Understanding Potential Recharacterization and Subordination Attacks Against Bridge Loans Made by Venture Capital and Private Equity Firms By David Kupetz It is not unusual for Venture Capital (VC) and Private Equity (PE) firms to make bridge loans to companies they control when they encounter financial distress and face a liquidity crunch. When these loans fail to serve as a bridge out of financial distress, challenges may subsequently be presented to the nature and/or priority of such loans. VC and PE firms should be aware of the potential attacks that may be brought against their position as bridge lenders in the event of an ultimate bankruptcy or insolvency of their borrower. Based on the law that has developed in the federal circuit courts of appeal, bridge loans made by VC and PE firms (and by others) in good faith and with some foresight should generally not be susceptible to successful attacks. A basic concept underlying the Bankruptcy Code is that claims of creditors are entitled to distribution ahead of holders of equity interests in the debtor. Treating an equity investor on a par with unsecured creditors disregards the principles underlying the absolute priority rule in a manner that undermines this basic bankruptcy concept. In furtherance of this policy, the similar and sometimes overlapping, but distinct doctrines of "recharacterization" and "equitable subordination" were developed by case law. While equitable subordination has been incorporated into the Bankruptcy Code (section 510(c)), recharacterization continues to be applied solely as a creation of case law. Recharacterization and equitable subordination are doctrines that are aimed at different conduct and have different remedies (although sometimes based on the same facts). The recharacterization analysis generally involves determining whether a funding instrument labeled as "debt" is really in the nature of an equity investment. Under recharacterization, the substance of the transaction will govern over form. Where the circumstances show that a debt transaction was actually an equity infusion, the recharacterized claim will be treated as equity. In contrast, equitable subordination is based on an assessment of the creditor's behavior. It is used to remedy inequity or unfairness to the debtor's other creditors by demoting the subordinated creditor's right to repayment to the rights of other creditors or equity holders. Accordingly, although some courts have confused the doctrines or have mistakenly found that equitable subordination supplants recharacterization in the context of bankruptcy, the doctrines address distinct concerns and require bankruptcy courts to conduct different inquiries. The recharacterization of debt to equity is a legal concept rooted primarily in tax law. While various courts have adopted multi-factor tests when considering recharacterization of debt to equity, the overarching inquiry is the intent of the parties at the time of the transaction. The question is whether the parties to the transaction intended the "loan" to be a disguised equity contribution. Their intent may be inferred from what is stated in the contract, from what the parties do through their actions, and from the economic reality of the surrounding circumstances. Caution is necessary when applying the multi-factor tests adopted by courts to frame the recharacterization analysis. Otherwise, VC and PE firms, other insiders and other non- DAP\ 2461489.1 9/2/2016 (10:57 AM) 1 conventional lenders of last resort who provide financial support to a business in financial distress will be discouraged from attempting to save businesses teetering on the edge of demise. Ultimately, recharacterization and equitable subordination involve questions of fact that must be addressed on a case-by-case basis. The majority approach adopted by courts of appeals addressing recharacterization in the bankruptcy context has used multi-factor tests imported from tax cases. The Third, Fourth, Sixth, and Tenth Circuits have used the bankruptcy court's broad equitable power under section 105 of the Bankruptcy Code as the basis for the court's authority to recharacterize debt as equity. See Redmond v. Jenkins (In re Alternative Fuels, Inc.), 789 F.3d 1139 (10th Cir. 2015); Grossman v. Lothian Oil, Inc. (In re Lothian Oil), 650 F.3d 539, 542-43 (5th Cir. 2011); Cohen v. KB Mezzanine Fund II, LP (In re SubMicron Sys), 432 F.3d 448, 454 (3d Cir. 2006); In re Dornier Aviation, 453 F.3d 225, 231 (4th Cir. 2006); In re Hedged-Investments Associates, Inc., 380 F.3d 1292, 1298 (10th Cir. 2004); Bayer Corp. v. MascoTech, Inc. (In re Autostyle Plastics, Inc.), 269 F.3d 726,748 (6th Cir. 2001). These courts have adopted a flexible legal framework for recharacterization in bankruptcy. In their recharacterization analyses in bankruptcy matters, the courts of appeals applying multi-factor tests, have not deviated significantly. While the specific number of factors utilized by each circuit varies, the tests largely overlap as to the factors considered and are very similar if not completely identical. The 6th Circuit laid out an 11-factor test borrowed from tax cases, including: (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 identify of interest between the creditor and the shareholder; (7) the security, if any, for the advances; (8) the corporation's ability to fund financing from outside lending institutions; (9) the extent to which the advances were subordinated to the claims of outside creditors; (10) the extent to which the advances were used to acquire capital assets; and (11) the presence or absence of a sinking fund to provide repayments. Autostyle Plastics, 269 F.3d at 749-50. The 3rd Circuit, however, noted that a "mechanistic scorecard" approach is not the answer to the recharacterization question. As a result, "while a formulaic checklist certainly aides the court in analyzing whether a loan should be regarded as debt or equity, courts utilizing a multi-factor test must contextualize the facts giving rise to the loan and keep in mind the economic realities surrounding such loan." In re SubMicron Sys, 432 F.3d at 456. Further, the multi-factor tests should be considered with the recognition that these tests are derived from tax cases involving very different issues than priority disputes in bankruptcy cases, and taking into account the realities of modern financing. In Alternative Fuels, Inc., the most recent federal appeals court decision addressing recharacterization, the 10th Circuit, in 2015, reversed a bankruptcy court's application of the doctrine. The court explained that regardless of the presence of factors supporting recharacterization, courts are to exercise caution in applying the doctrine. The 10th Circuit emphasized that (i) it is important that courts not discourage owners from attempting to salvage a business by requiring all additional contributions be in the form of equity, (ii) owners may be the be the only party willing to make a loan to a struggling business, and (iii) punishing owners DAP\ 2461489.1 9/2/2016 (10:57 AM) 2 for seeking to save a distressed business is not a desirable social policy nor required by prior case law. See In re Alternative Fuels, Inc., 789 F.3d at 1153. The 11th Circuit adopted an amazingly broad alternative two-prong test. Under this minority approach, "shareholder loans may be deemed capital contributions in one of two circumstances: (1) where the trustee proves initial under-capitalization; or (2) where the trustee proves that the loans were made when no other disinterested lender would have extended credit. See Estes v. N&D Properties (In re N&D Properties, Inc.), 799 F.2d 726, 733 (11th Cir. 1986). In contrast, the 4th Circuit has held that "a claimant's insider status and a debtor's undercapitalization alone will normally be insufficient to support the recharacterization of a claim." In re Dornier Aviation, 453 F.3d at 234. The 5th Circuit in In re Lothian Oil, 650 F.3d 593 (5th Cir. 2011), articulated a different legal framework for recharacterization by bankruptcy courts. While the actual test to be applied may be very similar to that applied by the majority of courts of appeals following the multi-factor approach, the 5th Circuit held that a bankruptcy court must look to the applicable nonbankruptcy law (generally state law) to determine whether the claims at issue may be recharacterized as equity. Further, the 5th Circuit rejected the per se rule applied by the district court below limiting application of recharacterization to insiders, stating the "[u]nless state law makes insider status relevant to characterizing equity versus debt, that status is irrelevant in federal bankruptcy proceedings." In re Lothian Oil, 650 F.3d at 544-45. In Fitness Holdings International, Inc., 714 F.3d 1141 (9th Cir. 2013), the 9th Circuit addressed for its first time the question of whether bankruptcy courts have the power to recharacterize debt to equity. While it might seem obvious that bankruptcy courts have such power, the 9th Circuit's Bankruptcy Appellate Panel in In re Pacific Express, Inc., had earlier held that bankruptcy court's lack such authority because "characterization of claims as equity or debt" is governed and limited by equitable subordination under Bankruptcy Code section 510(c). In re Pacific Express, Inc., 69 B.R. 112 (9th Cir. BAP 1986). Rejecting Pacific Express, the 9th Circuit joined other courts of appeals in concluding that the Bankruptcy Code provides bankruptcy courts with the power, distinct and independent from equitable subordination, to recharacterize claims. Ninth Circuit, however, rejected the recharacterization framework for the applied by the other courts of appeal, except for the 5th Circuit in Lothian Oil.