Venture capitalists (“VCs”) often provide needed debt financing such as bridge loans to emerging companies in financial distress. However, given their insider status with these companies, VCs may encounter issues with such financing in the event the emerging company files for relief under the Bankruptcy Code. One issue arises in the context of the potential conflict with the goal in bankruptcy to ensure that claims against a debtor’s estate are administered in an equitable fashion. Among other things, bankruptcy courts will seek to preclude lenders from disguising equity investments or capital contributions as loans, in order to obtain the same priority treatment with a company’s creditors in the event their investments fail and the company commences a bankruptcy case. In bankruptcy, parties may request that the court invoke its equitable powers under theories of equitable subordination and debt recharacterization, effectively to subordinate a VC’s claim in bankruptcy arising from such financing.
For these reasons, as discussed further below, VCs should always be mindful of the terms of and negotiations surrounding transactions they enter into with emerging companies as well as their ongoing interactions with these companies.
A bankruptcy court has the power under section 510(c) of the Bankruptcy Code to equitably subordinate an allowed claim to other claims. Section 510(c) does not set forth the requirements for equitable subordination. But the majority of courts have held that a claim may be equitably subordinated under the following circumstances: (1) the claimant engaged in some type of inequitable conduct; (2) the misconduct resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant; and (3) equitable subordination of the claim is not inconsistent with the provisions of the Bankruptcy Code. Courts have concluded that inequitable conduct usually involves the following types of behavior by the claimant: (1) fraud, illegality, and breach of fiduciary duty; (2) undercapitalization; and (3) use of the debtor as a mere instrumentality or alter ego. Under the requirements for equitable subordination, a court focuses on the behavior of the claimant whose claim a party seeks to have subordinated rather than the substance of any particular transaction.
Under equitable subordination, a court may scrutinize claims held by insiders, such as VCs, more carefully than those held by non-insiders. Specifically, a court may equitably subordinate a claim if the party seeking subordination can simply demonstrate some inequitable conduct on the part of the claimant and the claimant should be held responsible for such behavior. Conversely, parties seeking subordination will need to demonstrate that a non insider claimant engaged in more egregious behavior, such as fraud, before a court will consider subordinating a claim.
If the elements of equitable subordination are satisfied, a court will subordinate the claim only to the extent necessary to offset any injury or damage suffered by the creditor that suffered as a result of the claimant’s inequitable conduct.
Alternatively, a bankruptcy court may use its equitable powers under section 105 of the Bankruptcy Code to recharacterize any transaction the parties characterize as debt as an equity contribution to the debtor. Debt recharacterization differs from equitable subordination in that the former focuses generally on the substance of the transaction while the latter focuses solely on the behavior of the claimant. Further, when a claim is equitably subordinated, it is still considered debt of the debtor. But when a claim is recharacterized, the alleged debt is considered equity. Compared to equitable subordination, this remedy is especially problematic for VCs because it does not require a finding of inequitable conduct. Instead, the court must simply determine whether a debt actually existed or whether the alleged debt is disguised as an equity contribution. If the claim is recharacterized, then it is subordinated to the level of equity.
Courts within all federal circuits have permitted debt recharacterization, and there has been no indication that application of the remedy is restricted to shareholder loans. In so doing, the majority has applied a flexible factor test articulated by the Sixth Circuit known as the Roth Steel/AutoStyle test, based on the bankruptcy court’s equitable powers under section 105(a) of the Bankruptcy Code, looking to such factors as: (1) the names given to the instruments, if any, evidencing indebtedness; (2) the present or absence of a fixed maturity date and schedule of payments; (3) the source of repayments; (4) the right to enforce payment of principal and interest; (5) the adequacy or inadequacy of capitalization; (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 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; and (11) the presence or absence of a sinking fund to provide repayments. See In Roth Steel Tube Co., 800 F.2d 625, 630 (6th 1986); In re AutoStyle Plastics, Inc., 269 F.3d 726,731 (6th Cir. 2001). None of these factors are dispositive, and courts will consider all circumstances surrounding the alleged debt at issue.
While the majority of circuits will analyze the foregoing Roth Steel/AutoStyle factors in considering whether to recharacterize a debt, others have looked elsewhere. The Eleventh Circuit has employed, in some instances, a limited test focused on two circumstances: “Shareholder loans may be deemed capital contributions in one of two circumstances: where the [debtor] proves initial under-capitalization or where the [debtor] proves that the loans were made when no other disinterested lender would have extended credit.” In re N & D Props., 799 F.2d 726, 733 (11th Cir. 1986). However, courts within the Eleventh Circuit have varied employing the N & D Properties test in some cases and various multi-factor tests in others. See In re First NLC Fin. Servs., 415 B.R. 874, 880 (Bankr. S.D. Fla. 2009) (listing cases).
The Fifth and Ninth Circuits more recently have addressed the issue, declining to follow the majority and instead looking to section 502(b) of the Bankruptcy Code (pertaining to the allowance of claims) as authorization to recharacterize and holding that state law should govern the determination of the nature and scope of a right to payment unless a federal interest requires otherwise. In re Fitness Holdings Int’l, Inc., 714 F.3d 1141, 1148–49 (9th Cir. 2013); In re Lothian Oil, Inc., 650 F.3d 539, 542–44 (5th Cir. 2011).
Recently, the Tenth Circuit addressed the demarcation between jurisdictions in Redmond v. Jenkins (In re Alternate Fuels, Inc.), 2015 U.S. App. LEXIS 9915 (10th Cir. June 12, 2015), and expressly rejected the minority view, explaining that the concept of recharacterization is rooted in section 105(a) and not section 502(b) of the Bankruptcy Code:
Although related, disallowance and recharacterization require different inquiries and serve different functions. Under § 502(b), disallowance of a claim is appropriate “when the claimant has no rights vis-à-vis the bankrupt, i.e., when there is 'no basis in fact or law' for any recovery from the debtor.” … Recharacterization, on the other hand, is not an inquiry into the enforceability of a claim; instead, it is an inquiry into the true nature of a transaction underlying a claim. In this way, recharacterization is part of a long tradition of courts applying the “substance over form” doctrine.
Id. at *16 (internal citations omitted).
The Tenth Circuit ultimately determined that neither equitable subordination which it deemed “an extraordinary remedy to be employed by courts sparingly” nor recharacterization, after application of its own 13-factor test, were appropriate. As a policy consideration, the court refused to overemphasize the undercapitalization and financial condition of the debtor company because it would discourage lenders, including business owners, to provide rescue financing in similar situations. Notably, the court also pointed out that the promissory notes in question were not found to be invalid or unenforceable under applicable state law and that sufficient consideration was exchanged under state law. Thus, while rejecting the minority view, the Tenth Circuit’s decision still included analysis of applicable state law. While the Alternative Fuels decision appears to be favorable for lenders and business owners, it more importantly provides a reminder that the split among circuits remains and that both state law and the Roth Steel/AutoStyle factors warrant consideration.
What Should VCs Do When Dealing With Emerging Companies?
Most importantly, VCs should provide debt financing to emerging companies on terms that are consistent with arm’s-length negotiated financing provided by non insiders. Courts have emphasized that the more the transaction in question resembles a transaction negotiated at arm’s length, the more likely it will treat the transaction as debt rather than equity. Further, VCs should make sure that any debt financing provided to these companies reflects the characteristics of debt rather than equity, including the terms of the financing as well as how the transaction is documented. Notably, in some instances, courts employing both the majority and minority analyses may look to ascertain the intent of the parties. E.g., Alternative Fuels, supra, at *26; Bauer v. C.I.R., 748 F.2d 1365, 1367 (9th Cir. 1985) (applying California state law). Finally, VCs must make sure their dealings with the company on an ongoing basis reflect an upholding of the fiduciary duties they owe to the company.
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