By Artem Skorostensky, Goodwin Procter

A bankruptcy court has the equitable power to recharacterize debt to equity.  Recharacterization is a unique and rare remedy.  It is often perceived as more litigation threat than risk of genuine exposure. That said, lenders, shareholders and turnaround professionals must beware. The recent decision by Judge Martin Glenn in In re Live Primary, LLC, is a reminder that recharacterization still has sharp teeth.   

Debt Recharacterization

Bankruptcy courts have the “equitable power” under Bankruptcy Code Section 105(a) to recharacterize debt to equity.    

Debt recharacterization disputes most often arise when shareholders or sponsors lend capital to a distressed company after third-parties have passed on the opportunity. Certain debt instruments, such as zero coupon bonds, payment-in-kind debt instruments, mezzanine debt, and convertible bonds may pose heightened risk.

Live Primary, LLC

In 2015, Lisa Skye Hain started a shared office space company Live Primary, LLC, with an investment of over $6,000,000 from Joel Schreiber. Schreiber provided a draft operating agreement that called his investment a “loan.”  Primary Member LLC was formed as an investment vehicle for the Live Primary project.  Primary Member received a 40% membership interest in Live Primary in exchange for the loan.

In 2020, Live Primary commenced a chapter 11 proceeding.  Primary Member alleged in its proof of claim a debt of over $6,000,000 for “[l]oans extended to [Live Primary] as per operating agreement.”  Live Primary objected to the Primary Member’s claims, arguing that the loan was in fact an equity contribution.

Recharacterization Factors

The Court applied the following eleven factor AutoStyle test established by the Sixth Circuit:

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 identity of interest between the creditor and the stockholder.
7. The security, if any, for the advances.
8. The corporation’s ability to obtain 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.
11. The presence or absence of a sinking fund to provide repayments.

The Court held that recharacterization was warranted, and the loan by Primary Member was in reality an equity contribution. The Court relied on the following facts in reaching its determination:  (i) the absence of debt documents memorizing the loan; (ii) the loan had no fixed maturity date; (iii) the de minimis rate of interest and lack of interest payments; (iv) the only source of repayment for the loan was proceeds of an IPO; (v) reasonable outside lender would likely not have made a loan to Live Primary under existing circumstances; (vi) the loan was unsecured; (vii) the loan was effectively subordinated to other creditors; and (viii) the loan proceeds were used to acquire Live Primary’s first assets, which is a traditional usage of equity investments.

Takeaways

Debt recharacterization is not exiting litigation playbooks anytime soon. Live Primary is a cautionary tale for investors. Investors and advisors should carefully study Judge Glenn’s decision when considering an investment structure. Failure to do so may render that investment susceptible to a debt recharacterization challenge by an unsecured creditors’ committee seeking to increase recoveries for its constituents. Lenders can mitigate the risk of recharacterization by ensuring they properly document their intent to create a borrower-lender relationship and maintain market terms and conventions in documenting the investment.