A recent decision out of the Bankruptcy Court for the Southern District of New York1 interpreting Delaware law will probably impact other decisions throughout the country in light of the impact Delaware corporate law has in other jurisdictions.
In re: Live Primary, LLC
Insider investors loaned $6 million to Live Primary, a start-up company. The bankruptcy court found that the loan was an equity contribution. This finding was based on the terms of the transaction and the intent of the parties, and resulted in the investors’ loan being subordinated to the claims of other creditors of the company.
When the risks inherent in the transaction should not be placed on the creditors, loans can be recharacterized as equity. Typically, this occurs when the company is unable to obtain a loan elsewhere and thus the investors pony up so that they can be repaid before other creditors. Because of the inherent unfairness, case law has allowed bankruptcy courts to recharacterize these loans as equity. In other words, courts are willing to look beyond the label of the transaction and analyze substance over form.
The bankruptcy court in Live Primary reviewed the 11 factors set forth in the seminal case, In re AutoStyle Plastics, Inc., 269 F.3d 726, 749-750 (6th Cir. 2001):
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the names given to the instruments, if any, evidencing the indebtedness;
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the presence or absence of a fixed maturity date and schedule of payments;
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the presence or absence of a fixed rate of interest and interest payments;
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the source of repayments;
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the adequacy or inadequacy of capitalization;
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the identity of interest between the creditor and the stockholder;
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the security, if any, for the advances;
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the corporation’s ability to obtain financing from outside lending institutions;
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the extent to which the advances were subordinated to the claims of outside creditors;
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the extent to which the advances were used to acquire capital assets; and
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the presence or absence of a sinking fund to provide repayments.
No one factor is more important than the other. Instead, courts will look at the intent of the parties and whether the terms are comparable to an arm’s length transaction.
Here, when reviewing the 11 factors, the court in Live Primary noted there was no fixed maturity date nor schedule of payments, the interest rate of 1% was considered nominal, the loan was unsecured, the proceeds were used for operations as opposed to capital expenditures, payment was tied to the liquidity of the company or an IPO, Live Primary’s capitalization was listed at $1,000 and there was lack of revenue — leading the court to find that no lender would have provided such a loan. Thus, all these facts combined contributed to the loan being recharacterized as an equity contribution.
The Live Primary decision should serve as a guide when investors choose to fund their company and label the infusions as loans, especially when deciding whether reorganize the company in a Chapter 11 bankruptcy proceeding. It should also serve as a guide to creditors when deciding whether to litigate the recharacterization of a loan to equity.
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1. In re Live Primary, LLC, Case No. 20-11612 (MG) (Bankr. S.D.N.Y. Mar. 2, 2021)
