In a recent decision, In re Live Primary, LLC, 626 B.R. 171, 178 (Bankr. S.D.N.Y. 2021), the Bankruptcy Court for the Southern District of New York found that a $6 million debt claim arising from purported loans to a debtor from one of its members should be recharacterized as an equity interest. Although debt held by insiders and shareholders is often closely scrutinized when a debtor files for chapter 11 protection, recharacterization of this nature remains a rare form of relief so long as the lender has adhered to basic loan formalities. However, when dealing with unique facts and circumstances such as those presented in Live Primary, bankruptcy courts have relied on their equitable powers under section 105(a) of the Bankruptcy Code to recharacterize debt claims as equity. Live Primary provides a classic example of how courts will look beyond the mere labels that parties affix to a transaction and a reminder to lenders that the failure to properly document and appropriately treat a loan as actual debt may leave them holding nothing more than an equity claim behind the debtor’s other creditors.
Debtor Live Primary, a start-up shared office space company that operated co-working facilities with an array of amenities in Manhattan, filed for Chapter 11 protection in July 2020. COVID-19 related work restrictions on non-essential businesses adversely affected its business, leaving it unable to make rent payments.
One of the initial investors in the Debtor, a former investor in WeWork, had agreed to invest $6,000,000 in the Debtor’s business in exchange for a 40% membership interest in the Debtor. The remaining 60% membership interests were granted to two others in exchange for their full-time employment by the Debtor. Pursuant to the Debtor’s Limited Liability Company Agreement, Primary Member LLC (“PM”), an entity owned and controlled by the initial investor, would make a $6,000,000 “Loan” to the Debtor bearing an interest rate of 1% and payable through various disbursements (the “Purported Loan”). Proceeds received under the Purported Loan would be used to develop and operate Manhattan office space for the Debtor’s co-working business as well as fund any necessary startup expenses.
When the Debtor later filed for Chapter 11 bankruptcy, PM filed a proof of claim that included the various disbursements made under the Purported Loan, plus accrued interest. The Debtor objected to PM’s proof of claim, seeking, among other things, recharacterization of PM’s debt claim as equity. PM first argued that under Bankruptcy Rule 7001, an adversary proceeding was required to invoke the Court’s equitable powers for recharacterization and that the Debtor could not proceed by claim objection. In February 2021, the court held a trial to determine whether the procedural posture was correct and ultimately whether the advances made under the Purported Loan should be recharacterized as equity investments.
The Court first rejected PM’s contention that the Debtor was required to commence an adversary proceeding (as opposed to a claim objection) to seek recharacterization, noting that recharacterization does not fall under one of the ten enumerated categories identified in Bankruptcy Rule 7001 that require an adversary proceeding. Rather, the Court found that contested matters initiated by an objection to a claim are governed by Bankruptcy Rule 9014, which provides that such matters should be handled by motion.
Following traditional recharacterization analysis in the Second Circuit, the Court then turned to the AutoStyle factors. In re AutoStyle Plastics, Inc., 269 F.3d 726, 747–48 (6th Cir. 2001). The AutoStyle test requires an examination of the following eleven factors to determine whether the parties intended for the investment at issue to be debt or equity:
- the names given to the instruments, if any, evidencing the indebtedness;
- the presence or absence of a fixed maturity date and schedule of payments;
- the presence or absence of a fixed rate of interest and interest payments;
- the source of repayments;
- the adequacy or inadequacy of capitalization;
- the identity of interest between the creditor and the stockholder;
- the security, if any, for the advances;
- the corporation’s ability to obtain financing from outside lending institutions;
- the extent to which the advances were subordinated to the claims of outside creditors;
- the extent to which the advances were used to acquire capital assets; and
- the presence or absence of a sinking fund to provide repayments.
After analyzing each factor in turn, the Court found that, on balance, the factors weigh in favor of recharacterizing PM’s debt claim as equity.
The court found that the first six factors all weighed in favor of recharacterization. Under the first factor, the absence of any traditional debt documents such as a bond, indenture or note will indicate that the advances at issue were intended as equity and not debt. The court considered whether the Debtor’s Operating Agreement (which referred to the advances as a “loan”) acted as the master loan agreement, but found it doubtful that $6,000,000 in disbursements were governed by a single paragraph that did not include the provisions typically found in traditional debt documents. The court was unpersuaded by PM’s reliance on the references to a “loan” in the Operating Agreement and noted that the key determination was the “true substance” of the transaction. Accordingly, the Court found that the first factor weighed in favor of recharacterization. The Court found the second factor weighed in favor of recharacterization because the Purported Loan lacked a fixed maturity date and schedule of payments, and was payable only upon an IPO or liquidity event. In considering the third factor, the Court noted that the Purported Loan was subject to an interest rate of 1%, which was significantly lower than the 3.25% prime rate at that time – which a start-up of this nature would likely not have even qualified for. The court found that the de minimis interest rate indicated that the Purported Loan was intended as an equity investment. Under the fourth factor, the source of repayments, the court noted that the key consideration was whether repayment depended on the Debtor’s success. The court ultimately found the fourth factor weighed in favor of recharacterization since, under the Operating Agreement, repayment of the Purported Loan was tied to a liquidity event or IPO and not revenue. Similarly, the Court found the fifth factor weighed in favor of recharacterization because the Debtor would have been inadequately capitalized but for the Purported Loan and the sixth factor weighed in favor of recharacterization because the advances made under the Purported Loan could be viewed as proportionate to PM’s 40% equity ownership in the Debtor.
The Court’s analysis also found that the seventh, eighth and ninth factors weighed in favor of recharacterization. Since the advances under the Purported Loan were made on an unsecured basis and there was no security granted, the seventh factor weighed in favor of recharacterization. In applying the eighth factor, the court considered whether a reasonable lender would have extended similar financing to the Debtor. At the time the Purported Loan was agreed to, the Debtor was essentially a shell company with no operational history or assets. The Court found it doubtful that any reasonable lender would have granted disinterested financing to such a borrower with no security, loan agreement, promissory note, or fixed maturity, and found the eighth factor weighed in favor of recharacretization. The Court also found that the ninth factor weighed in favor of recharacterization because the rights under the Purported Loan were subordinated to the claims of certain other third-party lenders under the Operating Agreement.
Lastly, the Court found the tenth factor weighed in favor of recharacterization because the funds received from the Purported Loan were used at least in part to make capital-like investments necessary to start the Debtor’s business and the eleventh factor weighed in favor of recharacterization because there was no sinking fund or similar pool of money set aside to pay off the Purported Loan. In sum, the court found that all eleven factors from AutoStyle weighed at least slightly in favor of recharacterizing the Purported Loan as an equity investment.
Conclusion and Take-Away
Although recharacterization is a rare form of relief, it does not mean parties can ignore the risk that their debt claim will be treated as equity in bankruptcy if they fail to follow common loan formalities and truly treat the loan as debt. All lenders, particularly shareholders and insiders, should understand the various AutoStyle factors and how a court will apply them, which will allow loan structuring in a way to withstand a later challenge from a debtor or other stakeholders in the capital structure. Tightening up deal terms and the documents that support them to better align with the formalities typically associated with debt transactions will minimize the risk of recharacterization and provide greater certainty that a party will be afforded the priority they bargained for in an eventual bankruptcy.