It is generally recognized that a bankruptcy court has the power—either equitable or statutory—to recharacterize a purported debt as equity if the substance of the transaction belies the labels the parties have given it. A ruling handed down by the U.S. Bankruptcy Court for the Southern District of New York provides a textbook example of such a recharacterization. In In re Live Primary, LLC, 2021 WL 772248 (Bankr. S.D.N.Y. Mar. 1, 2021), the court held that a purported loan made to a startup limited liability company by one of its members should be treated as a capital contribution because, among other things, the company was inadequately capitalized and the unsecured “loan” was not properly documented, bore a de minimis interest rate, and was repayable only upon the occurrence of a stock offering or a change of control.


Source of Power to Recharacterize Debt as Equity.  The power to treat a debt as if it were actually an equity interest is derived from principles of equity. It emanates from the bankruptcy court’s power to ignore the form of a transaction and give effect to its substance. See Pepper v. Litton, 308 U.S. 295, 305 (1939). However, because the Bankruptcy Code does not expressly empower a bankruptcy court to recharacterize debt as equity, some courts disagree as to whether they have the authority to do so and, if so, the source of such authority.

Every circuit court of appeals that has considered the issue has upheld the power of a bankruptcy court to recharacterize a claim as equity, notwithstanding the parties’ characterization of a prepetition advance as a “debt.” See generally Collier on Bankruptcy (“Collier”) ¶ 510.02 (16th ed. 2021) (citing cases). Some circuits have held that a bankruptcy court’s power to recharacterize derives from the broad equitable powers set forth in section 105(a) of the Bankruptcy Code, which provides that “[t]he court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of [the Bankruptcy Code].” See In re Dornier Aviation (N. Am.), Inc., 453 F.3d 225 (4th Cir. 2006); In re SubMicron Sys. Corp., 432 F.3d 448 (3d Cir. 2006); In re Hedged-Invs. Assocs., Inc., 380 F.3d 1292 (10th Cir. 2004); In re AutoStyle Plastics, Inc., 269 F.3d 726 (6th Cir. 2001). In Hedged Investments, the Tenth Circuit explained that, if courts were bound by the parties’ own characterization of a transaction, “controlling equity owners of a troubled corporation could jump the line of the bankruptcy process and thwart the company’s outside creditors’ and investors’ priority rights.” Hedged Investments, 380 F.3d at 1298.

The Fifth and Ninth Circuits have taken a different approach, holding instead that section 502(b)(1) of the Bankruptcy Code, which provides in relevant part that “the court … shall allow [a] claim … except to the extent that … such claim is unenforceable against the debtor and property of the debtor, under any agreement or applicable law,” is the proper statutory authority for recharacterization. See In re Lothian Oil Inc., 650 F.3d 539 (5th Cir. 2011); In re Fitness Holdings Int’l, Inc., 714 F.3d 1141 (9th Cir. 2013).

The Eleventh Circuit has also recognized the legitimacy of the remedy, but without specifying the source of the court’s power to exercise it. See In re N & D Props., Inc., 799 F.2d 726, 733 (11th Cir. 1986) (noting that shareholder loans may be deemed capital contributions “where the trustee proves initial under-capitalization or where the trustee proves that the loans were made when no other disinterested lender would have extended credit”).

In In re Airadigm Communs., Inc., 616 F.3d 642, 653 (7th Cir. 2010), the Seventh Circuit declined to decide whether recharacterization of a debt was appropriate (although the bankruptcy court concluded below that it does not have the power to do so), but noted that the “overwhelming weight of authority” supports the authority of bankruptcy courts to recharacterize loans as equity.

Standard for Recharacterization.  In AutoStyle, the Sixth Circuit applied an 11-factor test derived for recharacterization from federal tax law. Among the enumerated factors are the labels given to the alleged debt; the presence or absence of a fixed maturity date, interest rate, and schedule of payments; whether the borrower is adequately capitalized; any identity of interest between the creditor and the stockholders; whether the loan is secured; and the corporation’s ability to obtain financing from outside lending institutions. This and similar tests have been adopted by many other courts. See, e.g., Dornier Aviation, 453 F.3d at 233 (applying AutoStyle factors); SubMicron Sys. Corp., 432 F.3d 448 (seven-factor test); Hedged Investments, 380 F.3d at 1298 (13-factor test); N & D Props., 799 F.2d at 733 (two-factor test); In re Transcare Corp., 2020 WL 8021060, *37 (Bankr. S.D.N.Y. July 6, 2020) (noting that “[c]ourts in this District have adopted the eleven-factor analysis set forth in AutoStyle“). Under the AutoStyle test, no single factor is controlling. Instead, each factor is to be considered in light of the particular circumstances of the case.

In Lothian Oil and Fitness Holdings, the Fifth and Ninth Circuits ruled that state law should determine whether a debt should be recharacterized as equity. Lothian Oil, 650 F.3d at 543-44; Fitness Holdings, 714 F.3d at 1148.

As explained by the court in In re Adelphia Commc’ns Corp., 365 B.R. 24, 74 (Bankr. S.D.N.Y. 2007), the “paradigmatic” recharacterization case involves a situation where “the same individuals or entities (or affiliates of such) control both the transferor and the transferee, and inferences can be drawn that funds were put into an enterprise with little or no expectation that they would be paid back along with other creditor claims.”

Distinction Between Recharacterization and Equitable Subordination.  A related but distinct remedy is “equitable subordination,” which was developed under common law prior to the enactment of the current Bankruptcy Code to remedy misconduct that results in injury to creditors or shareholders. It is expressly recognized in section 510(c) of the Bankruptcy Code, which provides that the bankruptcy court may, “under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or part of another allowed interest.”

In In re Mobile Steel Co., 563 F.2d 692 (5th Cir. 1977), the Fifth Circuit articulated what has become the most commonly accepted standard for equitable subordination of a claim. Under this standard, a claim can be subordinated if the claimant engaged in some type of inequitable conduct that resulted in injury to creditors (or conferred an unfair advantage on the claimant) and if equitable subordination of the claim is consistent with the provisions of the Bankruptcy Code.

Courts have refined the Mobile Steel test to account for special circumstances. For example, many courts make a distinction between insiders (e.g., corporate fiduciaries) and non-insiders in assessing the level of misconduct necessary to warrant subordination. See generally Collier at ¶ 510.05[3].

As explained by the court in Adelphia, “[t]he recharacterization analyses focus on the substance of the transaction, whereas equitable subordination analyses focus on the creditor’s behavior.” Adelphia, 365 B.R. at 74.

Live Primary

Live Primary, LLC (“debtor”) was a shared office space company based in New York. Created in 2015, its members were Lisa Skye Hain (“Hain”), Primary Member, LLC (“PM”), and Daniel Orenstein (“Orenstein”). PM was controlled by Joel Schreiber (“Schreiber”), who was also the founder of real estate investment firm Waterbridge Capital (“Waterbridge”).

Pursuant to the Delaware law-governed limited liability company agreement (“LLC Agreement”), the startup was to be funded by a $6 million “loan” from PM. Each tranche of the loan was to be evidenced by a promissory note and memorialized in a loan agreement. However, no loan agreement or promissory notes were ever executed.

The $6 million loan had no maturity date but was payable with accrued interest at the rate of 1% per annum upon the occurrence of a “liquidity event” (e.g., a merger, consolidation, or sale of the debtor) or an initial public offering (“IPO”) of the debtor’s stock.

The LLC agreement provided that, if PM failed to make any required disbursement of the loan proceeds, PM was obligated to pay the debtor a nonrefundable default fee, PM’s membership share would be diluted, and the debtor was entitled to seek an alternative source of senior priority bridge financing. The PM loan was to be repaid in full before any distribution to other members.

Although PM was the nominal lender for the $6 million loan, the advances were actually made by Waterbridge. The debtor’s books and records reflected that the loan was owed to either PM or Waterbridge.

The LLC agreement was later amended to create Class A Units—held equally by Hain, now the debtor’s sole manager after Orenstein resigned, and PM—and Class B units, held by Orenstein. The amended agreement provided that all transactions between the debtor (managed by Hain) and any member or executive required the unanimous consent of the Class A members (Hain and PM).

In 2019, an investor group led by David Kirshenbaum (“Kirshenbaum”) loaned the debtor $2.65 million. The provision in the LLC agreement governing member and executive transactions was then amended to require the unanimous consent of the Class A members and Kirshenbaum.

The debtor filed for chapter 11 protection in the Southern District of New York on July 12, 2020. PM filed a proof of claim in the case asserting a debt in the amount of approximately $6.4 million based on: (i) the initial $6 million loan plus additional advances and accrued interest; and (ii) 14 “other loans,” the outstanding principal, and interest of which amounted to approximately $81,000. According to PM, those other loans were discussed orally, but not formally documented. Instead, they were evidenced by email correspondence among Hain, Schreiber, and Waterbridge.

The debtor and certain of its noteholders objected to PM’s claim, arguing that: (i) the claim lacked prima facie validity because it was not supported by any written documentation evidencing the loans; (ii) the purported $6 million loan was in fact equity and should be recharacterized as such in accordance with AutoStyle; (iii) the “other loans,” which were disputed by the debtor, were unauthorized loans made by Waterbridge, which did not file a proof of claim; (iv) PM was not a creditor because all payments on the “other loans” were made to Waterbridge; and (v) PM’s claim should be disallowed under section 502(d) of the Bankruptcy Code because it received avoidable preferential transfers.

The Bankruptcy Court’s Ruling

Initially, Bankruptcy Judge Martin Glenn ruled that, even though PM’s claim was not memorialized in a loan agreement or promissory notes, the LLC agreement, the debtor’s books and records, the parties’ conduct, and other extrinsic evidence provided prima facie evidence of the purported loans. The court also held that PM had standing as a creditor to assert the claim for the loans because, among other things, the debtor treated PM and Waterbridge interchangeably. In addition, Judge Glenn concluded that an adversary proceeding was not required to seek recharacterization because the remedy does not fall under one of the 10 exclusive categories identified in Rule 7001 of the Rules of Bankruptcy Procedure (such as subordination of a claim or interest) and the debtor also proposed to recharacterize PM’s claim as equity under its chapter 11 plan.

Turning to recharacterization, Judge Glenn explained that the “‘ultimate exercise’ in evaluating any recharacterization claim ‘is to ascertain the intent of the parties'” (quoting In re Lyondell Chem. Co., 544 B.R. 75, 102 (Bankr. S.D.N.Y. 2016)). He rejected PM’s argument that, under Delaware law, the intent of the parties should be determined by reference to the terms of the LLC agreement, which clearly stated that the advances made by PM were loans. Instead, Judge Glenn wrote, “it is the meticulous application of the eleven AutoStyle Factors that reveals the actual intent of the Parties.”

Examining those factors, Judge Glenn noted that each of them supported a finding that the purported $6 million loan was in fact equity:

  • Although the LLC operating agreement and the debtor’s books and records labeled PM’s advances as loan, this was not dispositive, and the absence of any instruments evidencing a loan, such as a master promissory note, suggested otherwise.
  • The purported $6 million loan did not have a fixed maturity date.
  • The loan bore a de minimis interest rate, which accrued rather than being payable periodically.
  • The only source of repayment of principal and accrued interest was the proceeds of an IPO or a “liquidity event.”
  • Initial capital contributions under the LLC operating agreement amounted to only $1,000, which was “massively inadequate” because the debtor was a startup in its early stages of formation.
  • PM was both a member of the debtor and the purported creditor, and the “structure of contributions with money from PM and contributions of sweat equity from Orenstein and [Hain] are indicative of equity.” Under the LLC operating agreement, PM’s membership interest would be reduced in proportion to the amount of the loan it failed to fund.
  • The purported $6 million loan was unsecured.
  • As a startup, the debtor could not have obtained loans from other lenders that were remotely similar to the PM advances.
  • The purported $6 million loan was effectively subordinated to the claims of other creditors unless and until either an IPO or a liquidity event occurred.
  • The proceeds of the purported loan were used to acquire capital assets rather than to satisfy the debtor’s daily operating needs.
  • There was no “sinking fund”—a fund holding regular deposits that are accumulated with interest to pay off long-term debt—to provide for repayment of the purported loan.

Judge Glenn also held that PM’s claim based on the “other loans” should not be disallowed as “unauthorized” loans because, among other things, the Class A members approved the loans in writing, as required by the LLC operating agreement. However, he ruled that PM’s claim based on the other loans must be disallowed under section 502(d) because PM received (and had not repaid) a $40,000 avoidable transfer within 90 days of the bankruptcy petition date.


In many respects, Live Primary is a textbook example of the circumstances under which a bankruptcy court will conclude that a purported loan should be treated as equity. The court found that every one of the 11 AutoStyle factors weighed in favor of recharacterizing the series of advances at issue as equity infusions. Many other cases are not so black and white, and thus require that the court weigh various factors supporting recharacterization against those that do not in deciding whether the remedy is appropriate.

Some of the key takeaways from Live Primary include: (i) the bankruptcy court’s power to disregard the labels given to a transaction and to ascertain its substance in keeping with the priority scheme underlying federal bankruptcy law; and (ii) the fact-intensive analysis required to determine whether recharacterization of a debt as equity is warranted.