The Bankruptcy Court Southern District of New York Uses the 11-Factor Test for Re-Characterization of Debt as Equity

The Bankruptcy Court Southern District of New York Uses the 11-Factor Test for Re-Characterization of Debt as Equity

The Bankruptcy Court for the Southern District of New York ruled that a purported debt held by an entity with an almost-majority membership interest in the debtor company was in fact equity disguised as a loan. Live Primary, LLC, 20-11612-mg, (Bankr. S.D.N.Y., 2021).

The Primary Member LLC (“PM”) was formed to invest in a shared start-up named Live Primary, LLC (the “debtor”). In exchange of a contribution of $6,000,000, PM received a forty percent membership interest in the start-up.  The transaction was documented in the LLC agreement as a loan. The other two members of the start-up received thirty percent membership interest in exchange for their full-time employment by the company. An LLC agreement was executed among the three members, which stated that, a) the aggregate capital contribution for the start-up would be $1,000, b) PM’s contribution was a loan with multiple tranches, c) each tranche borrowed was to be evidenced by a promissory note, and d) the outstanding borrowing would be entitled to interest of one percent per year. The agreement also stated that the loan was to mature and become payable upon a particular type of merger, consolidation or debtor’s initial public offering.  

Thereafter, the debtor filed a bankruptcy petition. In response, PM filed a proof of claim for amounts drawn on the loan. However, the debtor objected to the same.  A hearing was conducted by the Court to resolve the issue and the loan was re-characterized, with a balance in the proof of claim of $6,354,900, as equity.

The Court noted that the bankruptcy court is given an authority to re-characterize debt as equity under the section 105(a) of the Bankruptcy Code. The provision states that “the court may issue any order, process, or judgment that is necessary to carry out the provisions of the Bankruptcy Code”. The Court thereby rejected PM’s contention that state law should be made applicable as the rule of decision. The Court then adjudicated on the prevailing issues and applied the eleven factor test established by the Sixth Circuit[1]. Under the test, the first factor stated that exercise of re-characterization essentially involved sidelining the label attached to the transaction and instead considering its substance. The Court noted that there was a lack of meaningful instrument of debt in the present case as the notes stated in the LLC agreement were never issued. The second factor states the presence or absence of a fixed maturity date and schedule of payments. The Court observed that the loan had no fixed maturity. It stated that, “no reasonable lender would make over $6,000,000 unsecured advances to a start-up business without a fixed maturity. Therefore, the Court concluded that considering the factor, re-characterizing the loan as equity seemed more reasonable. Likewise, the third factor talked about the presence or absence of a fixed interest rate and interest payments. The Court observed that even though there was a fixed rate of interest, it accrued to only one percent and that the de minimis rate clearly indicated that the loan was actually equity.

The fourth factor established law that an interest is better characterized as equity if it is repaid only out of profits of the debtor. This factor also weighed in towards re-characterization of loan as equity. The fifth factor which talks about inadequacy of capitalization supported the re-characterization. The sixth factor established that a stockholder giving a loan to a corporation in proportion to its ownership interest indicates that the loan is actually equity. The seventh factor talks about absence of security. And since the loan in the present case was unsecure, the seventh factor also leaned towards re-characterization. Further, the eight factor states the ability to obtain loans from lending institutions. The ninth factor talks about provision which prevented the subordination of the loan to other loans. Since there was no such provision, the Court also took into account the stated factor. The tenth factor discussed the character of the advance. In the present case, the advance was given in the initial stage of the business without which the start-up could not have started. Lastly, the eleventh factor relates to the presence or absence of a sinking fund to provide repayments. Since the loan in the present case was unsecured and there was no sinking fund available, the Court considered this factor as well. The Court gave an extensive judgment regarding the re-characterization of loan as equity. The decision reiterated that the Bankruptcy Courts can use their authority to re-characterize the loan as equity. The corporations should keep in mind the eleven-factor test of characterization to steer clear of this issue at a later stage.

[1] In Re: Autostyle Plastics, Inc., 269 F.3d 726 (6^th Cir. 2001)