In SGK Ventures, LLC, the Bankruptcy Court for the Northern District of Illinois ordered that the secured claims of two entities controlled by insiders of the debtor be equitably subordinated to the claims of unsecured creditors.

The debtor (Keywell), a metal recycling company, had a long-standing practice of distributing nearly all of its net income to its members through either special or tax distributions. In 2007 and 2008, Keywell distributed approximately $43.3 million and $29.3 million, respectively, to its members. In late 2008, Keywell found itself in extreme financial distress, eventually tripping a liquidity covenant with its senior lender.

To alleviate its liquidity crisis, Keywell initially sought to offer preferred stock to its members. After consulting with bankruptcy counsel, however, the equity deal was scrapped and instead Keywell issued notes to NewKey, an entity created and owned by Keywell’s existing equity holders. The note NewKey purchased was secured by a second lien on Keywell’s assets, subordinate only to the lien in favor of Keywell’s senior lender.

NewKey ultimately lent Keywell $3.5 million. Despite the loan, Keywell’s financial condition did not improve. Still unable to secure outside financing, Keywell again raised capital through the sale of another note, this time to new entity, NewKey II, again created and owned by Keywell’s existing equity holders.  NewKey II purchased a $5 million note from Keywell. Again, Keywell’s financial condition did not improve, and Keywell ultimately filed for bankruptcy protection in September 2013.

Keywell’s liquidating trustee filed suit against Keywell’s members, seeking to: (1) avoid certain distributions made to Keywell’s members in 2007 and 2008 as fraudulent transfers; (2) recharacterize the NewKey loans as equity contributions; and (3) equitably subordinate the NewKey loans to the claims of unsecured creditors.

The court held that the trustee could not prove that the 2007 and 2008 distributions were fraudulent because the trustee did not show that Keywell was rendered insolvent after the distributions. The court also held that the trustee could not sustain her recharacterization claim, noting that recharacterization is not a right established under the Bankruptcy Code, and the facts of the case did not support such a claim under applicable Illinois law. Unlike cases where courts found cause to recharacterize a loan, the NewKey loans were thoroughly documented with specified interest and payment terms and other indicia of a true debt deal.

Regarding the third claim, the court concluded that both NewKey loans that were made by Keywell equity holders should be equitably subordinated to the claims of the unsecured creditors. The court found various instances of inequitable conduct, which established a claim for equitable subordination.

  • First, the 2007 and 2008 distributions to members, although not fraudulent, were inequitable because they drained Keywell of capital and left it without the required equity cushion needed to hedge against price fluctuations of Keywell’s metal business.
  • Second, the change from an equity offering to debt was inequitable, and ultimately diminished any equity cushion available to pay unsecured creditors. Effectively, the equity holders used their position to elevate what should have been equity over unsecured creditors who normally have a higher priority in a bankruptcy proceeding.
  • Third, Keywell’s finances were kept completely secret, which prevented unsecured creditors from knowing about Keywell’s large distributions to its members. The Court noted that “fairness….is primarily about disclosure.”

NewKey and NewKey II have subsequently appealed the decision to the district court for the Northern District of Illinois.

While equitable subordination has been deemed an “extraordinary remedy,” the SGK Ventures decision is consistent with other decisions ordering equitable subordination due to inequitable conduct by insiders of closely-held corporations, especially where equity interests appear to be elevated to secured debt on the eve of bankruptcy. The outcome of any case will be driven by the facts, but insiders should be careful when making a loan to bail out their distressed company.