Beautifying Your Financial Picture

How Your Commercial Loan Might Be Recharacterized During Bankruptcy

by Darryl Nguyen

Bankruptcy court has the power to reorder claims or interest through the recharacterization of debt as equity. This is done to increase the amount of money that creditors can receive from a commercial debtor and also makes it possible to eliminate competing claims. Recharacterization allows for several claims to be dismissed based on provisions found in the bankruptcy code.

How a Claim Can Become Subordinated

In some cases, due to the inequitable conduct of one of the parties, either a creditor or debtor, a claim might arise or might be tainted. Under these circumstances, provisions in the bankruptcy code are used to resolve this. This can lead to a claim being subordinated.

A claim that is subordinated is not entirely eliminated, but it is not prioritized as much as claims that aren't subordinated. In some cases, if there are limited funds to distribute, those claims that are subordinated receive no distribution. The benefit is that those who do not have subordinated claims are paid a larger share.

Courts Have Flexibility When Recharacterizing Debt

There is no section of the bankruptcy code that determines exactly how debts can be recharacterized, so the courts are responsible for determining whether or not they can recharacterize a debt. However, the majority of courts have decided that they have the right to recharacterize debt. In many cases, recharacterization is even seen as being essential for bankruptcy courts to be able to function.

Risk Factors That Can Lead to Debt Recharacterization

There are many factors that can lead to a loan being recharacterized. The lack of notes or evidence of indebtedness may lead the courts to suspect that the loan was actually a capital contribution. If the loan doesn't have a maturity date and a fixed obligation to pay, it looks more like an equity investment.

There should be evidence of an interest rate and interest rate payments for the loan to look like a loan. There are also several other factors, such as the lack of a security, that would lead a debt to be recharacterized. 

Because of how complex the bankruptcy code is, it's highly recommended that your business seek the help of commercial bankruptcy services, such as the Molleur Law Office, rather than trying to understand it yourself. In addition to being difficult to understand, courts often make exceptions to rules, and lawyers are often able to find ways to help their clients in ways that their clients often can't imagine.