The Bottom Line
In In re SGK Ventures, LLC, Case No. 15 C 11224, 2017 WL 2683686 (N.D. Ill. June 20, 2017), Judge Durkin of the District Court for the Northern District of Illinois sets out a thorough analysis for addressing recharacterization and equitable subordination of claims. In the process, the court reestablishes a high threshold for the equitable subordination of secured loans by insiders. Pursuant to section 510(c) of the Bankruptcy Code, the Bankruptcy Court for the Northern District of Illinois granted equitable subordination of secured loans made by the debtor’s insiders. The bankruptcy court reached this conclusion because the debtor (i) dealt primarily in steel without adequately hedging against price fluctuations and while routinely distributing excess cash to owners rather than maintaining an equity cushion, (ii) had originally intended the first secured loan by insiders to be a preferred stock issuance, and (iii) kept its financial problems a secret from its trade creditors. However, on appeal, District Judge Durkin reversed the bankruptcy court’s equitable subordination holding after finding no basis for the holding.
The case involves SGK Ventures, LLC (formerly known as Keywell, LLC), a closely held company that has been in the scrap metal business since the 1920s. The Debtor had historically been profitable, but during the 2008 financial crisis, the Debtor’s financial condition sharply declined with several months of net income losses. During this time, the Debtor’s main source of liquidity was bank debt. However, by December of 2008, the Debtor had breached a covenant in the underlying loan agreement, entitling the bank to cease lending money. In response, owners of the Debtor created NewKey Group LLC in January of 2009 and the LLC made a secured loan to the Debtor that helped pay down the bank loan and keep the Debtor solvent. Two years later, the Debtor’s financial condition once again plummeted and the Debtor defaulted on its bank loan agreement. This time, the owners of the Debtor extended the maturity of the secured loan made in 2009 and created a second LLC called NewKey Group II LLC that made a secured loan to the Debtor to pay down the bank loan and keep the Debtor solvent. However, this only provided a temporary solution since the Debtor filed for bankruptcy protection in September of 2014.
During the bankruptcy proceedings, the court-appointed trustee for the Debtor filed an adversary complaint against the Debtor’s insiders for, among other things, recharacterization of the 2009 and 2011 secured loans as equity and equitable subordination of these loans. The bankruptcy court held that the loans should not be recharacterized as equity, but should be equitably subordinated to claims of the Debtor’s unsecured creditors. However, on appeal, Judge Durkin of the District Court for the Northern District of Illinois reversed the bankruptcy court’s equitable subordination holding while affirming the bankruptcy court’s recharacterization holding.
In his June 20, 2017 opinion, Judge Durkin first addresses recharacterization by pointing out that circuits are split on following federal or state law on recharacterization. But Judge Durkin goes on to note that this issue is “somewhat academic” here since federal and Illinois law have the same standard. According to Judge Durkin, the primary question with regard to recharacterization is whether the involved parties called the instrument in question one thing when they in fact intended it to be something else. The judge notes that even though there is not one factor that is dispositive in answering this question, courts tend to recharacterize purported loans as equity when there are no loan documents and no interest payments. Here, the loans in question were formally documented and the Debtor paid interest on them. The trustee pointed to the company’s financial distress and the lenders’ insider status in arguing that the loans should be recharacterized, but Judge Durkin held that this alone was not enough to recharacterize purported loans as equity since “[t]he law does not limit insiders to equity contributions as a means to save a flagging enterprise.”
Judge Durkin next addresses equitable subordination by first citing the standard articulated by the Seventh Circuit, stating that courts will subordinate a claim when “ the claimant creditor engaged in inequitable conduct that  injured other creditors or conferred an unfair advantage on the claimant, but  not when subordination is inconsistent with the Bankruptcy Code.” Judge Durkin further cites the Seventh Circuit’s assertion that inequitable misconduct typically sufficient to merit equitable subordination falls within one of the following three areas: “(1) fraud, illegality, breach of fiduciary duties; (2) under-capitalization; [or] (3) claimant's use of the debtor as a mere instrumentality or alter ego,” but notes that under-capitalization alone is not enough. The trustee argued for equitable subordination based on the Debtor’s long-standing practice of distributing excess cash to the owners and relying on the bank debt, and eventually the LLCs’ loans, for liquidity. Judge Durkin concluded that this “hindsight criticism of [the Debtor’s] business strategy is not a basis for a finding of inequitable conduct” since the Debtor had successfully operated this way for years until it faced “the worst economic recession in more than 70 years.”
Furthermore, the trustee pointed to the high interest rates on the 2009 and 2011 loans as evidence of inequitable conduct, but Judge Durkin rejected this assertion since (i) the trustee put forth no evidence that the interest rates were exorbitant, and (ii) the loans allowed the Debtor to preserve the availability of its bank debt and pay creditors for four years leading up to its bankruptcy. Finally, the court addressed the trustee’s argument that the Debtor acted inequitably by keeping its poor financial condition secret, but again Judge Durkin rejected this argument because the Debtor, as a non-public company, had no obligation to disclose its poor financial condition and there was no evidence the Debtor denied requests from creditors for information about its financial condition. Accordingly, the trustee failed to establish that there was inequitable conduct and, thus, failed to provide a sufficient basis for equitable subordination.
Why the Case is Interesting
This case reestablishes a high threshold for the equitable subordination of secured loans by insiders. This threshold was arguably lowered when the bankruptcy court granted equitable subordination based on factors that have not traditionally provided the basis for a finding of inequitable conduct that warrants equitable subordination pursuant to section 510(c). The district court’s decision is subject to an appeal pending before the Seventh Circuit. The Seventh Circuit response to this appeal may affect whether the high threshold is maintained or lowered with respect to equitable subordination of secured loans by insiders.