How to Keep Follow-On Investments from Getting Squeezed

The decision to reinvest in a distressed company is a function of the rate of return on any marginal reinvestment, including the possibility of salvaging part of the initial investment, along with the risk to the marginal reinvestment should the company fall into bankruptcy. However, under the doctrines of “equitable subordination” and “recharacterization,” a bankruptcy court may still subordinate what was thought to be a debt reinvestment to the claims of other creditors. There is hope, however; three recent cases have helped shape the parameters in which a reinvestment can be made, while minimizing the possibility that the reinvestment will be subordinated under the doctrines of equitable subordination and recharacterization. While the effect of these two doctrines may be the same – the inability to recover the portion of the investment that has been subordinated until and unless all creditors have recovered – the principles underlying each of them, and the reasons for subordinating them, differ. Essentially, the doctrine of equitable subordination focuses on the behavior of the investor while recharacterization focuses on the substance of the transaction itself, i.e., whether it more closely resembles equity rather than debt.1 Thus, creditors, hungry to subordinate whatever claims possible, will generally argue that the claim should be recharacterized as equity (the term “recharacterization” is a misnomer, as the court is deciding whether in the first instance the claim is in reality debt or equity); should this argument fail, they will then contend that the debt should be equitably subordinated.2

Under Section 510(c) of the Bankruptcy Code, 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.”3 Although not spelled out in the Code, courts generally apply equitable subordination when the investor engages in some type of inequitable conduct that results in an actual injury to creditors or confers an unfair advantage on the claimant; otherwise, it is not inconsistent with the Bankruptcy Code.4 The Fifth Circuit Court of Appeals in Fabricators, Inc. v. Technical Fabricators, Inc. explained that “inequitable conduct” generally encompasses 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.”5 The investor’s position also affects the scrutiny given his or her behavior: if an insider (such as an officer or director of the company as a corporate fiduciary), “the party seeking subordination need only show some unfair conduct, and a degree of culpability,” whereas an outsider, then “even more egregious conduct such as gross misconduct tantamount to fraud, misrepresentation, overreaching or spoliation.”6 Equitable subordination is, therefore, a remedy to cure some type of misconduct, especially with regard to insiders, even if the investment substantively was in the form of debt.

Recharacterization, on the other hand, is not codified in the Bankruptcy Code; instead, it is a judicially-crafted doctrine that has developed under the bankruptcy’s equitable power to test the validity of debts. This power stems from a bankruptcy court’s authority under Section 105(a) of the Bankruptcy Code to “issue any order, process or judgment that is necessary or appropriate to carry out the provisions of the Code.”7 While a small handful of courts have held that they do not have the power to recharacterize debt as equity, the overwhelming majority of courts, including the Third, Fourth, Sixth and Tenth Circuit Court of Appeals, have adopted the recharacterization doctrine.8 Under the doctrine, the fundamental question is whether the parties “called an instrument one thing when in fact they intended it as something else.”9 Stated differently, it is the court’s job to ascertain based on the parties’ intent whether “the asserted debt is in fact debt or is instead an equity contribution disguised as debt.”10 If the court determines that it is in fact equity disguised as debt, the investment will be treated as equity, and therefore, subordinated to the claims of all unsecured creditors.

In attempting to discern the parties’ intent and whether an equity investment has been disguised as debt, the courts look at several factors. In In re Autostyle Plastics, Inc., the Court of Appeals for the Sixth Circuit set forth the following factors, also generally embraced by other courts facing the issue: “(1) the names given to the instruments, if any evidencing the indebtedness; (2) the presence or absence of a fixed maturity date and schedule of payments; (3) the presence or absence of a fixed rate of interest and interest payments; (4) the source of repayments; (5) the adequacy or inadequacy of capitalization; (6) the identity of interest between the creditor and the stockholder; (7) the security, if any, for the advances; (8) the corporation’s ability to obtain financing from outside lending institutions; (9) the extent to which the advances were used to acquire capital assets; and (10) the presence or absence of a sinking fund.”11

None of the above cited factors is determinative, but are analyzed on a case-by-case basis.12 However, some definitely appear to carry more weight than others, particularly with regard to reinvestments. Indeed, several courts have recognized that certain factors such as capitalization, solvency, collateral, ability to pay cash interest and debt capacity ratios do not readily apply when “existing lenders make loans to a distressed company” as such investors are trying to protect their existing loans.13 Those trying to protect existing investments can constitute a significant source of funding to a distressed company.

So what can existing lenders and insiders do to minimize the risk that any additional loan they extend to a distressed company is not later somehow subordinated to the claims of general unsecured creditors? Three recent cases highlight that both lenders and borrowers should follow the formalities. In two of these cases, the courts found that the reinvestments were indeed debt, primarily because the parties to the loans treated the reinvestment as debt. For instance, the Court of Appeals for the Third Circuit in In re SubMicron Systems Corporation refused to overturn the District Court’s finding that additional funds extended to the debtor were indeed debt. 14 The District Court had so held because the instruments were labeled debt with a fixed maturity and interest rate and because the debtor treated the loan as debt by recording the secured on its 10-Q SEC filing and UCC-1 financing statements. The Court of Appeals further explained that debt is characterized by the lender expecting “to be repaid with interest no matter the borrower’s fortunes,” whereas an equity investor is to be repaid based on the borrowers’ fortunes.15 The debt formalities discussed above as cited by the District Court were sufficient to indicate that payment was not dependant on the borrower’s fortunes. The more the debt formalities are laid out and followed, the more likely a bankruptcy court will characterize the loan as debt.

A bankruptcy court in In re Radnor Holdings Corp.16 reached a similar conclusion. Because (1) the transaction documents referred to the loan as debt; (2) all parties referred to the reinvestment as loans and/or indebtedness; (3) the transaction documents contained a fixed maturity date; (4) the documents gave the lender the right to enforce payment of principal and interest; (5) the reinvestment did not contain voting rights; and (6) were treated as priority debt instruments, the bankruptcy court could find no reason to characterize the loan as equity.17

In contrast, the case of In re Official Committee of Unsecured Creditors for Dornier Aviation (North America), Inc. presented a scenario in which the parties never set any formal documents and therefore could not follow them.18 Essential to the Fourth Circuit’s conclusion that the transaction was more consistent with equity were the district court’s findings that (1) there were no formal debt documents as the purported loan was essentially the deferment of payments on receivables owed to the lender by the debtor and the lender was an insider (a parent company); (2) the transaction involved no maturity date; (3) there were no fixed payments as the debtor was not required to pay until it was profitable; and (4) the lender had assumed the borrower’s losses.19

Based on the abovementioned cases, it is apparent that one principle focus of courts attempting to divine the parties’ intent is the documents creating the indebtedness, the terms therein and whether the parties actually follow the terms. Thus, any additional loan to a company should be properly described as a debt instrument and should include all the indicia of a debt instrument. For example, it should include a fixed maturity date, a payment schedule, a fixed rate of return, interest payments and, to the extent possible, security provisions for the loan. Moreover, the company should treat the loan as if it is debt. The company books should reflect that it is a loan and the company should attempt to make the scheduled payments (it being understood that if this issue actually comes up, the company has fallen into bankruptcy and presumably already defaulted under the loan). Finally, the lender should likewise treat the loan as debt, demanding payments when payments are due. The more a transaction looks and smells like an arm’s-length negotiation, the more likely a court will treat it as debt.20

But that’s only half the battle. There is still the issue of equitable subordination explored in more detail in the next issue of Venable’s Sub-Debt Report.