When a company files for bankruptcy, creditors often wonder about the likelihood of getting paid. The answer largely depends on the priority and treatment of each creditor’s claim in the bankruptcy process. The doctrines of recharacterization and equitable subordination can significantly impact the priority of a claim, potentially postponing or eliminating payment.

Recharacterization involves recategorizing debt as equity, which can drastically affect a creditor’s chances of recovery. Courts analyze the substance of financial transactions to determine whether an asserted debt should be treated as equity. If deemed equity, the claim is subordinated to all other claims, making it last in line for payment. This process ensures that genuine debt claims are prioritized over equity interests. The analysis for recharacterization is fact-intensive, considering factors such as the wording of debt documents, the presence of fixed maturity dates, and the company’s ability to secure third-party financing.

Equitable subordination, on the other hand, lowers the priority of a claim based on the creditor’s inequitable conduct, such as fraud. This doctrine assumes the claim is legitimate but reorders its priority to prevent unfair distribution among creditors. To equitably subordinate a claim, it must be shown that the creditor engaged in misconduct that harmed other creditors or conferred an unfair advantage. Unlike recharacterization, equitable subordination does not require the entire debt to be recategorized but only adjusts the priority to offset the creditor’s bad acts. Both doctrines are crucial in ensuring fair treatment of claims in bankruptcy, and creditors should seek competent legal counsel to navigate these complex issues. Read the full article here.