When a Loan Is Not a Loan 

06.16.2021

As a court of equity, the bankruptcy court has the power to determine whether a transaction booked as a loan should be recharacterized as a capital contribution. This may have enormous consequences in a bankruptcy case that pays or restructures debt and wipes out equity.

In the recent case of Live Primary, LLC, the U.S. Bankruptcy Court for the Southern District of New York recharacterized $6 million in “loans” to equity, weighing the factors listed below.  In re Live Primary, LLC, 2021 WL 772248 (Bankr. S.D.N.Y. Mar. 1, 2021). These are sometimes referred to as the “AutoStyle” factors from the 6^th Circuit case of In re AutoStyle Plastics, Inc., 269 F.3d 726 (6^th Cir. 2001) and also adopted by the 4^th Circuit in In re Dornier Aviation (N. Am.), Inc., 453 F.3d 225 (4^th Cir. 2006).

It should be noted that equitable recharacterization is a somewhat different concept than equitable subordination under section 510(c) of the Bankruptcy Code. While equitable subordination, by statute, allows the bankruptcy court to subordinate a creditor’s claim for improper conduct, recharacterization focuses on the substance of the transaction rather than the creditor’s behavior.

In Live Primary, the debtor was a shared office space company that started up with $6 million in “loan” commitments from Primary Member LLC (“PM”), in exchange for a 40% membership interest. The other two members, owning 30% each, were officers and employees of the company. The loans were referenced in the operating agreement but not further documented by promissory notes or a master loan agreement. Sometime after the $6 million fully funded, Live Primary filed chapter 11 and objected to PM’s proof of claim.

 The bankruptcy court applied the “AutoStyle” factors, as follows:

1. The names given to the instruments, if any, evidencing the indebtedness. PM did not issue promissory notes for any disbursement, and the mere fact that the parties referred to PM’s investment as a loan in the operating agreement and business records was not dispositive.
2. The presence or absence of a fixed maturity date and schedule of payments. The purported loan did not require any payments or mature until there was a public offering or liquidity event, such as a sale, merger, or consolidation.
3. The presence or absence of a fixed rate of interest and interest payments. There was a fixed rate of interest, but it accrued at a nominal annual rate of only 1%.
4. The source of repayments. The only source of repayment for the purported loans was a liquidity event, not the debtor’s revenues.
5. The adequacy or inadequacy of capitalization. The initial capital contributions under the operating agreement were only $1,000, and the $6 million funded by PM was needed to build out the debtor’s facilities.
6. The identity of interest between the creditor and the stockholder. The amount funded by PM was disproportionate to its 40% equity interest, but (a) the other two owners were employees contributing their “sweat equity” and (b) the operating agreement called for PM to lose its membership in proportion to the amount it failed to fund.
7. The security, if any, for the advance. The purported loan was not secured.
8. The corporation’s ability to obtain financing from outside lending institutions. PM invested in the very early stages of the debtor’s business without any security or personal guarantees, which the court found that no reasonable outside creditor would have done.
9. The extent to which the advances were subordinated to the claims of outside creditors. Because the purported loan was payable only upon an IPO or liquidity event, the court found that it was effectively subordinated to other creditors.
10. The extent to which the advances were used to acquire capital assets. The funds had the character of equity because they were provided in the early stages of the debtor and necessary to starting its business.
11. The presence or absence of a sinking fund to provide repayment. The purported loans were unsecured, but there was no sinking fund to cover repayment.

The debtor referred to the funding from PM as loans in its accounting records, carried a fixed interest rate, significantly exceeded PM’s ownership interest, and was not expressly subordinated to any other creditor; however, the Bankruptcy Court found each and every one of the 11 factors to weigh in favor of recharacterizing the purported loan as equity. The Court looked beyond form to substance, and applied the factors to determine the true intent of the parties. In particular, the use of funds for start-up capital, the absence of a fixed maturity date, and the fact that PM would lose equity to the extent it failed to meet funding requests, all weighed heavily in favor of recharacterization.

Contact any member of our team to discuss how bankruptcy might effect your debt/equity structure, and circumstances where a loan may actually not be a loan.