Practical Guidance®
Subordination and
Recharacterization
A Practical Guidance® Practice Note by Ira L. Herman, Blank Rome LLP
Ira L. Herman
Blank Rome LLP
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.
This practice note also discusses subordination of claims
under Section 510 of the Bankruptcy Code.
Finally, this practice note introduces the notion that a party
in interest in a bankruptcy case may object to a competing
creditor’s claims for strategic purposes. Creditors will
do this to increase their share of a finite bankruptcy pie.
The Bankruptcy Code provides objecting parties with
a robust “tool box” to accomplish this task, including
recharacterization, subordination, and disallowance.
This practice note discusses the requirements that must be
met for recharacterization, as follows:
• Subordination of Claims
• Recharacterization Requirements
• Recharacterization Factors
• Conclusion
For more information, see Equitable Subordination versus
Debt Recharacterization and Treatment of Claims in
Bankruptcy.
Subordination of Claims
Section 510 of the Bankruptcy Code governs subordination
of claims. Subordination does not eliminate claims; rather, it
results in the subordinated claim being removed from one
class of claims and placed in a class of claims that is afforded
a lower priority in the pecking order of the payments to be
made in a bankruptcy case. In many instances, a subordinated
claim receives no distribution. By the subordination of a
claim and its removal from a class of claims, claims remaining
in the class will benefit by receiving their proportionate
share of a distribution that otherwise would have been paid
to the now subordinated claim. In other words, although
the size of the pie remains the same in terms of dollars
available for distribution to the affected class of creditors,
the total dollar amount claims to be paid in that class is
reduced. Subordination under the Bankruptcy Code may be
contractual (Section 510(a)) or equitable (Section 510(c)).
Additionally, the Bankruptcy Code provides that claims for
damages “arising from [the] rescission of a purchased or sale
of a security of the debtor or of an affiliate of the debtor” are
subordinated by operation of law to claims.
