Debt or Equity? SDNY Bankruptcy Court Says “Debt” In Recent Case Of Rewriting One Party’s Claim As Equity Weil, Gotshal & Manges LLP

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overview

In a recent decision In re Live Primary, LLC, 626 BR 171, 178 (Bank No. SDNY 2021), the Southern New York City Bankruptcy Court ruled that a $ 6 million claim arising from alleged loans to a debtor by one of its members was considered to be Equity participation should be reposted. Although debt held by insiders and shareholders is often scrutinized when a debtor applies for Chapter 11 protection, such re-characterization remains a rare form of relief so long as the lender has followed basic credit formalities. However, when it comes to unique facts and circumstances like those in Live primary, bankruptcy courts have relied on their equity powers under Section 105 (a) of the Bankruptcy Act to re-characterize debt claims as equity. Live primary Provides a classic example of how courts go beyond the mere labels the parties put on a transaction and a reminder to lenders that failure to properly document a loan and properly treat it as actual debt can result in it only left one equity claim behind the other creditors of the debtor.

background

Debtor Live Primary, a shared office startup that operated co-working facilities in Manhattan with a range of amenities, filed for Chapter 11 protection in July 2020. COVID-19-related work restrictions for non-essential businesses adversely affected his business. so that she cannot make rent payments.

One of the debtor’s early investors, a former WeWork investor, agreed to invest $ 6,000,000 in the debtor’s business in exchange for a 40% interest in the debtor. The remaining 60% of the membership was granted to two others in exchange for their full-time employment by the debtor. Under the debtor’s limited liability company agreement, Primary Member LLC (“PM”), a company owned and controlled by the initial investor, would give the debtor a “loan” of $ 6,000,000 at an interest rate of 1% payable through various payouts (the “Alleged Loan”). The proceeds from the alleged loan would be used to develop and operate office space in Manhattan for the debtor’s co-working business, as well as to finance all necessary startup costs.

When the debtor later filed for Chapter 11 bankruptcy, PM filed a proof of entitlement showing the various payouts under the alleged loan plus accrued interest. The debtor objected to PM’s proof of claim and requested, among other things, that PM’s claim be re-characterized as equity. PM initially argued that Bankruptcy Rule 7001 required adversarial proceedings to invoke the court’s powers of equity to recalibrate and that the debtor could not proceed by appeal. In February 2021, the court conducted a lawsuit to determine whether the procedural position was correct and whether the advances made under the alleged loan could be characterized as equity investments.

analysis

The court initially dismissed PM’s allegation that the debtor had to commence adversarial proceedings (as opposed to a claim objection) to request re-characterization, stating that re-characterization did not fall under any of the ten enumerated categories included in of Bankruptcy Rule 7001 are identified and require an opponent to proceed. Rather, the court found that disputed matters brought about by an objection to a claim are subject to Bankruptcy Rule 9014, which provides that such matters should be dealt with upon request.

After the traditional second circuit re-characterization analysis, the court then turned to the AutoStyle Factors. With respect to AutoStyle Plastics, Inc., 269 F.3d 726, 747-48 (6th Cir. 2001). The AutoStyle The test requires an examination of the following eleven factors to determine whether the parties intended the investment in question to be debt or equity:

  1. the names of the instruments, if any, demonstrating the indebtedness;
  2. the presence or absence of a fixed schedule and payment schedule;
  3. the presence or absence of a fixed rate of interest and interest payments;
  4. the source of the repayments;
  5. the adequacy or inadequacy of capitalization;
  6. the identity of the interest between the obligee and the shareholder;
  7. the security, if any, for the advances;
  8. the company’s ability to obtain funding from outside credit institutions;
  9. to what extent the advances were subordinate to the claims of foreign creditors;
  10. the extent to which the advances were used to purchase fixed assets; and
  11. the presence or absence of a sinking fund to make repayments.

After analyzing each of these factors, we concluded that the factors taken together support the re-characterization of PM’s exposure as equity.

The court found that the first six factors all spoke in favor of re-characterization. Under the first factor, the lack of traditional debt documents such as a bond, note or note suggests that the advances in question were intended as equity rather than debt. The court examined whether the debtor’s operating agreement (in which the advances were referred to as a “loan”) acted as a master loan agreement, but found it doubtful that disbursements of $ 6,000,000 were regulated in a single paragraph, which is typically the in traditional promissory notes. The court was not convinced by PM’s reliance on the references to a “loan” in the operating agreement and found that the crucial finding was the “true content” of the transaction. Accordingly, the Court found that the first factor was in favor of re-characterization. The court found that the second factor was weighted in favor of re-characterization as the Alleged Loan did not have a fixed maturity and payment schedule and was only due in the event of an IPO or liquidity event. In examining the third factor, the court found that the alleged loan was subject to an interest rate of 1%, which was well below the then key interest rate of 3.25% – which a start-up of this type probably would not even have qualified for. The court found that the de minimis The interest rate indicated that the alleged loan was intended as an investment. As for the fourth factor, the source of repayments, the court found that the most important consideration was whether repayment depended on the debtor’s success. The court eventually ruled that the fourth factor was weighted in favor of re-characterization, as under the operating agreement, the repayment of the alleged loan was tied to a liquidity event or an IPO rather than revenue. The court also found that the fifth factor was weighted in favor of re-characterization because the debtor would not have been adequately capitalized without the alleged loan, and the sixth factor was weighted in favor of re-characterization because the advances made under the alleged loan were considered proportionate to the PM 40% equity share in the debtor.

Our analysis also showed that the seventh, eighth and ninth factors spoke in favor of re-characterization. Since the advances under the alleged loan were made unsecured and no collateral was given, the seventh factor argued in favor of a new characterization. In applying the eighth factor, the court examined whether a reasonable lender would have provided the debtor with similar funding. At the time the alleged loan was agreed, the debtor was essentially a letterbox company with no operating history or assets. The court found it doubtful that a reasonable lender would have provided such a borrower with interest-free financing with no collateral, loan agreement, promissory note, or fixed term, and found that the eighth factor was weighted in favor of re-characterization. The court also found that the ninth factor favored re-characterization, as the rights under the alleged loan were subordinate to certain other third party lenders under the operating agreement.

Finally, the court found that the tenth factor was weighted in favor of re-characterization because the funds received from the alleged loan were used, at least in part, to make equity-like investments necessary for the debtor to start business, and the eleventh factor, the weighted for re-characterization because there was no sinking fund or similar pool of money made available to repay the alleged loan. In summary, the court found that all eleven factors made up AutoStyle at least easy for a re-characterization of the Purported Loan as an equity investment.

Conclusion and take-away

While re-characterization is a rare form of relief, it does not mean that the parties can ignore the risk of their claim being treated as equity in bankruptcy if they fail to follow standard credit formalities and truly treat the loan as debt. All lenders, especially shareholders and insiders, should consider the various AutoStyle Factors and how a court will apply them that allow a loan to be structured to withstand later challenge by a debtor or other actors in the capital structure. Tightening the terms of the contract and the documents that support it to better address the formalities typically associated with debt transactions minimizes the risk of re-characterization and increases the certainty that a party will be given the priority hoped for in the event of a possible bankruptcy .



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