Tuesday, August 22, 2017

Issues Pertaining to Debt Recharacterization

By Bill Siegel

When closely held companies experience financial difficulty, typically the owners will loan money to the company with the anticipation that they will eventually be repaid.  The repayment of loans has a higher priority over any distribution to existing shareholders, and is on par with existing creditors.  Difficulties arise, however, when the company succumbs to bankruptcy or some other insolvency proceeding.  

 

Often, when the owners of a closely held company loan funds to a financially strapped company, the owners either fail to document the loan at all, or if adequately documented, the repayment schedule is not fulfilled because the company is busy catching up paying trade debt or existing third-party loans.

 

In a recent Bankruptcy decision in Chicago*1,  Judge Durkin said the primary question is whether, in the words of the Third Circuit Court of Appeals, “the parties called the thing one thing when they in fact intended it as something else.” Although Texas is governed by the Fifth Circuit, rather than the Third Circuit, this decision may nevertheless be instructive.  

 

The Chicago case involved a bankruptcy trustee seeking to recharacterize an insider loan from debt to equity.  Although Judge Durkin noted that while recharacterization normally occurs when an insider loan and interest are not paid, in this case, he refused to recharacterize the loans because the loans at issue had been papered and the interest rate was higher than a rate otherwise available to reflect the underlying risk.  Judge Durkin further noted that merely extending the maturity date was not compelling enough to recharacterize the debt to equity because if the loan had been called, bankruptcy would have followed.  

 

As an alternative remedy, the bankruptcy trustee sought to subordinate the loans to the claims of other creditors based on an “inequitable conduct” theory.  The trustee argued that the mere act of repaying the insiders themselves in accordance with the repayment provisions of the loan constituted inequitable conduct on the part of the owners.  Judge Durkin did not agree and pointed out that “hindsight criticism” regarding the ultimate demise of the company did not amount to inequitable conduct or mismanagement of the company because the loans were repaid with excess cash.  He further pointed out that the economic demise of the company was not because of mismanagement, but rather largely due to the worst recession experienced by this country in 70 years.  Moreover, even if the company was insolvent during the time the loans were repaid, the loans were made to keep the company viable by paying down trade and bank debt.  But for the loans, the company would not have been operational as long as it was.  To punish the owners based on a hindsight theory, the court concluded, would be unfair.  

 

The takeaway from this opinion is that during difficult times, if owners choose to fund their closely-held company through loans rather than equity contributions, the loans should be documented, the interest rate should be competitive, and the owners must comply with payment terms.  There is no guaranty that the loan will not be recharacterized as equity or subordinated to the payment of other non-insider claims but this case nevertheless stands for the proposition that it is unfair to judge the owners based on 20/20 hindsight.  

 

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*1. Stapleton v. NewKey Group LLC (In re SGK Ventures LLC), 15-11224 (N.D. Ill. June 20, 2017).

 

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