A recent concurrence from the Sixth Circuit is sending a signal that should get the attention of anyone who structures investments as a mix of debt and equity: The power of bankruptcy courts to reclassify your debt as equity may be on borrowed time. In Insight Terminal Solutions, LLC v. Cecelia Financial Management (In re Insight Terminal Solutions, LLC), Judge Eric Murphy openly questioned whether bankruptcy courts have any federal authority to recharacterize loans as equity at all and invited the Supreme Court to weigh in.
What Is Debt Recharacterization, and Why Should You Care?
In the simplest terms, debt recharacterization is the power of a bankruptcy court to look past the label on a financial instrument and declare that what the parties called “debt” was really “equity.” The consequences are dramatic. If your loan is recharacterized as an equity contribution, you move from the front of the repayment line to the very back, behind all other creditors. In a bankruptcy proceeding where recoveries may be limited, that shift can mean the difference between getting paid and getting nothing.
This matters most to companies and investors who make hybrid investments, including mezzanine financing, shareholder loans, convertible notes, or other instruments that blend characteristics of debt and equity. When a portfolio company or subsidiary files for bankruptcy, the characterization of those investments becomes a high-stakes question.
What Happened in Insight Terminal Solutions
The Sixth Circuit’s majority opinion in this case was relatively narrow: It reversed the bankruptcy court’s exclusion of deposition testimony in a dispute over whether certain obligations constituted debt or equity. On its face, that is an evidentiary ruling, important to the litigants, but not necessarily earth-shaking for the broader market.
The real news came from Judge Eric Murphy’s concurrence. Rather than simply joining the majority, Judge Murphy used the occasion to ask a far more fundamental question: Does a bankruptcy court even have the federal authority to recharacterize debt as equity in the first place? His concurrence did not overturn existing Sixth Circuit precedent, which holds that bankruptcy courts do possess this recharacterization power, but it put a clear target on that doctrine.
A Circuit Split That Could Reshape the Landscape
Judge Murphy’s concurrence is significant in part because it highlights an entrenched split among the federal circuits. Some circuits authorize bankruptcy courts to recharacterize debt as equity as part of their inherent equitable powers in restructuring proceedings. Others take a more restrictive view of judicial authority. The Sixth Circuit has historically fallen into the former camp, but the concurrence signals that at least one member of that court believes the doctrine deserves fresh scrutiny, and that the Supreme Court should resolve the differing approaches (resulting in differing outcomes) courts have used.
If the Supreme Court were to take up the issue and limit or eliminate the recharacterization power, it would represent a meaningful shift in the risk calculus for lenders and borrowers alike.
Practical Implications for Deal Makers
Even though this concurrence does not change the law today, it underscores several practical considerations for M&A practitioners, lenders, and investors structuring transactions:
- Venue matters more than ever. The disparate treatment of recharacterization across circuits means that where a borrower files for bankruptcy can materially affect whether an investor’s claim is treated as debt or equity. When negotiating credit agreements or making hybrid investments, give careful thought to governing law, forum selection, and the borrower’s likely bankruptcy venue.
- Document your debt like you mean it. Courts evaluating recharacterization look at the economic substance of a transaction, not just its label. Ensuring that loan documents reflect genuine indicia of debt (fixed maturity, stated interest rate, enforceable repayment obligation, arm’s-length terms) remains the best defense against recharacterization, regardless of which circuit you find yourself in.
- Watch the Supreme Court’s docket. Judge Murphy’s concurrence is an explicit invitation for the Court to grant certiorari on this issue. If it does, the outcome could either entrench or eliminate recharacterization as a tool available to bankruptcy courts, with significant implications for how hybrid investments are structured and priced.
What to Watch
The Insight Terminal Solutions concurrence does not overturn existing law, but the growing circuit split on recharacterization authority highlights the need for diligence on behalf of lenders, sponsors, and companies that rely on hybrid capital structures. Until the Supreme Court resolves this question, the safest course is to structure and document every investment with the assumption that a bankruptcy court might look behind the label the parties assigned and recharacterize what everyone thought was a debt into equity.
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