Debt or equity? SDNY Bankruptcy Court Declares “Debt” in Recent Case Involving Party Debt Reclassification as Equity | Weil, Gotshal & Manges LLP
In a recent decision, In re Live Primary, LLC, 626 BR 171, 178 (Bankr. SDNY 2021), the Bankruptcy Court for the Southern District of New York has estimated that a debt of $ 6 million resulting from alleged loans to a debtor of one of its members should be requalified as participation. Although debt held by insiders and shareholders is often scrutinized when a debtor seeks Chapter 11 protection, a requalification of this nature remains a rare form of relief as long as the lender has complied with the loan formalities of the debtor. based. However, when it comes to unique facts and circumstances such as those presented in Primary live, bankruptcy courts have relied on their equitable powers under Section 105 (a) of the Bankruptcy Code to requalify claims as equity. Primary live provides a classic example of how courts will look beyond the mere labels parties put on a transaction and a reminder to lenders that failure to properly document and appropriately treat a loan as actual debt can let them hold nothing more than a capital claim behind the debtor’s other creditors.
Debtor Live Primary, a shared office space startup that operated coworking facilities with an array of amenities in Manhattan, filed for Chapter 11 protection in July 2020. COVID-19-related work restrictions on workers non-essential businesses have affected its operations. , leaving him unable to pay the rent.
One of the Debtor’s original investors, a former WeWork investor, had agreed to invest $ 6,000,000 in the Debtor’s business in exchange for a 40% interest in the Debtor. The remaining 60% interest was granted to two others in exchange for their full-time employment by the Debtor. Pursuant to the debtor’s limited liability company agreement, Primary Member LLC (“PM”), an entity owned and controlled by the original investor, would make a “loan” of $ 6,000,000 to the debtor bearing a rate of 1% interest and payable through various disbursements. (the “deemed loan”). The proceeds received under the deemed loan would be used to develop and operate offices in Manhattan for the debtor’s co-working activities as well as to fund necessary start-up expenses.
When the debtor subsequently filed for Chapter 11 bankruptcy, PM filed proof of claim which included the various disbursements made under the alleged loan, plus accrued interest. The debtor objected to PM’s proof of claim, asking, among other things, to reclassify PM’s claim as equity. PM first argued that under Bankruptcy Rule 7001, adversarial proceedings were required to invoke the equitable powers of the court for requalification and that the debtor could not proceed as opposed to a claim. In February 2021, the court held a trial to determine whether the procedural posture was correct and ultimately whether the advances made under the alleged loan should be reclassified as equity investments.
The Court first rejected PM’s contention that the debtor was required to initiate adversarial proceedings (as opposed to a claim) to request requalification, noting that requalification does not fall into one of the ten categories. listed in bankruptcy rule 7001 that require an opponent to proceed. Rather, the Court concluded that the disputed matters initiated by an objection to a claim are governed by Bankruptcy Rule 9014, which provides that such matters must be dealt with by way of motion.
After a traditional requalification analysis in the second circuit, the Court then turned to the Auto styling factors. Regarding AutoStyle Plastics, Inc., 269 F.3d 726, 747–48 (6th Cir. 2001). the Auto styling 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:
- the names given to the instruments, if any, evidencing the debt;
- the presence or absence of a fixed due date and payment schedule;
- the presence or absence of a fixed interest rate and interest payments;
- the source of reimbursements;
- the adequacy or insufficiency of funding;
- the identity of interest between the creditor and the shareholder;
- the guarantee, where applicable, of the advances;
- the company’s ability to obtain financing from external lending institutions;
- the extent to which advances were contingent on claims of external creditors;
- the extent to which advances have been used to acquire capital assets; and
- the presence or absence of a sinking fund to ensure repayments.
After analyzing each factor in turn, the Court found that, overall, the factors weighed in favor of reclassifying PM’s claim as equity.
The court concluded that the first six factors all weighed in favor of requalification. According to the first factor, the absence of any traditional debt document such as a bond, trust deed or note will indicate that the advances in question were intended to be equity and not debt. The court questioned whether the debtor’s operating agreement (which called the advances a “loan”) served as a master loan agreement, but found it questionable whether $ 6,000,000 in disbursements was governed by a only paragraph that did not include provisions typically found in traditional debt documents. The court was not persuaded that PM relied on references to a “loan” in the operating agreement and noted that the key determination was the “real substance” of the transaction. Therefore, the Court concluded that the first factor weighed in favor of requalification. The Court concluded that the second factor weighed in favor of requalification because the alleged loan did not have a fixed due date and schedule and was only payable in the event of an IPO or liquidity event. Looking at the third factor, the Court noted that the alleged loan was subject to an interest rate of 1%, which was significantly lower than the prime rate of 3.25% at the time – which a start- up of this nature probably wouldn’t even qualify for. The court concluded that the de minimis interest rate indicated that the alleged loan was intended to be an investment in shares. Under the fourth factor, the source of the repayments, the court noted that the key consideration was whether the repayment depended on the success of the debtor. The court ultimately concluded that the fourth factor weighed in favor of the requalification since, under the operating agreement, the repayment of the alleged loan was linked to a liquidity event or an IPO and not to income. . Likewise, the Court concluded that the fifth factor weighed in favor of requalification because the debtor would have been insufficiently capitalized without the deemed loan and the sixth factor weighed in favor of requalification because the advances made under the deemed loan could be considered proportional to the 40% interest in the Debtor.
The Court’s analysis also revealed that the seventh, eighth and ninth factors weighed in favor of requalification. Since the advances under the alleged loan were made without collateral and no collateral was given, the seventh factor weighed in favor of requalification. Applying the eighth factor, the court considered whether a reasonable lender would have provided similar financing to the debtor. At the time the alleged loan was made, the debtor was essentially a shell company with no operating history or assets. The Court considered doubtful that a reasonable lender would have provided disinterested financing to such a borrower without collateral, loan contract, promissory note or fixed term, and concluded that the eighth factor weighed in favor of requalification. The Court also found that the ninth factor weighed in favor of requalification because the rights under the alleged loan were contingent on the claims of certain other third party lenders under the operating agreement.
Finally, the Court concluded that the tenth factor weighed in favor of requalification because the funds received from the alleged loan were used at least in part to make capital-type investments necessary to start the debtor’s business and the eleventh factor weighed in favor of requalification because there was no sinking fund or similar money fund set aside to repay the alleged loan. In sum, the court concluded that the eleven factors of Auto styling weighed at least slightly in favor of reclassifying the alleged loan as an equity investment.
Conclusion and takeaway
Although requalification is a rare form of relief, it does not mean that the parties can ignore the risk that their debt will be treated as equity in bankruptcy if they do not follow common lending formalities and genuinely process the loan. like a debt. All lenders, especially shareholders and insiders, need to understand the different Auto styling factors and how a court will apply them, which will allow loans to be structured in such a way as to withstand subsequent challenge from a debtor or other stakeholders in the capital structure. Tightening the terms of the agreement and the documents that support them to better align with the formalities typically associated with debt transactions will minimize the risk of requalification and provide greater certainty that a party will be given priority than it negotiated in the event of possible bankruptcy.