The Bankruptcy Code enables bankruptcy courts to take certain measures to facilitate the claims process and priority system. For example, section 502(b)(1) enables bankruptcy courts, upon objection, to disallow creditors’ claims based on applicable law or an agreement between the creditor and the debtor, and section 510(c) enables bankruptcy courts to equitably subordinate claims of creditors that engaged in inequitable conduct such that subordination would be appropriate to remedy any injury suffered by another creditor. Whether bankruptcy courts may recharacterize debt claims as equity, however, is not explicitly addressed in the Bankruptcy Code. Because of this, recharacterization analysis has been developed by the courts, resulting in a recent split of authority amongst courts that have addressed the issue and decided that bankruptcy courts may recharacterize debt claims as equity.
The Fourth, Sixth, Third, and Tenth Circuits have allowed bankruptcy courts to recharacterize debt claims as equity using their general equitable powers pursuant to section 105(a). Using the court’s equitable power, these courts developed the recharacterization analysis with minimal guidance, limited only by the Bankruptcy Code. Although allowing bankruptcy courts to recharacterize debt claims as equity, the Fifth Circuit has determined that the authority is grounded in section 502(b)(1), which grants bankruptcy courts the power to disallow claims. Using this Bankruptcy Code provision, the Fifth Circuit concluded that the power to recharacterize claims is tied to applicable state law, and thus will vary based on the particular state law applied.