The Bankruptcy Court for the Southern District of New York Recharacterizes Debt as Equity
In a recent decision, the Bankruptcy Court for the Southern District of New York held that a purported debt held by an entity with a near-majority membership interest in the Debtor was actually equity disguised as a loan.
In 2015, Primary Member LLC (“PM”) was formed to invest in a shared office space start-up called Live Primary, LLC (the “Debtor” and together with PM, the “Parties”). PM received a 40% membership interest in the start-up in exchange for a contribution of $6,000,000 (which investment was documented in the LLC agreement as a loan), while the two other members each received a 30% membership interest in exchange for their full-time employment by the company. The three members executed an LLC agreement, according to which, (1) the aggregate capital contribution for the start-up was $1,000; (2) PM’s $6,000,000 contribution was a loan with multiple tranches (the “Loan”); (3) each tranche borrowed was to be evidenced by a promissory note; (4) the outstanding borrowing were to accrue interest at 1% per year; and the Loan was to mature and become payable only upon a certain type of merger, consolidation or upon the Debtor’s IPO.
Following the Debtor’s bankruptcy petition, PM filed a proof of claim for amounts drawn on the Loan, to which the Debtor objected. The Court conducted a hearing on the issue and ultimately recharacterized the Loan, with a stated balance in the proof of claim of $6,354,900, as equity.
Authority to Recharacterize
The Court held that bankruptcy courts’ authority to recharacterize debt as equity is found in § 105(a) of the Bankruptcy Code, which provides that “the court may issue any order, process, or judgment that is necessary to carry out the provisions” of the Bankruptcy Code and rejected PM’s argument that state law should be applied as the rule of decision, an argument that two courts of appeals have adopted. The Court of Appeals for the Second Circuit has yet to rule on this issue.
The AutoStyle Factors Analysis
Moving to the dispute at hand, the Court applied the 11-factor test established by the Sixth Circuit in AutoStyle.
The first factor, the names given to the instruments, if any, evidencing the indebtedness, should not be dispositive the Court held, because the exercise of recharacterization essentially involves ignoring the label attached to the transaction and considering its substance instead. Further, it noted that there was a lack of a meaningful instrument of debt here—the promissory notes contemplated by the LLC agreement were never issued. PM argued that the LLC agreement should be considered the master loan agreements, but the Court expressed doubt that a $6,000,000 loan was intended to be governed by a single paragraph. On the second factor, the presence or absence of a fixed maturity date and schedule of payments, the Court noted that the Loan had no fixed maturity. Given that "no reasonable lender would make over $6,000,000 in unsecured advances to a startup business without a fixed maturity,” the Court concluded that this factor weighed in favor of recharacterizing the Loan as equity. On the third factor, the presence or absence of a fixed rate of interest and interest payments, the Court observed that although there was a fixed rate of interest, it accrued at only one percent and that the de minimis rate further indicated that the Loan was actually equity.
Regarding the fourth factor, source of repayment, the Court reiterated established law that an interest is better characterized as equity if it is paid only out of the debtor’s profits. Given that the Loan would be repaid only through the proceeds of an IPO, merger or consolidation, the Court concluded that the fourth factor also weighed in favor of recharacterizing the Loan as equity. The fifth factor, inadequacy of capitalization supports recharacterization because the Court held that “any suggestion that initial capitalization of $1,000 was sufficient for a new venture that projected that it needed more than $6 million to build out its facilities is frivolous.” The Court found that the sixth factor, identity of interest, is typically deployed to establish that a stockholder making a loan to a corporation in proportion to its ownership interest indicates that such a loan is equity. It concluded that here, “the structure of contributions with money from PM and contributions of sweat and equity from [the other two owners] are indicative of equity.” Since the Loan was advanced on an unsecured basis, the Court decided that the seventh factor, absence of security, also weighed in favor of recharacterizing the Loan as equity.
The Court weighed the eighth factor, the ability to obtain financing from outside lending institutions, in favor of recharacterizing since the Debtor could not have obtained loans “remotely similar” to those extended by PM at the time that PM extended them. The Court held that the ninth factor, the extent to which the advances were subordinated to the claims of outsider creditors, weighed in favor of recharacterization because no provision prevented the subordination of the Loan to other loans. The Court found that the tenth factor, the extent to which the advances were used to acquire capital assets, also indicated that the Loan had the character of equity given that it was provided in the early stages of the company and was necessary to start the business. Finally, the Court weighed the eleventh factor, the presence or absence of a sinking fund to provide repayments, in favor of recharacterizing the Loan as equity because the Loan was unsecured and there was no sinking fund to provide repayments.
As unique and rarely used remedy as it is, the opinion reminds us that under proper circumstances bankruptcy courts can and will use their authority to recharacterize debt as equity. As the case also reminds us, capitalization of start-ups may naturally meet at least some of the characterization factors, which makes it all the more important to ensure that to the largest extent possible, the parties avoid failing to properly address factors that are easily met.