B. Maturity date
The maturity date is often considered one of the most important factors in determining debt status. The maturity date indicated the time when the creditor is unconditionally entitled to require payment of the principal. A fixed or ascertainable maturity date is virtually essential to debt classification of an instrument. However, the presence of a maturity date is no conclusive since other factors may indicate that the instrument represents an equity investment. On the other hand, the absence of an unconditional right to demand payment is virtually conclusive. The amount of time between issuance and maturity also need to be considered. The shorter the time between issuance and maturity, the more likely the instrument will be considered debt. The IRS has said that it would scrutinize instruments with “unreasonably” long maturities. What is considered an unreasonably long maturity depends on all facts and circumstances, including the nature of the enterprise issuing the security. In this context, the ability of the issuer to satisfy the instrument is an important consideration. For example, an established company like Walt Disney is at a lesser risk of default on the maturity date of a 100-year term instrument than the Internet start-up firm. Again, it is important to remember that this analysis does not take place in a black box. If the term of the instrument is longer than the life of the issuer’s principal asset or if the instrument is overly weighted with equity characteristics, it is unlikely that a court will characterize the instrument as debt.
C. Remedies for Default
The remedy afforded a security holder in the event of default is also considered an important factor. The question here is whether the holder can force payment when the issuer fails to make a scheduled payment. A debt instrument generally gives the holder the right to sue the issuer if the issuer fails to make a scheduled payment. One the other hand, a disappointed equity holder’s only recourse is to exercise its voting rights to replace the board of directors. In order to be classified as debt, some courts have required that the instruments contain a maturity acceleration clause, in addition to the right to sure. Grace period provisions, allowing a debtor a period of time to make good on its obligation before the debtor enforces its remedies, generally do not have a negative effect on the determination of whether an instrument is debt.
Debt holders generally have a right to share with general creditors in the event that the issuer liquidates, whereas equity holders’ rights are subordinated to those of general creditors upon liquidation. However if an instrument is subordinated to the claims of general creditors, but ranks ahead of preferred and common stock holders, it is not necessarily denied debt status. For instance, the debt of a holding company is necessarily subordinated to all debt claims against its operating subsidiaries. Furthermore, the degree to which an instrument is subordinated to senior claims is also relevant. If subordination is only triggered by a default in payment of the senior claims or by bankruptcy, that instrument is more likely to be considered debt than would be an instrument where the subordinated claimants cannot be paid until all other claims have been discharged.
E. Certainty of Income
Shareholders are generally entitled to receive dividends only if there are corporate earning or surplus and upon discretionary action of the board of directors. On the other hand, bondholders are entitled to interest as specified in the relevant contract. The contract can provide for unconditional interest, or provide that interest is contingent upon adequate corporate earnings and becomes absolute when the condition is satisfied. However, if payment of interest is conditional upon corporate earnings and is only payable upon board discretion, the instrument resembles stock rather than debt.
Related to this factor is the adequacy of interest. The failure to provide for interest is generally fatal to the finding of debt with respect to an instrument. A true lender would not subject his or her capital to the risks of a venture without being adequately compensated for those risks. The failure to be compensated for such risks of venture without being adequately compensated for those risks. The failure to be compensated for such risk has been said to be evidence of primary concern for enhancing the issuer’s earnings and increasing the market value of its stock; this is the attitude of a shareholder, not a lender. As mentioned above, it is important that the interest provided be commensurate with the risk involved. The IRS held that adjustable variable-interest convertible notes were equity because (1) the guaranteed return was unreasonably low for comparable debt and (2) it was highly probable that the notes would be converted into equity.