It is not unusual for venture capital and private equity firms to make bridge loans to companies they control when they face a liquidity crunch. If these loans fail to serve as a bridge out of financial distress, their nature and/or priority may later be challenged.
VC and PE firms should be aware of the potential attacks. 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 US bankruptcy law is that creditors are entitled to distribution ahead of holders of equity interests. Treating equity investors on a par with unsecured creditors disregards the principles underlying the absolute priority rule. In furtherance of this policy, the similar and sometimes overlapping, but distinct doctrines of “recharacterisation” and “equitable subordination” were developed by case law. While equitable subordination has been incorporated into the Bankruptcy Code (section 510(c)), recharacterisation continues to be applied solely as a creation of case law.
Recharacterisation and equitable subordination are doctrines aimed at different conduct and have different remedies (although sometimes based on the same facts). The recharacterisation analysis generally involves determining whether a funding instrument labelled as “debt” is really in the nature of an equity investment. Under recharacterisation, the substance of the transaction will govern over form. Where the circumstances show that a debt transaction was actually an equity infusion, the recharacterised claim will be treated as equity.
In contrast, equitable subordination is based on an assessment of the creditor’s behaviour. It is used to remedy 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 recharacterisation in the context of bankruptcy, the doctrines address distinct concerns and require bankruptcy courts to conduct different inquiries.
The majority approach adopted by courts of appeals addressing recharacterisation in the bankruptcy context has used multi-factor tests imported from tax cases. 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 capitalisation; (6) the identity 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.
The 3rd Circuit has noted, however, that a “mechanistic scorecard” approach is not the answer to the recharacterisation question.
In Alternative Fuels Inc., the most recent federal appeals court decision addressing recharacterisation, 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 recharacterisation, courts are to exercise caution in applying the doctrine. The 10th Circuit emphasised 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 only party willing to make a loan to a struggling business, and (iii) punishing owners for seeking to save a distressed business is not a desirable social policy nor required by prior case law.
The 5th and 9th Circuits have articulated a different legal framework for the application of recharacterisation by bankruptcy courts. While the actual test to be applied under their approach may be very similar to the majority of courts of appeals following the multi-factor approach, the 5th and 9th Circuits have held that a bankruptcy court must look to the applicable non-bankruptcy law (generally state law tax cases) to determine whether the claims at issue may be recharacterised as equity.
EQUITY IN DISGUISE?
In summary, the courts of appeals are now viewing the doctrine of recharacterisation in bankruptcy cases through different lenses. Some circuits apply bankruptcy law and others apply state law. The alternative approaches, in most instances, may amount to a distinction without a difference. Most likely, multi-factor tests adopted from federal tax cases will continue to be applied under either approach. The ultimate question is whether the parties to the transaction intended the “loan” to be a disguised equity contribution. 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.
The doctrine of equitable subordination is directed at bad behaviour. Courts will subordinate a claim under Bankruptcy Code section 510(c) when a creditor engages in misconduct that injures other creditors or confers an unfair advantage on the claimant, but not when subordination is inconsistent with the Bankruptcy Code. Courts have recognised three categories of inequitable conduct: (1) fraud, illegality and breach of fiduciary duties; (2) undercapitalisation; or (3) the claimant’s use of the debtor as a mere instrumentality or alter ego.
Equitable subordination is an extraordinary remedy that the courts employ sparingly. Courts have described equitable subordination as the power to disregard an otherwise valid transaction. The hesitancy to apply equitable subordination springs from concerns regarding (i) upsetting a creditor’s legitimate expectations, (ii) creating legal uncertainty about whether courts will enforce otherwise binding agreements, thus increasing the cost of credit in general, and (iii) difficulty in proving that a creditor has engaged in inequitable behaviour.
‘IN GOOD FAITH’
Courts are inclined to apply a less stringent analysis of equitable subordination when the creditor is an insider or fiduciary of the debtor. In that context, the party seeking equitable subordination need only show some unfair conduct, and a degree of culpability, on the part of the insider. When existing shareholders simply seek to enhance their priority in liquidation by converting existing equity to debt in advance of bankruptcy without providing real new value to the company, their claim should be equitably subordinated to return them to their position in line as an equity holder.
However, when a bridge loan is provided in good faith with a reasonable basis to believe that the new funding may assist the company in a reorganisation or in otherwise salvaging its business, and is not designed in a manner to harm other creditors, there should be no basis for equitable subordination.
In conclusion, it is imperative that the economic realities of modern finance and the frequently limited options available to financially distressed businesses are recognised. Much of modern financing can be viewed as falling on a continuum between conventional debt and equity. Moreover, an insider is often the only source of funds for a struggling company. #Neither recharacterisation nor equitable subordination should be applied in a manner that discourages good faith loans or that defines debt financing in a more limited way than in the real world of modern finance. Otherwise, VC and PE firms, other insiders, and other non-conventional lenders of last resort which provide financial support to a business in financial distress, will be discouraged from attempting to save businesses teetering on the edge of demise.
David Kupetz is a shareholder in California-based law firm SulmeyerKupetz. He is an expert in restructuring, business reorganisation, bankruptcy, assignments for the benefit of creditors, and other insolvency solutions (email@example.com).