In a recent decision, the New York Southern District Bankruptcy Court ruled that an alleged debt held by an entity with a near majority interest in the debtor was in fact an interest disguised as a loan.
In 2015, Primary Member LLC (“PM“) Was formed to invest in a shared office space startup called Live Primary, LLC (the”Debtor“And with PM, the”Parties”). PM received a 40% stake in the start-up in return for a contribution of $ 6,000,000 (this investment was documented in the LLC agreement in the form of a loan), while the other two members each received 30% interest in exchange for their full-time employment with the company. The three members signed 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 multi-tranche loan (the “Ready”); (3) each tranche borrowed had to be evidenced by a promissory note; (4) the outstanding loan was to bear interest at 1% per annum; and the loan was to mature and become payable only on some type of merger, consolidation or on the debtor’s IPO.
As a result of the debtor’s request for bankruptcy, PM filed proof of claim for the amounts withdrawn from the loan, which the debtor objected to. The Court held a hearing on the matter and ultimately requalified the loan, with a balance shown in the proof of claim of $ 6,354,900, as equity.
Power to re-characterize
The Court held that the power of bankruptcy courts to reclassify debt as equity is found in Section 105 (a) of the Bankruptcy Code, which provides that “the court may make any necessary order, proceeding or judgment. to implement the provisions ”. of the Bankruptcy Code and rejected PM’s argument that state law should be applied as a rule of decision, an argument adopted by two appellate courts. The Second Circuit Court of Appeals has yet to rule on this issue.
AutoStyle Factor Analysis
Turning to the dispute in question, the Court applied the 11-factor test established by the Sixth Circuit in Auto styling.
the first factor, the names given to the instruments, if any, attesting to the debt, should not be decisive, the Court ruled, because the exercise of requalification is essentially to ignore the label attached to the transaction and consider it instead. the substance. Further, he noted that there was a lack of a significant debt instrument here – the promissory notes contemplated by the LLC agreement were never issued. PM argued that the LLC agreement should be considered master loan agreements, but the court expressed doubt that a loan of $ 6,000,000 was meant to be governed by a single paragraph. On the second factor, the presence or absence of a fixed maturity date and payment schedule, the Court noted that the loan did not have a fixed maturity date. Given that “no reasonable lender would make more than $ 6,000,000 in unsecured advances to a start-up business with no fixed maturity”, the Court found that this factor worked in favor of the loan’s reclassification as equity. third factor, the presence or absence of a fixed interest rate and interest payments, the Court observed that, although there is a fixed interest rate, it only accumulates at 1 % and the de minimis rate further indicated that the loan was in fact an equity interest.
Regarding the fourth factor, source of repayment, the Court recalled in established law that an interest is better qualified as capital if it is paid only on the profits of the debtor. Since the loan would only be repaid by the proceeds of an IPO, merger or consolidation, the Court concluded that the fourth factor also weighed in favor of requalifying the loan as equity. the fifth factor, insufficient capitalization supports requalification because the Court held that “any suggestion that an initial capitalization of $ 1,000 was sufficient for a new business that anticipated that it needed more than $ 6 million to building its facilities is futile. ” The Court concluded that the sixth factor, identity of interest, is generally deployed to establish that a shareholder making a loan to a company in proportion to its ownership interest indicates that such a loan is an equity investment. He concluded that here, “the structure of contributions with money from the 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, lack of collateral, also weighed in favor of the reclassification of the loan as capital.
The Court weighed the eighth factor, the possibility of obtaining financing from external credit institutions, in favor of requalification since the Debtor could not have obtained “remote” loans to those granted by PM at the time when PM extended them. The Court held that the ninth factor, the extent to which the advances were subordinated to the claims of external creditors weighed in favor of requalification as there was nothing to prevent the loan from being subordinated to other loans. The Court concluded that the tenth factor, the extent to which the advances were used to acquire fixed assets, also indicated that the loan was in the nature of equity as it was made at the very beginning 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 make the repayments, in favor of the requalification of the loan as equity because the loan was not guaranteed and there was no funds to ‘amortization to make repayments.
To take away
As unique and seldom used as it is, the Opinion reminds us that, under appropriate circumstances, bankruptcy courts can and will use their power to requalify debt as equity. As the case also reminds us, the capitalization of start-ups can naturally respond to at least some of the characterization factors, which makes it all the more important to ensure that to the greatest extent possible, the parties avoid failing to properly deal with the factors which are easily encountered.