A recent decision by Judge Shannon of the U.S. Bankruptcy Court in Delaware, In re Optim Energy, LLC, et al., No. 14-10262 (BLS) (Bankr. D. Del. May 13, 2014), highlights a shift in Delaware recharacterization jurisprudence.
In that case, Walnut Creek Mining Company (“Walnut Creek”), the debtor Optim Energy’s largest unsecured creditor, sought standing to pursue recharacterization, equitable subordination, and fiduciary duty claims on behalf of the estate against secured lenders, who were also equityholders, after no committee of unsecured creditors was appointed. In determining whether Walnut Creek had articulated a colorable claim for recharacterization – the predicate showing that Walnut Creek was required to make in order to obtain derivative standing — Judge Shannon deviated from what had become the standard recharacterization analysis in Delaware courts.
Historically, Delaware bankruptcy judges have looked to the eleven-factor “AutoStyle” test to determine whether to recharacterize a loan as an equity contribution. See In re Exide Techs., Inc., 299 B.R. 732, 740 (Bankr. D. Del. 2003) (citing In re AutoStyle Plastics, Inc., 269 F.3d 726, 752 (6th Cir. 2001)). In recent decisions, however, Delaware bankruptcy courts have gone through the motions of applying the eleven factors while emphasizing that the dispositive question was whether the overarching intent of the debtor and creditor was to disguise an equity investment as debt. InOptim Energy, Judge Shannon went further, and did not even enumerate the factors, focusing instead only on the indicia of the parties’ intent.
At issue was a 2007 transaction in which a holder of 50% of the debtor’s equity, ECJV Holdings, LLC, and its parent company, Cascade Investments LLC (collectively, “Cascade”), guaranteed the debtor’s secured loan from Wells Fargo. The debtor and Cascade agreed that the debtor would reimburse Cascade for any payments made pursuant to the guarantee. Under the guarantee agreement, Cascade took a junior security interest in substantially all of the debtor’s assets. In a 2011 restructuring, Cascade obtained 99% of the debtor’s equity and paid $5 million to Wells Fargo to partially pay down the debtor’s loan. The restructuring agreement characterized the $5 million as a capital contribution, and the debtor issued shares to Cascade in exchange. In early 2014, as the debtor prepared to file for bankruptcy, Cascade paid Wells Fargo the outstanding balance on a loan, which triggered the debtor’s obligations under the guarantee agreement. Cascade became the senior secured creditor in the ensuing bankruptcy.
Walnut Creek sought derivative standing to challenge that series of transactions. Bankruptcy courts will typically grant a creditor derivative standing only if the the creditor alleges a “colorable” claim that the debtor unjustifiably refuses to pursue. A claim is “colorable” if it meets the motion to dismiss standard: it must state a claim to relief that is plausible on its face. Judge Shannon found that the Walnut Creek had not met this standard.
As Judge Shannon noted, the inquiry in a recharacterization analysis is whether the parties intended to disguise an equity contribution as a loan, citing In re SubMicron Systems Corp.,432 F.3d 448, 456(3d Cir. 2006), the governing Third Circuit case on recharacterization, for the principle that no “mechanistic” score card suffices (a reference to the eleven-factor test) and that the parties’ intent can be inferred from the parties’ contracts and actions and the “economic reality of the surrounding circumstance.” Rather than weighing the eleven factors, Judge Shannon sought to infer the debtor’s and Cascade’s overarching intent over the course of the transactions based on the allegations made by Cascade.
Walnut Creek made several arguments for recharacterization, first arguing that the debtor was inadequately capitalized at the time of the guarantee. The Court disagreed, noting that the debtor had paid its operating costs and obligations for seven years after the 2007 guarantee. Crucially, the court noted that the guarantees were not a response to the underperformance or undercapitalization that led to the 2014 bankruptcy. Walnut Creek also alleged that the debtor granted Cascade a security interest without owing Cascade any debt. The court found that this fact did not support recharacterization because the transactions were required by Wells Fargo and were not unusual for facilities of this type.
Walnut Creek flagged Cascade’s waiver of fees under the forbearance agreement as indicative of an equity contribution, but the Court found that the parties’ forbearance agreement was consistent with a lender-debtor relationship, as lenders commonly grant forbearance to protect their existing loans. Walnut Creek also argued that Cascade’s various capital contributions in the form of equity demonstrated that the guarantees were part of the equity investment. Judge Shannon, however, found that the parties had kept their equity and debt relationships distinct, holding that Cascade’s capital contributions were equity investments that were unrelated to the guarantee that became secured debt. Finally, while Walnut Creek alleged that no prudent lender would have made Cascade’s guarantee, the Court noted that the conculsory nature of this assertion was insufficient to support a colorable claim for recharacterization.
After taking the totality of Walnut Creek’s allegations into account, the Court determined that Walnut Creek had not articulated a colorable claim for recharacterization, holding that Cascade and the debtor had “clearly identif[ied] and document[ed] debt versus equity arrangements,” a dispositive indication that the overarching intent of the guarantee was to create a debt.
Walnut Creek also sought standing to pursue equitable subordination and fiduciary claims, but the Court gave each claim short shrift. Judge Shannon wrote that Walnut Creek had not alleged any inequitable conduct that could justify subordination, and fiduciary duty claims could not be brought because the debtor’s LLC agreement eliminated all fiduciary duties.
Judge Shannon’s decision may mark a turning point in Delaware recharacterization jurisprudence. Delaware bankruptcy judges had been paying lip service to the eleven-factor AutoStyle test while trying to evaluate the intent of the parties’ to a transaction. Parties seeking recharacterization in Delaware must focus on the intent behind a transaction, avoiding rigid adherance to the AutoStyle test.