In re Hedged-Investments Associates, Inc.

• Decision Date: 26 August 2004
• Docket Number: No. 02-1192.,No. 02-1191.,02-1191.,02-1192.
• Citation: 380 F.3d 1292
• Parties: In re HEDGED-INVESTMENTS ASSOCIATES, INC.; Hedged-Securities Associates, LP; Hedged-Investments Associates, LP; Hedged-Investments Associates II, LP, Debtors, Harvey Sender, Trustee, Plaintiff-Appellee, v. The Bronze Group, Ltd., Defendant-Appellee, v. J. Daniel Brinker, Donald Shwayder, Alfred Weisner and Laurence Demuth, Jr., individually and as Class Representatives of Class III; Class III, Defendants-Appellants, and Fred Hannahs and Mary Estill Buchanan, individually and as Class Representatives of Classes I and II; Classes I and II, Defendants-Appellants.
• Court: U.S. Court of Appeals — Tenth Circuit

380 F.3d 1292

In re HEDGED-INVESTMENTS ASSOCIATES, INC.; Hedged-Securities Associates, LP; Hedged-Investments Associates, LP; Hedged-Investments Associates II, LP, Debtors,

Harvey Sender, Trustee, Plaintiff-Appellee, v. The Bronze Group, Ltd., Defendant-Appellee, v. J. Daniel Brinker, Donald Shwayder, Alfred Weisner and Laurence Demuth, Jr., individually and as Class Representatives of Class III; Class III, Defendants-Appellants, and Fred Hannahs and Mary Estill Buchanan, individually and as Class Representatives of Classes I and II; Classes I and II, Defendants-Appellants.

No. 02-1191.

No. 02-1192.

United States Court of Appeals, Tenth Circuit.

August 26, 2004.

Appeal from the United States Bankruptcy Court for the District of Colorado, Lewis T. Babcock, Chief Judge.

COPYRIGHT MATERIAL OMITTED

Bruce E. Rohde, Davis & Ceriani, P.C., Denver, CO (M. Frances Cetrulo and Edwin G. Perlmutter, Berenbaum, Weinshienk & Eason, P.C., Denver, CO, with him on the briefs), for Appellants.

Phillip D. Barber, Phillip D. Barber, P.C., Denver, CO (Randall J. Feuerstein, Dufford & Brown, P.C., Denver, CO), for Appellees.

Before EBEL, BALDOCK and KELLY, Circuit Judges.

EBEL, Circuit Judge.

This case is the latest to arise from the bankruptcy of Hedged Investments Associates, Inc. (HIA), a stock investment Ponzi scheme which was run for thirteen years by James Donahue until it finally collapsed in the fall of 1990. This long-running dispute again before us concerns the proper distribution of the assets in the bankruptcy estate.

In this appeal, certain equity investors in HIA and its affiliated entities (Appellants) ask us to reverse the district court's decision refusing to recharacterize as an equity investment a loan advanced to HIA by Defendant-Appellee The Bronze Group, Ltd. (Bronze Group). Appellants also ask us to reverse the district court and equitably subordinate the Bronze Group's claim on the assets of HIA's bankruptcy estate so that the Bronze Group would be treated on par with the Appellant equity investors. We exercise jurisdiction to review the district court's order under 28 U.S.C. § 158(d) and AFFIRM, holding that the Bronze Group loan does not meet either our criteria for recharacterization or for equitable subordination.

I. Background

Plaintiff Harvey Sender serves as the bankruptcy trustee for HIA. The individually named Defendants-Appellants were investors and limited partners in the various HIA sub-partnerships of Donahue's Ponzi scheme, and they represent three Classes of similarly situated investors who also joined as limited partners of HIA's affiliated partnerships. Classes I and II include HIA limited partners who were forced in prior litigation to return preferential and fraudulent transfers and partnership distributions they had previously received from HIA, totaling $6.7 million, back to the bankruptcy estate. Class III includes HIA limited partners who lost money on their investment, withdrawing less than they contributed to the partnerships. Their claims total $193.3 million. Defendant/Appellee The Bronze Group, Ltd. is a limited partnership, constituted by several private corporations' pension trusts, that advanced funds to HIA under a loan agreement concluded in June of 1986.

The Bronze Group's initial advance was for $900,000, and with subsequent repayments and new advances the total outstanding principal on its loans to HIA comes to $1.83 million. HIA faces claims from trade creditors for $18,000 and other loan claims similar to that of the Bronze Group's claim for approximately $1 million. The HIA bankruptcy estate has assets of approximately $11 million to divide among HIA's creditors and limited partners.

The Bronze Group's loan agreement with HIA was memorialized in a promissory note and accompanied by a security agreement and UCC-1 financing statements identifying the assets in one of HIA's trading accounts at Kidder Peabody as collateral. The agreement set a flexible interest rate, with a minimum rate of 15% per annum for the life of the loan, plus additional interest to match the rate of any greater HIA earnings, minus a fee of 4% per annum.

In this, the Bronze Group loan's payment terms were nearly identical to the profit payments Donahue had promised to HIA's limited partners/equity investors in the mid-80's. Under the limited partnership agreements, Donahue sent letters to the limited partners setting a guaranteed minimum return for the coming year, with additional profits distributed from HIA's overall gains minus a management fee that calculated out to approximately 4%. The minimum return promised to limited partners fluctuated over the course of HIA's existence from 8% to 12% to 15%, and in the mid-1980's the promised return was at 15%.

The Bronze Group loan transaction had some peculiar origins. Prior to the formation of the Bronze Group, a substantially similar group of individuals and trust funds had formed a partnership called BGL Associates (BGL), which had contracted with Broker Services, an asset-trading company managed by Mr. Donahue, to set up a stock trading account separate from the HIA partnerships. BGL never became a limited partner of HIA. Upon discovering that Mr. Donahue had not segregated BGL's funds but had commingled them with the pooled HIA accounts, the BGL partners cancelled their arrangement with Broker Services and asked to withdraw their funds totaling $900,000. The members of the now-dissolved BGL partnership then formed the Bronze Group and contributed $900,000, which was then loaned back to HIA under the Bronze Group promissory note.

Mr. Donahue's final disbursement of BGL funds took place on the same day as the contribution of the former BGL partners into Bronze Group and the Bronze Group's advance of $900,000 to HIA under the HIA-Bronze Group loan agreement. At the time of the three transactions, the bank account against which Mr. Donahue's checks to the BGL partners had been written contained $124,000 — far less than the $900,000 paid out to BGL's partners. Those checks did not bounce, however, since the former BGL partners simultaneously deposited $900,000 with the newly-formed Bronze Group, which in turn wrote a check for $900,000 to HIA as the initial advance on the Bronze Group loan. The bankruptcy court below aptly characterized this transaction as a "financial somersault."

During the next four years, HIA sent the Bronze Group 1099 tax forms detailing interest earned on the loan principal, and the Bronze Group asked HIA to fill out "audit letters" that certified to the Bronze Group's auditors that HIA owed the Bronze Group principal and interest on the funds it had borrowed. The Bronze Group made occasional withdrawals from the loan account, which were characterized as HIA's repayment of loan principal and accrued interest, and the Bronze Group also made periodic advances to HIA under the 1986 agreement.

The current case began when Mr. Sender filed for declaratory judgment in the bankruptcy court for the District of Colorado, requesting that the court approve the distribution of the bankruptcy estate to all of HIA's creditors and investors under a "cash-in, cash-out" system, in which each claimant or interest holder would receive a pro-rata share of the estate based upon the principal he or she had loaned or entrusted to HIA. The Bronze Group objected, asserting that its status as a lender to HIA gave it priority over the equity investors and demanding full payment of the principal and interest due under its loan agreement with HIA. The bankruptcy court held that the Bronze Group's advances to HIA did, in fact, constitute a loan, but the court equitably subordinated the Bronze Group's claim to equal priority with HIA's limited partners/equity investors, and ordered that the HIA estate be distributed on a pro-rata "cash-in, cash-out" basis.

The Bronze Group appealed the equitable subordination order to the district court, and the limited partner Classes cross-appealed the bankruptcy court's decision not to recharacterize the Bronze Group transaction as an equity investment rather than a loan. The District of Colorado affirmed the lower court's decision not to recharacterize the Bronze Group loan but reversed the bankruptcy court's equitable subordination order, entering a judgment in favor of the Bronze Group for the loan principal as well as all interest that accrued prior to HIA's filing for bankruptcy.

The limited partner Classes now appeal the district court's order. They first request that we reverse both lower courts' refusal to recharacterize the Bronze Group loan as an equity investment. They also urge us to reverse the district court on equitable subordination, thereby re-instating the bankruptcy court's order that the Bronze Group's claim be equitably subordinated to equal priority with the interests of HIA's limited partners and satisfied on the same "cash-in, cash-out" basis.

II. Recharacterization

A. Distinguishing Recharacterization from Equitable Subordination

We begin our analysis by reiterating the important distinction between the two remedies of recharacterization and equitable subordination.

When a putative loan to a corporation is recharacterized, the courts effectively ignore the label attached to the transaction at issue and instead recognize its true substance. The funds advanced are no longer considered a loan which must be repaid in bankruptcy proceedings as corporate debt, but are instead treated as a capital contribution.

The doctrine of equitable subordination, by contrast, looks not to the substance of the transaction but to the behavior of the parties involved. The funds in question are still considered outstanding corporate debt, but the courts seek to remedy some inequity or unfairness perpetrated against the bankrupt entity's other creditors or investors by postponing the subordinated creditor's right to repayment until others' claims have been satisfied. See Sinclair v. Barr (In re...