In re Official Committee of Unsecured

• Court: U.S. Court of Appeals — Fourth Circuit
• Writing for the Court: Diana Gribbon Motz
• Citation: In re Official Committee of Unsecured, 453 F.3d 225 (4th Cir. 2006)
• Decision Date: 27 June 2006
• Docket Number: No. 05-1930.,05-1930.
• Parties: In re OFFICIAL COMMITTEE OF UNSECURED Creditors FOR DORNIER AVIATION (NORTH AMERICA), INCORPORATED; Fairchild Dornier GMBH, Debtors. Fairchild Dornier GMBH; Doctor Eberhard Braun, Debtors-Appellants, v. The Official Committee of Unsecured Creditors (The Plan Monitoring Committee), Creditor-Appellee.

453 F.3d 225

In re OFFICIAL COMMITTEE OF UNSECURED Creditors FOR DORNIER AVIATION (NORTH AMERICA), INCORPORATED; Fairchild Dornier GMBH, Debtors Fairchild Dornier GMBH; Doctor Eberhard Braun, Debtors-Appellants, v. The Official Committee of Unsecured Creditors (The Plan Monitoring Committee), Creditor-Appellee.

No. 05-1930.

United States Court of Appeals, Fourth Circuit.

Argued: May 22, 2006.

Decided: June 27, 2006.

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ARGUED:

Ronald Barliant, Goldberg, Kohn, Bell, Black, Rosenbloom & Moritz, Ltd., Chicago, Illinois, for Appellants. James Paul Campbell, Campbell, Miller & Zimmerman, P.C., Leesburg, Virginia, for Appellee.

ON BRIEF:

Matthew A.C. Zapf, David E. Morrison, Goldberg, Kohn, Bell, Black, Rosenbloom & Moritz, Ltd., Chicago, Illinois; Benjamin C. Ackerly, Sr., Hunton & Williams, Richmond, Virginia; Linda Lemmon Najjoum, Hunton & Williams, McLean, Virginia, for Appellants.

Before WILKINS, Chief Judge, and MOTZ and KING, Circuit Judges.

Affirmed by published opinion. Judge MOTZ wrote the opinion, in which Chief Judge WILKINS and Judge KING joined.

OPINION

DIANA GRIBBON MOTZ, Circuit Judge:

At the urging of unsecured creditors, the bankruptcy court recharacterized a parent corporation's sale of parts to one of its subsidiaries as an equity contribution rather than a debt. The parent corporation appeals the district court's affirmance of the bankruptcy court's judgment. We affirm.

I.

Dornier Aviation (North America) (DANA) is a wholly-owned indirect subsidiary of Fairchild Dornier GMBH (GMBH), a German aircraft manufacturer.¹ GMBH sold spare parts to DANA so that DANA could provide warranty and provisioning support to GMBH customers; DANA also resold some of these parts to non-warranty end users for a profit. GMBH billed DANA with specific invoices for the parts it sent;² these invoices indicated that payment was due within 30 days "unless otherwise agreed." In addition, during annual reconciliations, GMBH and DANA typically signed a "statement of account" that detailed the amounts that DANA owed GMBH. However, despite these written agreements, evidence produced at trial demonstrated that DANA did not pay the invoices within 30 days. In fact, Thomas Brandt, GMBH's Chief Financial Officer, testified that DANA and GMBH had an agreement that DANA did not have to repay GMBH "until the whole operation turned positive." Brandt also testified that GMBH treated DANA "specially" because GMBH viewed its relationship with DANA as "a market investment" designed to expand its access to the North American market. Although Brandt explained that GMBH did expect DANA to repay its debts eventually, he also explained that there was no fixed maturity date and that GMBH would not seek repayment until DANA became profitable.

In 2000, GMBH commissioned an audit report from Pricewaterhouse Coopers. The audit calculated that the amount DANA actually owed to GMBH was significantly less than the amount that DANA and GMBH had agreed to three months earlier in the annual reconciliation: while the Pricewaterhouse audit found that DANA owed GMBH approximately $27 million, the annual reconciliation had indicated that DANA owed GMBH approximately $83 million. To account for the difference, the audit explained that GMBH had "assumed" some of DANA's losses because the two entities "are so close that there is an extensive and also financial dependency of [DANA] to [GMBH]."

In 2002, some of DANA's former employees filed an involuntary bankruptcy petition against DANA, which DANA did not oppose. The case was converted to a Chapter 11 reorganization, but DANA's efforts to reorganize were unsuccessful, and DANA eventually proposed a liquidation plan that was confirmed in 2003.³ GMBH brought an amended claim asserting that DANA owed GMBH approximately $146 million. The Official Committee of Unsecured Creditors (the Committee) objected to this claim, arguing that it should be either recharacterized as equity or equitably subordinated.

Before trial, the bankruptcy court granted partial summary judgment to the Committee and recharacterized about $44 million of GMBH's initial claim as equity.⁴ After a bench trial on the remaining $102 million claim, the bankruptcy court rejected the Committee's equitable subordination argument, but found that GMBH had overstated its claim by $10 million and that $84 million of GMBH's claim — the spare parts claim — should be recharacterized as equity. The recharacterization left GMBH with an allowed claim of $6.475 million.

GMBH appealed the recharacterization determination to the district court, arguing that the bankruptcy court lacked the power to recharacterize claims, erred in applying the recharacterization doctrine to GMBH's claim, and made a number of factual findings that were clearly erroneous. The district court affirmed the judgment of the bankruptcy court, and GMBH appeals. We review the bankruptcy court's legal determinations de novo and its factual findings for clear error. See Canal Corp. v. Finnman (In re Johnson), 960 F.2d 396, 399 (4th Cir.1992).

II.

The Bankruptcy Code instructs a bankruptcy court to allow a creditor's claim against the bankruptcy estate unless a party in interest objects and a recognized exception applies. See 11 U.S.C. § 502 (2000). The Code sets forth, in § 726, a priority scheme for the distribution of the debtor's assets. See id. § 726. The statutory priority scheme provides, inter alia, that the claims of all unsecured creditors must be satisfied before holders of equity interests can recover anything from the estate. See id. § 726(a). A bankruptcy court may alter the priority of an allowed claim via equitable subordination; that is, the court may reduce the priority of all or part of an allowed claim if it finds that the creditor engaged in inequitable conduct. See id. § 510(c)(1); see also United States v. Noland, 517 U.S. 535, 538, 116 S.Ct. 1524, 134 L.Ed.2d 748 (1996). The Code also authorizes a bankruptcy court to "issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title." 11 U.S.C. § 105(a) (2000).

Despite the broad language in § 105(a) and the priority scheme in § 726, GMBH contends that the Bankruptcy Code does not permit a bankruptcy court to recharacterize an allowed claim that is ineligible for equitable subordination. GMBH argues that the bankruptcy court's decision to recharacterize the $84 million spare parts claim as an equity contribution violates the principle that a bankruptcy court may not use its equitable powers "to alter the substantive rights of the parties." IRS v. Levy (In re Landbank Equity Corp.), 973 F.2d 265, 271 (4th Cir.1992).

We disagree. In our view, recharacterization is well within the broad powers afforded a bankruptcy court in § 105(a) and facilitates the application of the priority scheme laid out in § 726. The Code establishes a system in which contributions to capital receive a lower priority than loans because "the essential nature of a capital interest is a fund contributed to meet the obligations of a business and which is to be repaid only after all other obligations have been satisfied." See Diasonics, Inc. v. Ingalls, 121 B.R. 626, 630 (Bankr.N.D.Fla.1990) (quoting Asa S. Herzog & Joel B. Zweibel, The Equitable Subordination of Claims in Bankruptcy, 15 Vand. L.Rev. 83, 94 (1961)). Thus, implementation of the Code's priority scheme requires a determination of whether a particular obligation is debt or equity. Where, as here, the question is in dispute, the bankruptcy court must have the authority to make this determination in order to preserve the Code's priority scheme. If the court were required to accept the representations of the claimant, as GMBH appears to argue, then an equity investor could label its contribution a loan and guarantee itself higher priority — and a larger recovery — should the debtor file for bankruptcy. Thus, denying a bankruptcy court the ability to recharacterize a claim would have the effect of subverting the Code's critical priority system by allowing equity investors to jump the line and reduce the recovery of true creditors. In light of the broad language of § 105(a) and the larger purpose of the Bankruptcy Code, we believe that a bankruptcy court's power to recharacterize is essential to the proper and consistent application of the Code.

GMBH contends that recharacterization does not exist independently of the bankruptcy court's disallowance power under § 502(b) or the court's equitable subordination power under § 510(c). This argument seems to be rooted in GMBH's view that recharacterization serves the same purposes and requires the same analysis as disallowance or equitable subordination. In fact, contrary to GMBH's arguments, recharacterization requires a different inquiry and serves a different function.

Disallowance of a claim under § 502(b) is only appropriate when the claimant has no rights vis-à-vis the bankrupt, i.e., when there is "no basis in fact or law" for any recovery from the debtor. Diasonics, 121 B.R. at 631 (quoting Herzon & Zweibel, supra, at 86). When a bankruptcy court disallows a claim, the claim is completely discharged. Id. at 631. By contrast, recharacterization is appropriate when the claimant has some rights vis-à-vis the bankrupt. That is, when a bankruptcy court recharacterizes a claim, it necessarily recognizes the existence of a relationship between the debtor and the claimant, but it determines that the relationship is one of an equity owner rather than a creditor.

In the present case, GMBH presented evidence of a claim arising out of the spare parts transactions between GMBH and DANA. The bankruptcy court initially determined that a portion of this claim met the formal requirements sufficient to support allowance under § 502(b). The allowance inquiry required the bankruptcy court to determine whether there is...