Understanding Potential Recharacterization and Subordination Attacks Against Bridge Loans Made by Venture Capital and Private Equity Firms

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1 Understanding Potential Recharacterization and Subordination Attacks Against Bridge Loans Made by Venture Capital and Private Equity Firms By David Kupetz It is not unusual for Venture Capital (VC) and Private Equity (PE) firms to make bridge loans to companies they control when they encounter financial distress and face a liquidity crunch. When these loans fail to serve as a bridge out of financial distress, challenges may subsequently be presented to the nature and/or priority of such loans. VC and PE firms should be aware of the potential attacks that may be brought against their position as bridge lenders in the event of an ultimate bankruptcy or insolvency of their borrower. Based on the law that has developed in the federal circuit courts of appeal, bridge loans made by VC and PE firms (and by others) in good faith and with some foresight should generally not be susceptible to successful attacks. A basic concept underlying the Bankruptcy Code is that claims of creditors are entitled to distribution ahead of holders of equity interests in the debtor. Treating an equity investor on a par with unsecured creditors disregards the principles underlying the absolute priority rule in a manner that undermines this basic bankruptcy concept. In furtherance of this policy, the similar and sometimes overlapping, but distinct doctrines of "recharacterization" and "equitable subordination" were developed by case law. While equitable subordination has been incorporated into the Bankruptcy Code (section 510(c)), recharacterization continues to be applied solely as a creation of case law. Recharacterization and equitable subordination are doctrines that are aimed at different conduct and have different remedies (although sometimes based on the same facts). The recharacterization analysis generally involves determining whether a funding instrument labeled as "debt" is really in the nature of an equity investment. Under recharacterization, the substance of the transaction will govern over form. Where the circumstances show that a debt transaction was actually an equity infusion, the recharacterized claim will be treated as equity. In contrast, equitable subordination is based on an assessment of the creditor's behavior. It is used to remedy inequity or unfairness to the debtor's other creditors by demoting the subordinated creditor's right to repayment to the rights of other creditors or equity holders. Accordingly, although some courts have confused the doctrines or have mistakenly found that equitable subordination supplants recharacterization in the context of bankruptcy, the doctrines address distinct concerns and require bankruptcy courts to conduct different inquiries. The recharacterization of debt to equity is a legal concept rooted primarily in tax law. While various courts have adopted multi-factor tests when considering recharacterization of debt to equity, the overarching inquiry is the intent of the parties at the time of the transaction. The question is whether the parties to the transaction intended the "loan" to be a disguised equity contribution. Their intent may be inferred from what is stated in the contract, from what the parties do through their actions, and from the economic reality of the surrounding circumstances. Caution is necessary when applying the multi-factor tests adopted by courts to frame the recharacterization analysis. Otherwise, VC and PE firms, other insiders and other non- DAP\ /2/2016 (10:57 AM) 1

2 conventional lenders of last resort who provide financial support to a business in financial distress will be discouraged from attempting to save businesses teetering on the edge of demise. Ultimately, recharacterization and equitable subordination involve questions of fact that must be addressed on a case-by-case basis. The majority approach adopted by courts of appeals addressing recharacterization in the bankruptcy context has used multi-factor tests imported from tax cases. The Third, Fourth, Sixth, and Tenth Circuits have used the bankruptcy court's broad equitable power under section 105 of the Bankruptcy Code as the basis for the court's authority to recharacterize debt as equity. See Redmond v. Jenkins (In re Alternative Fuels, Inc.), 789 F.3d 1139 (10 th Cir. 2015); Grossman v. Lothian Oil, Inc. (In re Lothian Oil), 650 F.3d 539, (5th Cir. 2011); Cohen v. KB Mezzanine Fund II, LP (In re SubMicron Sys), 432 F.3d 448, 454 (3d Cir. 2006); In re Dornier Aviation, 453 F.3d 225, 231 (4th Cir. 2006); In re Hedged-Investments Associates, Inc., 380 F.3d 1292, 1298 (10th Cir. 2004); Bayer Corp. v. MascoTech, Inc. (In re Autostyle Plastics, Inc.), 269 F.3d 726,748 (6th Cir. 2001). These courts have adopted a flexible legal framework for recharacterization in bankruptcy. In their recharacterization analyses in bankruptcy matters, the courts of appeals applying multi-factor tests, have not deviated significantly. While the specific number of factors utilized by each circuit varies, the tests largely overlap as to the factors considered and are very similar if not completely identical. The 6 th Circuit laid out an 11-factor test borrowed from tax cases, including: (1) the names given to the instruments, if any, evidencing the indebtedness; (2) the presence or absence of a fixed maturity date and schedule of payments; (3) the presence or absence of a fixed rate of interest and interest payments; (4) the source of repayments; (5) the adequacy or inadequacy of capitalization; (6) the identify of interest between the creditor and the shareholder; (7) the security, if any, for the advances; (8) the corporation's ability to fund financing from outside lending institutions; (9) the extent to which the advances were subordinated to the claims of outside creditors; (10) the extent to which the advances were used to acquire capital assets; and (11) the presence or absence of a sinking fund to provide repayments. Autostyle Plastics, 269 F.3d at The 3rd Circuit, however, noted that a "mechanistic scorecard" approach is not the answer to the recharacterization question. As a result, "while a formulaic checklist certainly aides the court in analyzing whether a loan should be regarded as debt or equity, courts utilizing a multi-factor test must contextualize the facts giving rise to the loan and keep in mind the economic realities surrounding such loan." In re SubMicron Sys, 432 F.3d at 456. Further, the multi-factor tests should be considered with the recognition that these tests are derived from tax cases involving very different issues than priority disputes in bankruptcy cases, and taking into account the realities of modern financing. In Alternative Fuels, Inc., the most recent federal appeals court decision addressing recharacterization, the 10 th Circuit, in 2015, reversed a bankruptcy court's application of the doctrine. The court explained that regardless of the presence of factors supporting recharacterization, courts are to exercise caution in applying the doctrine. The 10 th Circuit emphasized that (i) it is important that courts not discourage owners from attempting to salvage a business by requiring all additional contributions be in the form of equity, (ii) owners may be the be the only party willing to make a loan to a struggling business, and (iii) punishing owners DAP\ /2/2016 (10:57 AM) 2

3 for seeking to save a distressed business is not a desirable social policy nor required by prior case law. See In re Alternative Fuels, Inc., 789 F.3d at The 11 th Circuit adopted an amazingly broad alternative two-prong test. Under this minority approach, "shareholder loans may be deemed capital contributions in one of two circumstances: (1) where the trustee proves initial under-capitalization; or (2) where the trustee proves that the loans were made when no other disinterested lender would have extended credit. See Estes v. N&D Properties (In re N&D Properties, Inc.), 799 F.2d 726, 733 (11 th Cir. 1986). In contrast, the 4 th Circuit has held that "a claimant's insider status and a debtor's undercapitalization alone will normally be insufficient to support the recharacterization of a claim." In re Dornier Aviation, 453 F.3d at 234. The 5 th Circuit in In re Lothian Oil, 650 F.3d 593 (5 th Cir. 2011), articulated a different legal framework for recharacterization by bankruptcy courts. While the actual test to be applied may be very similar to that applied by the majority of courts of appeals following the multi-factor approach, the 5th Circuit held that a bankruptcy court must look to the applicable nonbankruptcy law (generally state law) to determine whether the claims at issue may be recharacterized as equity. Further, the 5th Circuit rejected the per se rule applied by the district court below limiting application of recharacterization to insiders, stating the "[u]nless state law makes insider status relevant to characterizing equity versus debt, that status is irrelevant in federal bankruptcy proceedings." In re Lothian Oil, 650 F.3d at In Fitness Holdings International, Inc., 714 F.3d 1141 (9 th Cir. 2013), the 9 th Circuit addressed for its first time the question of whether bankruptcy courts have the power to recharacterize debt to equity. While it might seem obvious that bankruptcy courts have such power, the 9 th Circuit's Bankruptcy Appellate Panel in In re Pacific Express, Inc., had earlier held that bankruptcy court's lack such authority because "characterization of claims as equity or debt" is governed and limited by equitable subordination under Bankruptcy Code section 510(c). In re Pacific Express, Inc., 69 B.R. 112 (9 th Cir. BAP 1986). Rejecting Pacific Express, the 9 th Circuit joined other courts of appeals in concluding that the Bankruptcy Code provides bankruptcy courts with the power, distinct and independent from equitable subordination, to recharacterize claims. Ninth Circuit, however, rejected the recharacterization framework for the applied by the other courts of appeal, except for the 5 th Circuit in Lothian Oil. In cases involving tax matters, the 9 th Circuit has had a long history of addressing recharacterization of debt to equity. In that context, the 9 th Circuit has held that in attempting to determine the true intended substance of the transaction, the court looks to the economic realities of the transaction at the time it was made and to whether the parties intended their advance at that time to be at the risk of the success of the business (equity) or a definite obligation payable in any event (debt). See In re Moreggia & Sons, Inc., 852 F.2d 1179, (9 th Cir. 1988), In re Global Western Development Corp., 759 F.2d (9 th Cir. 1985), In re United Energy Corp., 944 F.2d 589, 596 (9 th Cir. 1991), and Pepper v. Litton, 308 U.S. 295, (1939). Having its roots in tax law, the question of recharacterization of debt to equity most frequently has been addressed in federal court. Nonetheless, law has developed in various states recognizing debt recharacterization as a potential defense to the enforceability of DAP\ /2/2016 (10:57 AM) 3

4 insider loans. For example, a leading case discussing Massachusetts law with regard to recharacterization provides that whether an advance should be treated as an equity contribution to, rather than creating a debt of, an entity depends upon, broadly, two main factors (1) the objective intent of the contributor; and (2) whether, under the specific circumstances, equitable considerations require treatment of the advance as an equity contribution. Accordingly, Massachusetts law injects "equitable considerations" into the analysis as opposed to strictly adhering to a substance over form approach followed by other courts. See Am. Twine Ltd. P'ship v. Whitten, 392 F.Supp. 2d 13, 21 (D. Mass. 2005). Whether an investment is determined to be debt or equity can have significant impact in tax and bankruptcy situations. However, the contextual setting for addressing these issues is very different in bankruptcy cases from tax matters. Tax cases frequently involve solvent companies where the focus is whether a transaction between the investor and the corporation should be deemed to be a debt that would generate a tax benefit to the investor. In contrast, in a bankruptcy case, the issue is frequently whether the claimant/investor who provided a "loan" to a financially distressed enterprise should be treated on par with other creditors or subordinate to them as a holder of equity. Nonetheless, the law of recharacterization of debt to equity, as applied in bankruptcy cases, has generally been imported from federal tax law. In summary, the courts of appeals are now viewing the doctrine of recharacterization in bankruptcy cases through different lenses. Some circuits apply bankruptcy law and others apply state law. The conclusions reached, however, are likely to be the same in most cases regardless of the approach taken. The majority approach applies a federal test patterned on tax cases. The approach adopted by the 5 th Circuit in Lothian Oil and the 9 th Circuit in Fitness Holdings requires the application of state law. The alternative approaches, in most instances, may amount to a distinction without a difference. Most likely, multifactor tests adopted from federal tax cases will continue to be applied under either approach. Further, recharacterization is a question of fact that will continue to be determined on a case-by-case basis. Ultimately, recharacterization is a question of fact that must be addressed on a case-by-case basis. The question is whether the parties to the transaction intended the "loan" to be a disguised equity contribution. Their intent may be inferred from what is stated in the contract, from what the parties do through their actions, and from the economic reality of the surrounding circumstances. In contrast to the majority approach for recharacterization, which rejects inclusion of equitable considerations, the doctrine of equitable subordination is directed at bad behavior. Courts will subordinate a claim under Bankruptcy Code section 510(c) when a creditor engages in misconduct that injures other creditors or confers an unfair advantage on the claimant, but not when subordination is inconsistent with the Bankruptcy Code. See In re Sentinel Management Group, Inc., 728 F.3d 660, 669 (7 th Cir. 2013). "The statute authorizing equitable subordination does not indicate what conduct justifies the Draconian remedy, but there is general agreement in the case law that the defendant's conduct must be not only 'inequitable' but seriously so ('egregious,' 'tantamount to fraud,' and 'willful' are the most common terms employed) and must harm other creditors." Grede v. Bank of New York Mellon (In re Sentinel Management Group, Inc.), 809 F.3d 958, 965 (7 th Cir. 2016). Courts have recognized three categories of inequitable conduct: (1) fraud, illegality, and breach of fiduciary duties; (2) DAP\ /2/2016 (10:57 AM) 4

5 undercapitalization; or (3) claimant's use of the debtor as a mere instrumentality or alter ego. In re Alternate Fuels, Inc., 789 F.3d Equitable subordination is an extraordinary remedy that the courts employ sparingly. Courts have described equitable subordination as the power to disregard an otherwise valid transaction and have recognized that there is a need to be extremely cautious before disregarding an otherwise valid transaction. See In re Sentinel Management Group, Inc., 728 F.3d at 669, citing In re Lifschultz Fast Freight, 132 F.3d 339, 347 (7 th Cir. 1997). The hesitance to apply equitable subordination springs from concerns regarding (i) upsetting a creditor's legitimate expectations, (ii) creating legal uncertainty about whether courts will enforce otherwise binding agreements, thus, increasing the cost of credit in general, and (iii) difficulty in proving that a creditor has engaged in inequitable behavior. Courts are inclined to apply a less stringent analysis of equitable subordination when the creditor is an insider or fiduciary of the debtor. In that context, the 10 th Circuit has held that "the party seeking equitable subordination need only show some unfair conduct, and a degree of culpability, on the part of the insider." In re Alternate Fuels, Inc., 789 F.3d at 1155, citing In re Hedged-Investments Assocs., Inc., 380 F.3d 1292, 1297 (10 th Cir. 2004). "Underhanded behavior is typically clearest when 'corporate insiders [have attempted] to convert their equity interests into secured debt in anticipation of bankruptcy.'" In re Sentinel Management Group, Inc., 728 F.3d at 669, citing Kham & Nate's Shoes No. 2, Inc. v. First Bank of Whiting, 908 F.2d 1351, 1356 (7 th Cir. 1990). When existing shareholders simply seek enhance their priority in liquidation by converting existing equity to debt in advance of bankruptcy without providing real value to the company, their claim should be equitably subordinated to return them to their position in line as an equity holder. However, when a bridge loan is provided in good faith with a reasonable basis to believe that the new funding may assist the company in a reorganization or in otherwise salvaging its business, and is not designed in a manner to harm other creditors, there should be no basis for equitable subordination. In conclusion, it is imperative that the economic realities of modern finance and the frequently limited options available to financially distressed businesses are recognized. Much of modern financing can be viewed as falling on a continuum between conventional debt and equity. Moreover, an insider is often the only source of funds for a struggling company. Neither recharacterization nor equitable subordination should not be applied in a manner that discourages good faith loans or that defines debt financing in a more limited way than in the real world of modern finance. David Kupetz is a shareholder in SulmeyerKupetz PC. He is an expert in restructuring, business reorganization, bankruptcy, assignments for the benefit of creditors, and other insolvency solutions. You can reach him at dkupetz@sulmeyerlaw.com. DAP\ /2/2016 (10:57 AM) 5