Bankruptcy Court Identifies Alleged Loan as Equity Under Delaware Law | Troutman pepper

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When is a loan not a loan? The SDNY Bankruptcy Court in In Re: Live Primary, LLC [1] ruled that a $ 6 million start-up loan was in fact a contribution to capital after analyzing the terms of the transaction and the intention of the parties. The court characterized the loan as equity as the alleged loan worked as an equity investment should work. Accordingly, the insider investor’s claim was subordinate to the claims of the company’s creditors.

The risks of re-characterization

Shareholders, sponsors and third party lenders should be aware of the risks of requalification. Many debt securities held by these parties have similar risk profiles to equity investments, such as payment-in-kind debt (PIK), mezzanine debt, and convertible notes. Bankruptcy courts look beyond the “label” of a transaction, analyzing substance rather than form to reveal a contribution to capital disguised as debt. The significance of the requalification is that if the court determines that a loan is treated more specifically as a contribution to capital, the court will subordinate the debt of the deemed creditor to the obligations of the debtor under the distribution scheme of the Bankruptcy Code, which classifies debts before capital debts in order of distribution in the event of bankruptcy.

The purpose of re-characterization

The purpose of the requalification is to prevent a shareholder from transferring the risk of participation in the capital to the other creditors of the debtor. For example, an insider may provide financing to a start-up or financially troubled business unable to obtain third-party financing. If the business is successful, the insider will be repaid on the loan with interest, and the value of any principal held by the insider may increase. If the business is unable to repay the loan but has not yet filed for bankruptcy, the insider may classify the loan as a contribution to equity. This has the effect of giving the insider something of value – more equity – if they cannot be repaid in cash at the expense of other creditors in the business who also cannot be repaid. If the company declares bankruptcy, the insider will file a claim on the loan as a creditor and be repaid before it would have been repaid as an equity holder under the Bankruptcy Code distribution scheme. In doing so, the insider will also dilute the amount available to repay to the company’s true creditors.

The case

In this case, Debtor Live Primary LLC (Live Primary) is a wellness-focused coworking and shared office space started by two former WeWork executives. In 2015, Lisa Skye and Danny Orenstein founded Live Primary, with most of the initial funds coming from a $ 6,000,000 contribution from colleague Joel Schreiber through a limited liability company that Schreiber formed called Primary Member LLC (Primary Member ). Schreiber provided a draft operating agreement for Live Primary which referred to the indebtedness to Live Primary as a ‘loan’ rather than a capital contribution from the primary member (Schreiber also had a 40% stake in Live Primary through the main member).

The operating agreement provided that the loan could be commemorated by a separate loan agreement and that each disbursement under the loan was to be evidenced by a promissory note. However, as Live Primary continued to open new locations and funds were disbursed, no separate loan agreement was made and no promissory note was ever issued. Interest accrued on the loan at 1.0% per annum, compounded annually. There was no principal payment schedule and accrued interest was only payable upon a specified liquidity event or the subscribed initial public offering of Live Primary.

Recharacterization factors

The Principal Member alleged in his proof of claim that the debt was a loan. Live Member retorted that the debt was in fact a contribution to the capital. Sixth Circuit Courts (as well as Third, Fourth, and Tenth Circuits and the Southern District of New York) assess the merits of requalification requests based on the 11 factors set out in the Sixth Circuit decision. In re AutoStyle Plastics, Inc. [2]:

  1. the names given to the instruments, if any, evidencing the debt;

  2. the presence or absence of a fixed due date and payment schedule;

  3. the presence or absence of a fixed rate of interest and interest payments;

  4. the source of reimbursements;

  5. the adequacy or insufficiency of funding;

  6. the identity of interests between the creditor and the shareholder;

  7. the guarantee, if applicable, for the advances;

  8. the company’s ability to obtain financing from outside credit institutions;

  9. the extent to which advances were contingent on claims of external creditors;

  10. the extent to which advances have been used to acquire capital assets; and

  11. the presence or absence of a sinking fund to make repayments.

Depending on the context and the specifics of a transaction, each factor may vary in importance. When considering all of the factors, courts take into account the intention of the parties and whether the terms are comparable to an arm’s length transaction.

In this case, the absence of a fixed due date and payment schedule, the nominal interest rate of 1%, the unsecured nature of the loan and the only repayment opportunities linked to a liquidity event or a liquidity event. IPOs all supported the court’s conclusion. that the loan was in fact an equity investment. The minimum capitalization of Live Primary ($ 1000 had been paid by members at the time of the advance) and the lack of income led the court to conclude that a reasonable outside lender would probably not have made a loan and were convincing facts in the loan requalification. . The fact that the loan proceeds were used to finance operating expenses rather than capital expenses denoted another factor that weighed in towards requalification. Ultimately, the court ruled that the loan should be requalified, as the loan worked as equity would work and proof of claim was not allowed.

Minimize the risk of re-characterization

To minimize the risk of requalification, shareholders, sponsors and third party lenders should ensure that the form and substance of the transaction is comparable to an arm’s length transaction. The factors in the AutoStyle the decision can be a guide. The parties should also commemorate their intention, for example that the advances are meant to be debt and that attempts to obtain debt financing from third parties have failed. These strategies can avoid the risk of requalification.


[1] 2021 WL 772248 (Bankr. SDNY Mar 2, 2021).

[2] 269 ​​F.3d 726 (6th Cir. 2001).

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