Legal Definitions - recharacterization

Recharacterization occurs when a court determines that a financial contribution an "insider" made to a business should be treated differently from how the insider originally labeled it. Specifically, it's a court's decision that what an insider called a "loan" to their company should actually be considered a "capital contribution" or investment in the company. This usually happens when the business is facing liquidation or bankruptcy.

The primary purpose of recharacterization is to protect outside creditors. If an insider's "loan" is recharacterized as a capital contribution, the insider is treated like an owner or investor rather than a lender. This means they get paid back only after all other legitimate creditors (like suppliers, employees, and banks) have been fully satisfied, and only if there are any assets remaining.

Courts consider several factors when deciding whether to recharacterize a transaction, including:

• Whether the company was adequately capitalized from the beginning.
• Whether the company could have obtained similar financing from an independent lender.
• How the transaction was documented and treated in the company's financial records.
• The economic reality of the transaction, rather than just its label.
• Whether the "loan" had typical loan terms (e.g., fixed repayment schedule, interest rate, collateral).

Examples of Recharacterization:

• Scenario: Underfunded Startup
  Example: Sarah starts a new tech company, "Innovate Solutions," with very little initial capital. To cover essential operating expenses like rent and salaries, she "lends" the company $200,000, recording it as a loan on the company's books. She doesn't set a clear repayment schedule or interest rate, nor does she require collateral. Two years later, Innovate Solutions fails and enters liquidation, owing money to various software vendors and its landlord.

  Explanation: A court might recharacterize Sarah's $200,000 "loan" as a capital contribution. The court would likely find that the company was severely undercapitalized from the start, and Sarah's "loan" was essentially the initial funding necessary for the business to even begin operating, rather than a true arm's-length loan. By recharacterizing it, the outside vendors and landlord would be paid from the company's remaining assets before Sarah receives any funds.

• Scenario: Desperate Funding for a Failing Business
  Example: "Global Logistics Inc." is experiencing severe financial difficulties and is on the brink of bankruptcy. No bank or external lender is willing to provide additional financing. To try and save the company, the CEO, David, "lends" Global Logistics $1 million, documenting it as a short-term loan. However, the company's financial state is so dire that there's no realistic prospect of repayment. Despite David's efforts, Global Logistics eventually files for bankruptcy.

  Explanation: In this situation, a court could recharacterize David's $1 million "loan" as a capital contribution. The court would consider that no independent lender would have provided funds under such circumstances, indicating that David's "loan" was more akin to an owner's desperate attempt to prop up a failing investment rather than a genuine debt. This recharacterization would ensure that other creditors, such as suppliers and employees, have priority over David in receiving payment from the company's assets during bankruptcy proceedings.