contesting the Jenkinses’ claim, aiming to recharacterize their loans to AFI as equity contributions or to have their secured claims subordinated or disallowed. The bankruptcy court determined that both the $3,823,862.92 and $487,298.62 claims should be recharacterized as equity, leading to the setting aside of AFI's assignment of Cabanas litigation proceeds since the Jenkinses no longer had an allowed claim. The court found that the Jenkinses failed to meet their burden of proof regarding their claim's validity and amount. Alternatively, if the claims were not recharacterized or disallowed, they would be treated as unsubordinated, unsecured claims, but the secured claim on the Cabanas proceeds would be equitably subordinated.
The bankruptcy court’s order was entered on December 10, 2012, requiring the notice of appeal to be filed by December 24, 2012. The Jenkinses filed their notice on December 26, which was timely due to Christmas Eve being recognized as a holiday by both federal and state proclamations, thus falling under Rule 9006(a). The appellate court has jurisdiction over timely appeals from bankruptcy court decisions within the Tenth Circuit, and no party opted for district court review, allowing appellate consideration. The order is final and resolves the parties’ adversary proceeding.
The issues for review include: (A) whether the bankruptcy court correctly recharacterized the Jenkinses’ promissory notes as equity, subject to de novo legal review and clear error factual review; (B) whether the court erred in equitably subordinating the Jenkinses’ secured claims, also a mixed issue of law and fact; and (C) whether the court properly disallowed the Jenkinses’ claim, with the standard of review being de novo for legal determinations and clear error for factual findings related to evidence sufficiency.
The bankruptcy court chose to recharacterize the Jenkinses' claims due to their beneficial ownership of AFI during the alleged cash infusions, rather than simply disallowing or subordinating the claims. The court utilized the thirteen-factor test from the Tenth Circuit's In re Hedged-Investments to support its decision. The Jenkinses argued that the Supreme Court's ruling in In re Travelers implicitly abrogated multiple-factor tests for recharacterization, claiming that Kansas law does not recognize such a doctrine, thus contending their claim should be allowed under applicable state law without recharacterization. They also referenced the Supreme Court's decision in Law v. Siegel, asserting that bankruptcy courts lack discretion to disallow claims based on equitable considerations. However, the Fourth Circuit's ruling in In re Official Committee of Unsecured Creditors for Domier Aviation countered this by affirming that bankruptcy courts must determine whether obligations are debt or equity to maintain the priority scheme of the Bankruptcy Code. This ruling underscores the necessity for courts to have the authority to recharacterize claims to prevent equity investors from unfairly prioritizing their claims over true creditors.
A bankruptcy court's authority to recharacterize claims is vital for the effective application of the Bankruptcy Code, as outlined in § 105(a). GMBH argues that recharacterization is dependent on the disallowance power under § 502(b) or the equitable subordination power under § 510(c), suggesting it serves the same purpose. However, recharacterization involves a distinct inquiry, recognizing a relationship between the debtor and claimant, while determining that the claimant's position is as an equity owner rather than a creditor. Unlike disallowance, which completely negates a claim, recharacterization acknowledges the claim but adjusts its treatment to that of an equity interest. The decisions in Travelers and Law do not negate a bankruptcy court's recharacterization power, and the Jenkinses have yet to convincingly argue against the permissibility of equitable recharacterization under Kansas law.
The Hedged-Investments factors, established by the Tenth Circuit, are relevant for determining whether claims should be treated as loans or equity. These non-exclusive factors include aspects such as the naming of certificates, maturity dates, payment sources, rights to enforce payments, management participation, creditor status, party intent, capitalization levels, and repayment behavior. These factors aim to differentiate true debt from disguised equity but are not determinative on their own; their relevance and significance depend on the specific circumstances of each case. The Jenkinses' claims are based on three Notes and unspecified additional amounts, but they have not provided sufficient accounting details to support their claims.
At the time the Notes were executed, AFI had no economic incentive to reclaim the mining sites, as doing so would necessitate incurring debt without any financial benefit. Although AFI was legally obligated to reclaim the sites, failure to do so would result in the State of Missouri claiming the surety bonds, and AFI would owe the Jenkinses for the lost Certificates of Deposit. Jenkins was aware that AFI could not repay the Notes or any advances, as AFI lacked valuable assets, business operations, capital, and income. Consequently, Jenkins had no economic benefit from AFI, with the only potential recovery being the uncertain release of the Certificates of Deposit, contingent on reclamation bond release as stated in the Notes.
The bankruptcy court analyzed the factors from the Hedged-Investments framework, ultimately determining that the evidence favored recharacterizing the Jenkinses’ loans as equity. It found two factors inapplicable, three factors only superficially supporting the loan characterization, and seven strongly favoring recharacterization. The court noted that while the documents were labeled as promissory notes, they did not adhere to traditional loan formalities, as critical repayment terms were missing or marked 'N/A.' It clarified that the advances were not structured like conventional loans, which have clearly defined amounts, repayment terms, and interest, but rather resembled equity investments where repayment is contingent and uncertain. Equity entails risks and does not guarantee a return proportional to the amount invested, contrasting with the characteristics of a loan.
Evidence is lacking to confirm that the terms of the promissory notes were established before the advances were made, and the amounts advanced do not align with the note amounts. There is no accounting linking the alleged funds to the notes, and no records exist for any advances prior to or in accordance with the alleged loan. The Notes lack reasonably equivalent consideration, as AFI did not receive anything for the first $500,000 note, and while there is some evidence of advances, it fails to connect these advances to the amounts specified in subsequent promissory notes. At the time of the advances, the Jenkinses’ potential return was uncertain and contingent on the proceeds from Certificates of Deposit. The bankruptcy court's consideration of this uncertainty favored loan characterization, which was viewed as generous to the Jenkinses.
Regarding the fixed maturity date, which typically indicates a loan rather than equity, the Jenkinses claimed this factor supported loan treatment since the Notes included a five-year repayment date. However, the bankruptcy court found that there was effectively no fixed maturity date, as Jenkins was aware that AFI could not repay the Notes and the advances were solely to secure release of the Certificates of Deposit, the timing of which was uncertain.
The source of payments was another consideration, with the bankruptcy court concluding that the Jenkinses relied on the Certificates of Deposit for repayment rather than AFI, leaning heavily towards recharacterization. The Jenkinses’ argument, which suggested that advances to a struggling business should not influence recharacterization, misinterpreted the court’s findings. They incorrectly framed AFI as a 'flagging business' when it was out of operation, and repayment was not dependent on AFI’s success but rather on the reclamation of mining sites.
Finally, regarding the right to enforce payment, the bankruptcy court determined that the Jenkinses' enforcement rights were 'illusory' since both Jenkins and Pommier knew that AFI could not pay the Notes, rendering attempts to enforce payment futile. The Jenkinses contended that the terms of the Notes should prevail, arguing that AFI's inability to pay was irrelevant. However, the court emphasized that recharacterization considers the substance of a transaction rather than its superficial labels.
Jenkins recognized he could not enforce payment of the Notes, with the bankruptcy court supporting the conclusion that the Jenkinses’ right to enforce payment was 'illusory.' The fifth factor regarding 'participation in management' was deemed to superficially support treating the advances as loans, but since Jenkins already controlled AFI at the time of the advances, this factor could have been considered inapplicable. The sixth factor related to the 'status of the contribution' was ruled irrelevant by the bankruptcy court, a conclusion disputed by the Jenkinses due to the absence of subordination language in the Notes. However, the court noted that if advances were used to pay AFI’s creditors, the Jenkinses effectively subordinated their right to payment. The seventh factor, 'the intent of the parties,' was clarified through the pre-trial order, indicating that the advances aimed to secure the Jenkinses’ investment by funding reclamation, with repayment expected from the Certificates of Deposit, not from AFI. Jenkins explicitly acknowledged that AFI lacked funds to pay the Notes. The eighth factor, 'thin' or adequate capitalization, raised by the Jenkinses, indicated an undercapitalization issue; however, given AFI's lack of capital, business activity, and income prospects, the court’s emphasis on this factor was justified. The Jenkinses’ actions appeared focused on obtaining the Certificates of Deposit rather than reviving AFI.
The bankruptcy court found that AFI's complete lack of capital strongly favored recharacterization as equity. The Jenkinses, who were both the sole shareholders and the sole providers of advances to AFI, demonstrated a 100% identity of interest, which the court concluded also favored equity characterization. The tenth factor regarding the source of interest payments was deemed inapplicable, as AFI had not made any interest payments, and the court clarified that the interest provision in the Notes did not pertain to actual payment sources. The Jenkinses' argument regarding the Cabanas litigation was dismissed because at the time of the Notes' signing, AFI lacked identifiable income sources for such payments.
The bankruptcy court noted that AFI had unsuccessfully sought loans from at least six banks, indicating that no reasonable creditor would have acted similarly, which strongly supported the notion that the advances were capital contributions rather than loans. The twelfth factor, concerning the use of advances for capital assets, was of reduced significance since AFI had not made any capital acquisitions during the relevant period. Lastly, the court observed that none of the Notes were paid by their due dates, nor were extensions requested, although this failure was not viewed as a default by the parties involved. This factor also strongly supported recharacterization. Overall, the bankruptcy court's determination that the Jenkinses' claim should be recharacterized as equity was well-supported by the facts, as analyzed through the Hedged-Investments factors. Additionally, Jenkins paid Warmack $549,250 to acquire Warmack’s equity interest in AFI, Cimarron, and the Certificates of Deposit.
AFI did not receive any funds from the payments made, which were classified as equity interests meant to enable the Jenkinses to acquire Certificates of Deposit. AFI lacked the capital to finance reclamation efforts, could not secure external funding, and would gain no economic benefit from completing the reclamation. The Jenkinses, as beneficial owners and controllers of AFI, were aware of AFI's inability to pay the Notes, indicating that the reclamation and advances were solely for their benefit and should be regarded as equity contributions.
The Bankruptcy Court correctly disallowed the Jenkinses' proof of claim because they failed to prove the validity and amount of their claim. The burden of proof lies with the creditor, and the court found no direct link between the claimed reclamation costs and the Notes. Only one of the worksheets provided by the Jenkinses was acknowledged, and these were not contemporaneous records but rather summaries based on checks. There was no evidence of a $500,000 transfer to AFI in December 1999; instead, the funds advanced in late 1999 were used to settle secured debt on equipment owned by Cimarron, resulting in the Jenkinses receiving Warmack's interest in AFI, Cimarron, and the Certificates of Deposit.
Moreover, a $170,000 advance to AFI in June 2000 was used for Cimarron's debt to Girard National Bank, and thus did not benefit AFI. Payments included in the Jenkinses' claim, such as a $137,900 payment on November 6, 2001, and subsequent payments in 2004 and 2005, were made directly to Girard National Bank with no evidence that AFI benefited. Overall, AFI did not receive any consideration for at least $891,535.23 of the approximately $2,423,812.81 claimed by the Jenkinses, as many checks were endorsed to Cimarron rather than deposited into an AFI account.
The Jenkinses seek $487,298.62 for reclamation-related claims and accounts associated with Dan Card and Pat Miller, in addition to three Notes. However, there is no promissory note from AFI to support this claim, and the only evidence provided—exhibit G—is a handwritten list labeled “Total Money Due 10-31-08,” which lacks foundational support and does not satisfy the burden of proof required for a claim. Consequently, the bankruptcy court could either speculate on the claim's validity or disallow it, and it chose the latter, supported by evidence showing the Jenkinses did not meet their burden.
Additionally, the Jenkinses’ secured claim should be subordinated according to Section 510 of the Bankruptcy Code, which allows for the subordination of claims to address inequities resulting from a claimant's conduct. Three criteria must be satisfied for equitable subordination: 1) inequitable conduct by the claimant; 2) injury to other creditors or unfair advantage to the claimant; and 3) consistency with Bankruptcy Code provisions. The conduct in question includes fraud, undercapitalization, or treating the debtor as an alter ego.
Jenkins' role as an insider subjects his actions to heightened scrutiny, requiring proof of unfair conduct and culpability. Evidence indicates that AFI was undercapitalized and that Jenkins manipulated the company for personal gain, including securing unsupported Notes that far exceed legitimate advances. Jenkins’ use of AFI to obtain the assignment of litigation proceeds to back his unsubstantiated claims further illustrates potential misconduct. Jenkins contends that subordination is unwarranted, asserting that no harm was done to creditors due to his advances leading to litigation proceeds. However, this justification does not excuse his attempt to prioritize his reclamation costs over other creditors when there was no repayment source at the time of his advances.
Jenkins leveraged his insider knowledge and control of AFI to secure assignment of litigation proceeds from the Cabanas litigation, disadvantaging other creditors. The Jenkinses claim a secured interest that arose from utilizing AFI for personal gain while it was undercapitalized. Their actions provided them an unfair advantage, allowing them to secure a questionable debt at the expense of others. The bankruptcy court found their claim inadequately documented, lacking sufficient consideration, and grossly overstated, resulting from their own misconduct. Consequently, the court equitably subordinated their claim, affirming that it should be classified as unsecured. The court’s legal conclusions and factual findings were upheld, and a motion by Appellee Redmond to strike certain exhibits from the appellate record was denied, maintaining the relevance of the documents considered. The net proceeds from the litigation, approximately $5 million after costs and fees, are held by the bankruptcy court.
In the referenced legal case, the court evaluated the relationship between the amounts of certain Notes and transfers to AFI, concluding that while the Notes did not directly correlate to these transfers, they approximately reflected the total of checks issued by Green Acres to AFI in the previous year. The court noted that AFI's sole income derived from advances made by the Jenkinses to settle creditor claims, rendering the payment of other creditors irrelevant to the Jenkinses' non-payment. Constructive subordination was mentioned as a potentially relevant consideration, particularly regarding the prioritization of creditor payments over the terms of the disputed financial instrument. Citations to various cases and checks were referenced to support the court's findings, emphasizing the importance of specific documentation in the proceedings.
