Insiders who support their business enterprises in the form of loans should take comfort in a recent decision by the Bankruptcy Court for the Western District of Virginia in which the bankruptcy court declined to recharacterize a member’s loans to a limited liability company as capital contributions. Financial transactions in which an insider advances money to its business are likely to be highly scrutinized by a court in a bankruptcy case and, in certain instances recharacterized as equity notwithstanding having been labeled as a loan. However, as this case demonstrates, not all transactions involving an insider warrant recharacterization.
An Overview on Recharacterization
Recharacterization occurs when a court recasts a debt as a capital contribution and, therefore, an advance that should be treated as equity. The Bankruptcy Code provides that a company must satisfy all of its debts prior to making any payments to equity holders. Thus, the practical effect of recharacterization is that in most bankruptcy cases, the insider making such advance will not receive any distributions in repayment of the advanced funds.
Unlike equitable subordination, where the inquiry focuses on the creditor’s inequitable conduct, recharacterization involves determining whether a debt actually exists. The Fourth and Sixth Circuit have adopted eleven factors as appropriate considerations when determining whether a court should recharacterize a claim. These factors include:
- The names given to the instruments, if any, evidencing the indebtness;
- 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
The Fourth Circuit has held that the significance of these factors will vary given that recharacterization is a “highly fact-dependent inquiry that will be different in application from case to case” and therefore the factors are not dispositive of the matter.
Background – In re Virginia Broadband, LLC
The debtor, Virginia Broadband LLC (the “LLC”), filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code in November 2012, and the case was thereafter converted to chapter 7. Warren Manuel, an equity holder since 2004 and the LLC’s CEO from 2004-2010 and again from 2011-2012, filed three proofs of claim. The first two claims sought repayment of funds that Mr. Manuel had lent the LLC prior to the petition date. The third claim sought reimbursement for expenses Mr. Manuel incurred on behalf of the LLC prior to the bankruptcy filing. The chapter 7 trustee for the LLC objected to these claims and sought to have each claim either equitably subordinated or recharacterized as equity.
The Court’s Analysis
The bankruptcy court dismissed the trustee’s argument regarding equitable subordination because the LLC failed “to demonstrate a sufficient factual basis for [the bankruptcy court] to find inequitable conduct or harm.”
In conducting its recharacterization analysis, the bankruptcy court reviewed the eleven factors to be considered by courts in the Fourth Circuit. The court determined that many of these factors strongly supported its decision in declining to recharacterize Mr. Manuel’s claims. In particular, the court noted that Mr. Manuel’s advances to the LLC had been documented as notes, a form that is typically associated with a loan, and that each advance had a fixed maturity date or a maturity date that was certain to fall within an eleven month time-frame. The court also considered whether the LLC was able to obtain other funds from outside entities and found that Mr. Manuel’s advancements of funds were more suggestive of debts because other third parties were willing to lend money to the LLC during the same period as Mr. Manuel’s advancements.
Furthermore, although one of the transactions in question came at a time when “things were tight” for the LLC, the court noted that if “courts recharacterized debt each time an insider made a loan to a struggling company, no insider (or perhaps any creditor) would lend financial assistance to a distressed company for fear of punitive action by a bankruptcy court.” Ultimately, the bankruptcy court held that Mr. Manuel’s claims were debts of the LLC and would not be recharacterized as equity contributions.
The bankruptcy court’s decision in In re Virginia Broadband, LLC reinforces the notion that insiders may support their business enterprises through the lending of money. It is not a certainty that such monetary advances will be recharacterized as equity contributions. However, as the analysis conducted by the bankruptcy court makes clear, insiders hoping to have their advances treated as debt rather than equity need to pay particular attention to both the express terms and the circumstances surrounding the transaction.