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IN RE OUTBOARD MARINE CORPORATION

July 21, 2003

IN RE OUTBOARD MARINE CORPORATION ET AL., DEBTORS. ALEX D. MOGLIA, NOT INDIVIDUALLY, BUT AS CHAPTER 7 TRUSTEE FOR OUTBOARD MARINE CORPORATION AND ITS RELATED DEBTOR ENTITIES, APPELLANT,
v.
QUANTUM INDUSTRIAL PARTNERS, LDC, APPELLEE.



The opinion of the court was delivered by: Harry Leinenweber, District Judge

MEMORANDUM OPINION AND ORDER

This matter comes before the Court on appeal from the United States Bankruptcy Court for the Northern District of Illinois. The Appellant, Alex D. Moglia (hereinafter, "Moglia" or the "Trustee"), appeals the bankruptcy court's decision to grant third party defendant Quantum Industrial Partners, LDC's ("Quantum") motion to dismiss brought under Federal Rule of Civil Procedure 12(b)(6) ("Rule 12(b)(6)"). Jurisdiction is conferred upon the Court pursuant to 28 U.S.C. § 158(a) and 1334. For the reasons given below, the bankruptcy court's decision is affirmed in part and reversed in part and remanded for further proceedings consistent with this opinion.

I. BACKGROUND

Outboard Marine Corporation ("OMC") and its related debtor entities once constituted one of the world's largest designers, manufacturers, and sellers of boats, outboard marine engines, and marine parts. In January 1998, OMC and its pre-petition lenders created a loan and security agreement. OMC granted the lenders a security interest in many of OMC's assets, including accounts receivable, inventory, and general intangibles.

Two years later, OMC sold 650,000 shares of convertible preferred stock and warrants to Quantum and to Greenlakes Holding II, LLC, for $6.5 million. On May 5, 2000, and again on July 19, 2000, Quantum bought an additional 200,000 shares for a total of 400,000 at a cost of $40 million. With these purchases, Quantum allegedly became the beneficial or direct owner of nearly 100% of OMC stock.

On October 10, 2000, the lenders and OMC made the tenth amendment to their January 1998 loan and security agreement, adding an additional $45 million loan as Tranche B. Tranche A consisted of all the loans made by the lenders to date, a total of $105 million. On the same day, October 10, 2000, Quantum purchased a 100% participation interest in Tranche B. Quantum agreed to have Tranche B subordinated to Tranche A and gave all its legal rights against OMC over to Bank of America (the "BofA"), the lead lender in OMC's credit facility.

On December 22, 2000, OMC voluntarily filed for bankruptcy under Chapter 11. BofA subsequently brought an action against OMC to collect on BofA's secured loans. In response, the Trustee filed counterclaims against BofA, among others, as well as a third party complaint against Quantum. Counts I and II of the third party complaint sought a declaratory judgment that Quantum's and the lenders' claims to OMC's estate are subordinate to OMC's right to reimbursement of its debtor in possession expenses under 11 U.S.C. § 506(c) and 552(b). Count III of the third party complaint sought a declaratory judgment that Quantum and the lenders were not entitled to collect interest and reasonable fees, costs, or charges under 11 U.S.C. § 506(b) because the collateral for the credit facility is allegedly less than $128 million. Count IV of the third party complaint sought the recharacterization of OMC's $45 million debt, allegedly owed to Quantum, as an equity security and not a secured debt. Quantum filed a motion to dismiss the Trustee's complaint pursuant to Rule 12(b)(6). The bankruptcy court, finding that the Trustee had not alleged that Quantum had a claim against OMC for payment of the debt, granted the motion as to Counts I, II, and III. In addition, the bankruptcy court, finding that it had no authority to recharacterize debt as equity, granted the motion as to Count IV. The Trustee appealed the bankruptcy court's decision on all four counts to this Court.

II. STANDARD OF REVIEW

The Court reviews the bankruptcy court's decision to dismiss the Trustee's third-party complaint with prejudice under the de novo standard of review. Home Valu, Inc. v. Pep Boys, 213 F.3d 960, 963 (7th Cir. 2000). The purpose of a motion to dismiss under Rule 12(b)(6) is to challenge the legal sufficiency of a complaint, not the merits of the case. Autry v. Northwest Premium Servs., Inc., 144 F.3d 1037, 1039 (7th Cir. 1998); United States v. Sherwin-Williams Co., 165 F. Supp.2d 797, 803 (C.D. Ill. 2001). When ruling on a motion to dismiss, the court "must accept as true all well-pleaded factual allegations in the claim, and draw all reasonable inferences in the light most favorable to the nonmoving party." Sherwin-Williams, 165 F. Supp.2d at 803 (citing Gutierrez v. Peters, 111 F.3d 1364, 1368-69 (7th Cir. 1997)). The Court may also consider "those matters of which the court may take judicial notice," Gomez v. Ill. State Bd. of Educ., 811 F.2d 1030, 1039 (7th Cir. 1987), specifically existing law. Sherwin-Williams, 165 F. Supp.2d at 803. Dismissal is appropriate only if it appears beyond doubt that the nonmoving party can prove no set of facts that would entitle the nonmoving party to the relief requested in the complaint. Henderson v. Sheahan, 196 F.3d 839, 846 (7th Cir. 1999). The nonmoving party must allege all the elements for each cause of action to withstand a motion to dismiss. Lucien v. Preiner, 967 F.2d 1166, 1168 (7th Cir. 1992).

III. DISCUSSION

This appeal presents two discrete questions. First, the Trustee argues that Quantum does in fact have a "claim" against the debtor, OMC, despite the absence of a direct transaction between OMC and Quantum and that the bankruptcy court erred in dismissing Counts I, II, and III of the Trustee's complaint against Quantum. Second, the Trustee argues that the bankruptcy court erred in granting Quantum's motion to dismiss Count IV of the Trustee's third party complaint because the court erroneously found that it lacked the authority to recharacterize the transaction between OMC, BofA, and Quantum outside of the remedy of equitable subordination. The Court affirms the bankruptcy court's decision with respect to Counts I, II, and III and reverses with respect to Count IV.

A. Count IV — Recharacterization

The Court first addresses the threshold issue of whether a bankruptcy court has the authority to recharacterize a debt as equity. The Trustee argues that the transaction involving BofA, Quantum, and OMC was, in reality, an equity investment in OMC by Quantum that was disguised as a participation interest in a loan. In an oral ruling, the bankruptcy court dismissed Count IV because "Quantum is not alleged to have a claim [right to payment] against the debtor, and, therefore, there is . . . no debt to recharacterize" and "in my opinion there is no basis in bankruptcy law to recharacterize a debt as equity." (R. at 31.) The court based its ruling, in part, on the provision of the remedy of equitable subordination in the Bankruptcy Code (the "Code"), 11 U.S.C. § 510(c), a doctrine that permits a creditor's claim to be subordinated to other claims when that creditor has acted inequitably. See, e.g., In re Lifschultz Fast Freight, 132 F.3d 339, 344-45 (7th Cir. 1997). The court reasoned that, because a claim can be subordinated to other claims under the doctrine of equitable subordination and because equitable subordination is explicitly codified in § 510(c) while recharacterization is not explicitly codified but would produce a similar result, then the principle of inclusio uno, exclusio alterus suggests that Congress did not intend bankruptcy courts to have the authority to recharacterize a debt. The Court disagrees with the bankruptcy court's reasoning and holds that a bankruptcy court has the authority to recharacterize a debt as equity. The Court also holds that the Trustee need not allege that Quantum has a right to payment, or "claim," against the debtor in order to access this remedy.

While the Seventh Circuit has never ruled specifically on the propriety of recharacterizing a debt as equity in a bankruptcy proceeding, the court has acknowledged in passing a cause of action for recharacterization that is distinct from equitable subordination. In re Lifschultz, 132 F.3d at 345 n. 3. In addition, a bankruptcy court for the Northern District of Illinois recognized recharacterization of debt to equity as a valid cause of action distinct from equitable subordination. In re Kids Creek Partners, L.P., 212 B.R. 898, 931-32 (Bankr. N.D. Ill. 1997). After laying out the ...


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