In re Live Primary, LLC, 626 B.R. 171 (2021), United States Bankruptcy Court, S.D. New York
The Bankruptcy Court for the Southern District of New York recharacterized a $6 million debt claim arising from purported loans to a debtor as an equity interest. Although recharacterization of purported debt as equity is an available relief that is not usually granted, the Court found it appropriate given the unique circumstances presented in this case. Following the 11-factor recharacterization test from the Sixth Circuit in In re AutoStyle Plastics, Inc., the Court held that the purported loans were recharacterized as equity because of, among other things, the failure to issue any promissory notes, the absence of fixed, realistic dates for repayment, the de minimis interest rate, the subordination of the purported loan to other debt, the lack of any security or sinking fund, and the use of advances for initial operating expenses.
In 2015, Primary Member LLC (“PM”) was formed to invest in debtor Live Primary, LLC (the “Debtor” or “Live Primary”), a shared office space start-up company. PM had agreed to invest $6 million in Live Primary in exchange for a 40% membership interest in the company. The remaining 60% membership interest was granted to two others in exchange for their full-time employment by the company. The three members of Live Primary executed a Limited Liability Company Agreement which provided that (1) the aggregate capital contribution for Live Primary was $1,000 (PM’s portion being $400); (2) PM was to advance $6 million to Live Primary as a single “loan” in multiple tranches; (3) each tranche disbursement of the loan was to be evidenced by a promissory note made by Live Primary in favor of PM; (4) the disbursements of the loan were to accrue interest at 1% per year; and (5) the loan was to mature and become payable only upon a certain liquidity event or Live Primary’s IPO. The LLC agreement also provided that PM’s loan to Live Primary was for the establishment of two shared office facilities as well as to fund any necessary startup expenses.
Following the Debtor’s chapter 11 petition, PM filed a proof of claim alleging a debt claim for the loan extended to the Debtor plus accrued interest as per the LLC agreement, to which the Debtor objected. The Debtor’s objection sought, among other things, recharacterization of PM’s debt claim as equity. The Court conducted a hearing on the issue and, as further described below, ultimately recharacterized the loan as equity.
Quoting the Sixth Circuit in In re AutoStyle Plastics, Inc., the Court noted that recharacterization is appropriate where the circumstances show that a debt transaction was actually an equity contribution ab initio. The Court further provided that the “paradigmatic” recharacterization case involves a situation where the same entities (or their affiliates) control both the transferor and the transferee, and interferences can be drawn that funds were put into an enterprise with little or no expectation that they would be paid back along with other creditor claims. The Court then applied the 11-factor test established by the Sixth Circuit in AutoStyle and found that the factors revealed “the economic reality” that PM’s loan functioned as equity.
The Court noted that the first factor, “the names given to the instruments, if any, evidencing the indebtedness,” should not be dispositive because a recharacterization involves ignoring the label attached to the transaction at issue and instead recognizes its true substance. The Court was unpersuaded by PM’s reliance on the references to a “loan” in the LLC agreement. The Court found that the promissory notes contemplated by the LLC agreement were never issued, and noted that the absence of notes or other instruments of indebtedness was a strong indication that the advances were capital contributions and not loans. Accordingly, the Court found that the first factor weighed in favor of recharacterization.
On the second factor, “the presence or absence of a fixed maturity date and schedule of payments,” the Court found the second factor weighed in favor of recharacterization because PM’s loan lacked a fixed maturity date and schedule of payments, and was payable only upon a liquidity event or IPO. It further noted that no reasonable lender would make $6 million in unsecured advances to a start-up without a fixed maturity date.
In considering the third factor, “the presence or absence of a fixed rate of interest and interest payments,” the Court noted that although there was a fixed rate of interest of 1% per year, it was significantly lower than the 3.25% prime rate at that time, for which a start-up would not have qualified. The Court found that the de minimis rate further indicated that the loan was equity.
The Court found that the fourth factor, “the source of repayments,” weighed in favor of recharacterization because the only source of repayment under the LLC agreement would be the proceeds of an IPO or a liquidity event, and not revenues.
On the fifth factor, “the adequacy or inadequacy of capitalization,” the Court found that the initial contribution of $1,000 was massively inadequate and that it was obvious that PM’s $6 million advance was necessary for the start-up to begin operations. The Court further noted that any suggestion that initial capitalization of $1,000 was sufficient for a new venture that projected that it needed more than $6 million to build out its facilities is “frivolous.”
Regarding the sixth factor, “the identity of interest between the creditor and the stockholder,” the Court found that it weighed in favor of recharacterization, as PM’s advances could be viewed as proportionate to PM’s 40% equity ownership in the Debtor. The Court further noted that the fact that the LLC agreement provided that PM would lose its membership in proportion to the amount of the loan if it failed to fund any of the tranches further supported the Court’s conclusion.
Since the advances under the loan were made on an unsecured basis and there was no security granted, the Court found that the seventh factor, “the security, if any, for the advances,” weighed in favor of recharacterization.
In considering the eighth factor, “the corporation’s ability to obtain financing from outside lending institutions,” the Court found that the Debtor could not have obtained loans at the time that were remotely similar to those extended by PM—a $6 million “loan” with no security, no loan agreement, no promissory note, and no fixed maturity date. Accordingly, the Court found that the eighth factor weighed in favor of recharacterization.
The Court concluded that the ninth factor, “the extent to which the advances were subordinated to the claims of outside creditors,” weighed in favor of recharacterization because no provision prevented subordination of PM’s loan to other loans.
On the tenth factor, “the extent to which the advances were used to acquire capital assets,” the Court found that the investment had the character of equity given that it was provided in the early stages of the Debtor’s establishment and was necessary to start the business rather than to purchase capital assets. Accordingly, the Court found that the tenth factor weighed in favor of recharacterization.
Finally, the Court found that the eleventh factor, “the presence or absence of a sinking fund to provide repayments,” weighed in favor of recharacterization as the loans were unsecured and there was no sinking fund to provide repayments.
Although recharacterization of purported debt as equity is an available relief that is rarely granted, this Court’s opinion reminds us that bankruptcy courts’ equitable powers include the ability to look beyond form to substance.
By: Margaret G. Parker-Yavuz (Akin Gump LLP) and Chanwon (Pio) Yoon (Akin Gump LLP)