Article

Recharacterization Risks: Avoiding the Pitfalls

February 13, 2019

From time to time, particularly when the economy hits a rough patch and bankruptcies and foreclosures are frequent, clients and their lawyers are disappointed when carefully structured transactions are disregarded by a court or found to be an entirely different type of transaction—with results that can range from unpleasant to disaster. This article discusses areas where recharacterization risks are significant and highlights ways to avoid these risks.

Recharacterization occurs most frequently in bankruptcy or reorganization proceedings, where transactions are challenged in order to reclaim transferred assets for the seller’s bankruptcy estate or to improve the position of some classes of creditors in a purchaser bankruptcy. Courts tend to look at these proceedings on a case-by-case, fact-specific basis, and there is no consensus as to the precise factors that apply, or the weight to be given to these factors. Different courts give different weight to the perceived intent of the parties. Nevertheless, as a general rule, courts tend to consider the economic substance of the transaction rather than the names that the parties give the documents.

Sale/Leaseback Transactions

Courts have recharacterized sale/leasebacks as grants of equitable mortgages when the economic substance of the transaction has most of the hallmarks of a secured financing, and the purchaser/lessor bears few if any of the risks of ownership. A number of factors have led courts to find that the transaction is not a true sale and leaseback. If the purchase price paid for the property was based on the seller’s financing needs rather than market prices for similar property, the transaction looks more like a mortgage financing. Other factors are whether the “rent” for the term of the lease is equivalent to the “purchase price” of the property, and whether the term of the lease is equivalent to the useful life of the buildings on the property. An important factor pointing in the direction of an equitable mortgage is a tenant option to repurchase the property at the expiration of the lease term for a nominal sum rather than the fair market value of the property. Courts usually require the presence of several of these factors to make a determination, and none of them is necessarily dispositive of the issue.

In one case, recharacterization occurred when the sale/leaseback/option-to-repurchase transaction involved property conveyed to an investor by deed, but the property’s value far exceeded the purchase price. The seller retained possession of the property and paid all operating expenses following the sale. Further, the amount of rental payments plus a single payment at the time of exercise of the option to repurchase equaled the purchase price amount advanced by the investor-buyer.

Where a sale and leaseback is recharacterized as an equitable mortgage, a bankruptcy trustee of the seller (or the seller as debtor in possession) may seek to reclaim the property. Also, the mortgage lien may not be perfected unless recording requirements have been complied with. This could result in the loss of secured status in bankruptcy proceedings. Further, it may be very difficult to foreclose the equitable mortgage unless the transaction documents contain the “magic language” required in many states in order to make available applicable streamlined foreclosure procedures. There might also be a loss of title insurance coverage in the absence of appropriate endorsements or affirmative insurance.

Recharacterization of Debt as Equity

Loan transactions are also subject to recharacterization as equity, particularly when the lender is an insider and financing is not available from other sources. Again, courts have considered a number of factors, including the names given to documents evidencing indebtedness, the presence of a fixed maturity date (and fixed interest rate), and the schedule of payments. Other factors include whether the source of repayments is tied to the success of a business, the adequacy of capitalization, whether the debt is secured, and the extent to which advances were subordinated to other debt. Secured obligations are much more likely to be treated as debt than equity.

Even if a debtor is undercapitalized, and the lender is an insider, courts have been reluctant to recharacterize a loan as an equity contribution if the loan complies with the proper formalities for a valid loan agreement, the advances are used to reduce senior debt, the advances were treated as a loan in the borrower’s business records, the lender has the right to enforce payment of principal and interest, and the debtor could have secured funds from other lenders. These factors strongly indicate that the parties intended to enter into a loan transaction. On the other hand, courts have viewed purported loan transactions as equity investments if the loans lacked fixed maturity dates, the debtor was not required to pay the loan until it became profitable, the party advancing funds was an insider having control of management, and financing was not available from other sources.

Again, none of these factors is likely to be conclusive.

Where debt is recharacterized as equity, the lender will lose its right to exercise creditor remedies to recoup its investment. It also will lose its ability to participate as a creditor in bankruptcy or reorganization proceedings, and could lose tax benefits.

Recharacterization of Mortgage Loan Sales

Under some circumstances, a mortgage loan sale could be recharacterized as financing secured by the loan rather than a “true sale.” Courts have recharacterized a sale of assets as a pledge of the assets as security for a loan even though the parties have treated the transaction as a sale. There is no conclusive set of factors, and again the courts usually apply a “facts and circumstances” approach. Factors affecting the decision include how the purchase price compares to the fair market value of the assets being transferred, whether the seller bears the risk of loss from defaults on the mortgage loans being sold, and the extent of recourse to the seller for other flaws in the mortgage loans. Other factors are whether the seller has the right to reacquire the loans being transferred, and at what price, and whether the seller retains the burden of servicing the loans for less than market compensation. Again, no single factor is likely to be controlling.

The consequences of a finding that there was a secured financing rather than a true sale could be unfortunate, particularly in a bankruptcy or reorganization proceeding where the seller is the debtor. The trustee in bankruptcy or debtor in possession might seek a court order requiring the purchaser to turn over the mortgage loans, and the automatic stay could prevent the purchaser from receiving the proceeds of loan collections.

Recharacterization of Other Transactions

Where there is an agreement between a mortgage lender and borrower that the borrower will allow the lender to record a deed in lieu of foreclosure if specified defaults occur, with the deed held in escrow, there is a risk that the transaction will be viewed as a second lien equitable mortgage, or integrated with the original mortgage transaction. In either case, the lender is prevented from causing the deed to be recorded without compliance with statutory foreclosure procedures.

Transactions that involve participating, or contingent interest, or “shared appreciation” mortgage loans, give lenders the right to receive a portion of the income from the property or its sale or refinancing as “additional interest.” These transactions need to be carefully structured in order to avoid the risk of recharacterization as a joint venture.

Convertible mortgages give the lender an option to convert the mortgage into a purchase of the mortgaged property. While rarely seen today, these involve the risk that the option may be recharacterized as an integral part of the mortgage and subject to compliance with statutory foreclosure procedures. This type of option can also raise significant risks of unenforceability as “clogging the equity of redemption” under an ancient doctrine, still alive in many jurisdictions, intended to protect borrowers from losing their property without strict compliance with statutory foreclosure rules.

While beyond the scope of this article, it should be noted that recharacterization can also cause tax problems.

Conclusion

Courts have applied a number of factors on a case-by-case basis to determine if the economic substance of certain types of transactions is truly consistent with the way they have been characterized by the parties. When this has not been the case, courts have frequently recharacterized the transactions, with unfortunate results for the parties. Where these risks exist, it is crucial for contracting parties to consult legal counsel in the early stages in order to identify and minimize possible problems.