For a distressed company running low on capital, an investment from insiders may represent a last best hope for survival. Insiders may be willing to risk throwing good money after bad for a chance to save the company even when any third party would stay safely away. Insiders  of a failing company may also have an ulterior motive for making an eleventh hour capital infusion, as they may use their control over a distressed company to enhance their position relative to the company’s other creditors. The line between a good faith rescue and bad faith self-dealing is often a hazy one.

Once a company does file for bankruptcy, non-insider creditors often challenge prepetition insider transactions on multiple grounds, including fraudulent transfer, recharacterization of debt into equity, breaches of fiduciary duty, and equitable subordination of debt below claims of other creditors. In In re SGK Ventures, LLC, the United States Bankruptcy Court for the Northern District of Illinois granted equitable subordination pursuant to section 510(c) against a secured loan made by insiders. The decision, which applied a relatively low standard to find “inequitable conduct,” will provide ammunition to parties seeking to reverse insider transactions to generate a return for creditors nationwide.

1. The Debtor’s Business

Before declaring bankruptcy, the SGK Ventures, LLC was named Keywell, LLC (“Keywell”). Keywell operated as a scrap metal intermediary—it bought scrap metal from a network of more than 1,000 suppliers, processed it, and sold it to producers of aerospace metals and stainless steel. Keywell was managed by two of its members (the “Managers”), who together owned more than 70% of the company.

Stainless steel accounted for the majority of Keywell’s sales, and its profitability closely followed the fluctuations of the price of stainless steel. The company charged purchasers a premium based on a percentage of the price of stainless steel. When stainless steel prices were higher, the dollar amount Keywell’s profit margin would increase. For example, a 20% rate applied to scrap purchased at $1.00 per pound would generate 20 cents, but if the steel were purchased at $2.00 per pound, the same rate would generate 40 cents of profit. More importantly, Keywell would sell scrap an average of 35 days after purchasing it. If steel prices rose during that period, Keywell would reap the windfall. If prices fell, profitability would plunge. Keywell could have hedged its exposure to price fluctuations by purchasing futures contracts, but it did not do so. In fact, the company often increased its exposure by holding inventory longer during price upswings, substantially enhancing Keywell’s profits while steel prices rose, but exacerbating the damage when steel prices fell.

While prices of steel rose, Keywell retained little cash to weather a potential decline in the market. Keywell’s operating agreement provided that it would distribute any available cash to its members. To provide liquidity, Keywell maintained a revolving line of credit with Bank of America, secured by a lien on all assets (the “Revolver”). The maximum amount Keywell could borrow under the Revolver (the “loan availability”) was based on a percentage of its inventory and accounts receivable.

Unfortunately for Keywell, its business plummeted shortly after a distribution to members in March 2008. Sharp decreases in the price of stainless steel and the company’s sales volume led to months of net income losses. By December 2008, it had breached a covenant on its Revolver. Keywell needed to convince Bank of America to continue lending, as no alternative financing was available. To do so, Keywell attempted to raise money from its members.

2.  Keywell Incurs Secured Debt to its Members

Keywell initially sought to raise capital from its members through a purchase of new preferred shares via a confidential offering memorandum. Keywell’s Managers, holders of a majority of Keywell equity, approved the share offering. Before the transaction could be completed, however, the Managers asked their attorney how to insulate the proceeds from the sale of preferred shares in an eventual bankruptcy. The attorney advised that there was no way to prevent the investment from being subordinate to claims of creditors while also allowing the company access to the proceeds. Several days after receiving that advice, Keywell withdrew the preferred stock offering and instructed its members to destroy the offering memorandum.

To protect investors’ capital in the event of bankruptcy, the Managers formed NewKey, LLC (“NewKey I”) and offered Keywell members equity interests in the new entity through a confidential private placement memorandum. After NewKey I was funded, it purchased a promissory note from Keywell dated March 20, 2009 (the “2009 Note”), which was secured by a second lien on the company’s assets. Keywell used the proceeds of the 2009 Note to reduce the balance of its Revolver and to meet short term capital needs. The sale of the NewKey I interests and the purchase of the 2009 Note resulted in a transaction identical to the original preferred stock offering, except under its terms the 2009 Note would be paid before unsecured creditors in a bankruptcy.

In 2011, following two years of ups and downs, Keywell again found itself in default with Bank of America. In response, Keywell entered into a transaction similar to the one consummated in 2009. A new entity, NewKey Group II, LLC (“NewKey II” and, together with NewKey I, “NewKey”) formed and funded by Keywell members, purchased another promissory note on October 18, 2011 (the “2011 Note” and, together with the 2009 Note, the “Notes”). Keywell used the 2011 Note to further reduce the balance on its revolver. Ultimately, Keywell’s business continued to decline, and it filed for bankruptcy in September 2013.

3. Adversary Proceedings Regarding Claims Against Members

During the chapter 11 case, the creditors’ committee filed a complaint seeking avoidance of Keywell’s distributions to members made in 2007 and 2008, recharacterization of the Notes as equity, and equitable subordination of the Notes. After Keywell’s chapter 11 plan became effective, a liquidating trustee (the “Trustee”) continued the litigation on behalf of the bankruptcy estate. NewKey also brought an adversary proceeding to demand immediate payment of the Notes.

Concluding that Keywell was not in financial distress following the distributions, the Court dismissed the Trustee’s fraudulent conveyance claims. Turning to the recharacterization count, the Court noted that the Seventh Circuit (which covers federal courts in Illinois, Indiana, and Wisconsin) does not recognize a cause of action for recharacterization under the Bankruptcy Code. As such, recharacterization would only be possible under Illinois law, which applies a more stringent recharacterization standard than the Bankruptcy Code. Using that standard, the Court ruled that the 2009 Note and 2011 Note could not be recharacterized under Illinois law.

The Court did, however, grant equitable subordination of NewKey’s claims pursuant to section 510(c) of the Bankruptcy Code, ruling that the Notes should be treated as equity and be subordinate to unsecured debt. The grounds for equitable subordination are (i) that the party against whom subordination is sought engaged in inequitable conduct, (ii) the conduct must have caused harm to other parties with claims, and (iii) the subordination does not contradict other policies of the Bankruptcy Code. The decision turned on whether NewKey’s conduct was inequitable, and the Court ruled that it was.

Citing a decision of the Seventh Circuit, In re Lifschulz Fast Freight, the Court explained that Keywell’s undercapitalization alone was not sufficient grounds for equitable subordination. However, three additional considerations made NewKey’s conduct inequitable in the Court’s eyes:

  1. Keywell’s practice of dealing in stainless steel without adequately hedging against price increases caused unnecessarily severe fluctuations in earnings. Instead of maintaining a sufficient equity cushion to sustain it through a price decrease, the company paid large distributions to members during good times. When a sustained decrease occurred, the company and its creditors were unprotected.
  2. The 2009 Note had initially been intended as an issuance of stock. The documentation for the issuance had been fully prepared and the transaction approved by Keywell’s major shareholders. Nevertheless, the issuance was never consummated because Keywell’s managers wanted to situate themselves better in a potential bankruptcy. Instead of recapitalizing the Debtors with the equity that had been withdrawn through earlier distributions, the members replaced the capital with secured debt, which diminished the funds available for unsecured creditors.
  3. Keywell’s finances, and the transactions at issue, were kept secret from its trade creditors. Because trade creditors would not have known about the transactions, they could not react by refusing to provide credit or demanding better terms.

4. Analysis

This ruling, with its relatively low threshold for inequitable conduct, is exceedingly friendly toward unsecured creditors seeking equitable subordination of debt, particularly in light of what the Court did not find. Notably, the Court did not conclude that the Managers had breached their fiduciary duties, that the transactions benefited NewKey at Keywell’s expense, or that Keywell or its creditors were worse off as a result of the Notes. Instead, the Court compared the Notes only to an unconsummated equity raise. In addition, the Court did not find that the Managers had misled trade creditors about Keywell’s finances, only that all transactions were kept confidential.

The judge seemed equally offended by all three factors: the secrecy, the inadequate equity cushion, and the fact that the 2009 Note was initially conceived as a preferred stock offering. However, none of these factors have traditionally provided the basis for a finding of inequitable conduct in a 510(c) analysis. The following are examples of insider misconduct that gave rise to equitable subordination in other jurisdictions, all of which evidence more explicit wrongdoing:

  1. An equityholder breached its fiduciary duty to a debtor by surreptitiously purchasing discounted debt claims against the debtor, then using them to influence the course of the debtor’s bankruptcy. Citicorp Venture Capital, Ltd. v. Committee of Creditors Holding Unsecured Claims of Papercraft Corporation, 160 F.3d 982 (3d. Cir 1998).
  2. Two insider caused a debtor to repurchase the insiders’ shares and to repay the loans made by the insider, all while the debtor could not pay its suppliers. In re Le Café Crème, Ltd., 244 BR 221, (Bankr. S.D.N.Y. 2000).
  3. An insider made a “loan” to a debtor that was in actuality just a cash infusion, as there was no documentation, maturity date, payment schedule, or interest paid. In re Interstate Cigar Co., Inc., 182 B.R. 675 (Bankr. E.D.N.Y. 1995).
  4. The president of a debtor bribed a public official, then caused the debtor to engage in a transaction to attempt to cover up the bribe. In re Mid-American Waste Systems, Inc., 284 BR 53 (Bankr. D. Del. 2002).

Unsecured creditors seeking to equitably subordinate loans made by insiders should take careful note of this decision, which is subject to an appeal pending before the United States District Court for the Northern District of Illinois.