Thinking about investing in a distressed company? If the company declares bankruptcy, your investment may be subject to equitable subordination, whereby your claim is subordinated to the claims of other creditors. One of the most crucial factors in determining whether your claim is equitably subordinated is whether you are deemed an insider as an insider’s actions undergo significantly more scrutiny than those of non-insiders. Of course, when investing in a distressed company, the more control over the entity’s, the better, right? Actually, this may be an instance where you are better off trading a little control for a safer financial position. Being an insider may put you on the outside track.
As discussed in the July 2007 issue of Venable LLP’s Sub-Debt Report, two distinct, but related, doctrines govern whether an investment in a distressed company, which, at least on its face, appears to be debt, can be subordinated to the claims of other unsecured creditors: recharacterization and equitable subordination. Recharacterization focuses on whether the purported debt is actually an equity investment, while equitable subordination focuses on the behavior of the creditor. In a claim for recharacterization, the court attempts to discern whether the creditor and debtor intended the investment to be equity even though it may have been characterized as debt. To ascertain the intent of the parties at the time they entered into the transaction, the court looks at, among other factors, the actual terms of the investment and whether the parties indeed treated the investment as debt. For a more in depth discussion on recharacterization, please see the July 2007 issue of the Venable LLP Sub-Debt Report.
Section 510(c) of the Bankruptcy Code provides that a bankruptcy court may “under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or part of another allowed interest.”1 Under the doctrine, a court may subordinate an otherwise lawful claim if it finds that the creditor’s claim resulted from inequitable behavior or wrongdoing on the part of the creditor.2 In determining whether a claim should be subordinated, courts generally apply a three pronged test: “(1) the subordinated creditor must have engaged in some type of inequitable conduct; (2) the misconduct must have resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant; and (3) equitable subordination of the claim must not be inconsistent with the provisions of the Bankruptcy Act.”3
The type of inequitable conduct that can result in equitable subordination is generally encompassed by three categories: “(1) fraud, illegality and breach of fiduciary duties; (2) undercapitalization; or (3) claimant’s use of the debtor as a mere instrumentality or alter ego.”4 Importantly, the investor’s status as an insider also affects the level of scrutiny given to his or her behavior. The conduct of insiders is given greater scrutiny than that of non-insiders. While the case law can be quite nuanced in this area and outcomes in cases can be highly fact dependent, it has been said that the party seeking subordination of an insider’s claim “need only show some unfair conduct, and a degree of culpability,” whereas it must show “even more egregious conduct such as gross misconduct tantamount to fraud, misrepresentation, overreaching or spoliation” with respect to a non-insider’s claim.5 Thus, the determination as to whether the investor is an insider can have a significant effect on whether the court subordinates the claim.
Under Section 101(31)(B) of the Bankruptcy Code, an “insider” of a corporation includes a “(i) director of the debtor; (ii) officer of the debtor; (iii) person in control of the debtor; (iv) partnership in which the debtor is a general partner; (v) general partner of the debtor; or (vi) relative of a general partner, director, officer, or person in control of the debtor.”6 The most ambiguous of the above categories is the “person in control.” To be a “person in control,” one has to exercise “day-to-day control” over the business affairs and decision making of the company.7 The mere “monitoring or exertion of influence regarding financial transactions in which the creditor has a direct stake” alone is insufficient to establish the “day-to-day control” required. The creditor “must control the company so as to dictate corporate policy and disposition of corporate assets without limits.”8
In addition, an affiliate of a debtor or an insider of an affiliate is also an insider.9 Under the Bankruptcy Code, an affiliate includes an “entity that directly or indirectly owns, controls, or holds with power to vote, 20 percent or more” of the debtor’s outstanding voting securities.10
Indeed, there are numerous scenarios under which a creditor has exercised influence over a debtor without being held to be a “person in control.” For instance, covenants that the debtor “submit frequent reports on receivables, invoices, and operations” and even those that require the creditor to “receive all payments on the receivables, ha[ve] the power to endorse checks, and obtain concessions” have been held insufficient to establish the required “day-to-day control.” In these instances, the creditor is not exercising control over the day-to-day decisions of the debtor.11 In addition, attendance at board meetings coupled with the receipt of reports has been held insufficient.12 Even the designation of a member of the debtor’s board by a creditorshareholder has been held insufficient.13
Moreover, while courts may pay closer attention to loans made to undercapitalized companies, undercapitalization alone is generally insufficient to warrant equitable subordination. Most courts require evidence of some type of misconduct because “any other analysis would discourage loans from insiders to companies facing financial difficulties and that would be unfortunate because it is the shareholders who are most likely to have the motivation to salvage a floundering company.”14
If an investor is not an insider, his or her actions are examined under the less scrutinizing, “egregious conduct” test. In fact, it has been said that this standard is so high that it is “rarely if ever met.”15 Conversely, one seeking equitable subordination of an insider’s claim need only present some material evidence of unfair conduct at which point the burden shifts to the insider to show that his or her actions were fair and taken in good faith.16 This is so because an insider has a greater opportunity for misconduct and self-dealing at the expense of others, as he or she can exercise control over the debtor’s decisions. A non-insider, on the other hand, cannot control the decisions of the debtor and, therefore, any transactions between the non-insider and debtor are presumed to be at arm’s length.
What steps can an investor take to minimize the risk of equitable subordination of its claim? It appears that one of the most important steps is to avoid being found to be an insider. When investing one should consider structuring any equity position it may have or may take in the entity so as to own, control and hold less than 20% of the debtor’s voting securities. It should also avoid being a director, officer or general partner in the entity. A creditor can attend board meetings and may even designate one of its officers or employees as a director, officer or general manager of the debtor so long as the party so designated is not an affiliate of the debtor. The creditor may require the debtor to provide detailed reports to it. It may even require that all receivables and payables be funneled through it. Simply requiring that a debtor comply with demanding covenants is insufficient to confer insider status.17 What must be avoided is turning the debtor into the creditor’s alter ego by making the day-to-day decisions of the debtor: the debtor must have at all times the power to act autonomously and disregard the advice of the creditor.18 By working within these parameters, one can reduce the risk of having his or her claim equitably subordinated while still retaining the power to monitor and exercise some amount of influence over the debtor’s performance.