VWI Properties LLC, the pre-petition purchaser of the secured debt associated with the hotel property owned by Mt. Olive Hospitality LLC (the debtor), filed several objections challenging the validity of certain unsecured claims totaling more than $4 million and the characterization of those claims as debt. VWI further asserted through a motion that the alleged noteholders were insiders of the debtor and thus ineligible to vote on the confirmation of the debtor’s proposed chapter 11 plan. Below, we consider VWI’s process for objecting to the note-holders’ claims, the characterization of the transactions at issue as debt or equity, and VWI’s argument for “non-statutory insider” status of the claimants.
Process for Objecting to Claims
Four of the 13 challenged claimants filed an untimely proof of claim, and the others failed to file any proof of claim.[1] Notwithstanding the foregoing, the bankruptcy court noted that the debtor listed all of these claims on its Schedule F (as amended), and that this listing “constitute[s] prima facie evidence of the validity and amount of the claims of creditors, unless they are scheduled as disputed, contingent, or unliquidated.”[2] None of these claims were scheduled as such by the debtor, and therefore, prima facie validity was afforded to each claim.[3] Once prima facie validity is afforded, the burden shifts to the objector (VWI) to “produce sufficient evidence to negate the prima facie validity of the filed claim.”[4] If the objector can accomplish this, the burden shifts back to the claimant to establish by a preponderance of the evidence the validity of its claim.[5]
The claimants attempted to meet their evidentiary burdens by relying upon, among other things, various promissory notes. The bankruptcy court, however, found that the “evidentiary demonstration by VWI regarding the preparation of certain of the promissory notes at issue conclusively establishes that those notes must be completely disregarded as substantiation for the claim for which they are submitted, because the circumstances of their preparation are so implausible that the version offered by the debtor cannot be believed.”[6] That said, even without the promissory notes to evidence the claims, the bankruptcy court noted that the claimants could still prevail (and avoid the recharacterization) if they could establish, by a preponderance of the evidence, that their actual intent was for these advances to be loans and not equity.[7]
Debt vs. Equity Characterization
Courts have developed criteria to evaluate an instrument as either debt or equity, including a common 13-factor test. Consideration of select factors with respect to the facts in this case is provided below:
- Source of payments made under the instrument: “[N]o regular payment of principal or interest was made to the claimants,”[8] indicating that payments may have been dependent upon earnings.
- Degree of capitalization and debtor’s ability to obtain loans from outside lenders: “[I]f the notes were all considered to be debt, the debtor … would have been too thinly capitalized, and would probably not have been able to consummate [the primary mortgage].”[9]
- Whether the company failed to repay on the due date: The debtor was not making timely repayments to the noteholders.[10]
To conclude whether the claimants met their evidentiary burden, the bankruptcy court decided to follow the Third Circuit’s decision in In re SubMicron Systems Corp. and make a fact-intensive inquiry into “what the parties actually intended and acted on in each case,” and not use a specific multi-factor test or “mechanistic scorecard.”[11] The bankruptcy court explained that under this framework, the actual intent of the parties for each transaction “may be inferred from what the parties say in their contracts, from what they do through their actions, and from the economic reality of the surrounding circumstances.”[12] In the end, only four of the 13 claimants survived VWI’s challenge to their various claims.[13]
“Non-Statutory Insider” Status Is Denied
VWI also filed a motion to designate these claimants as non-statutory insiders under 11 U.S.C. § 101(31) and to challenge their ability to vote as members of the unsecured class of creditors (assuming that their claims were found to be valid).[14] The bankruptcy court denied VWI’s motion, concluding that “there was no evidentiary basis to establish that the transactions were not accomplished at arm’s length.”[15]
The bankruptcy court noted that determining who constitutes a non-statutory insider “requires consideration of both the nature of the relationship between the parties and whether the transactions in question were conducted at arm’s length.”[16] Relying on In re Winstar Communications Inc., the bankruptcy court noted that the Third Circuit has clarified that for purposes of qualifying as an insider under 11 U.S.C. § 101(31)’s “person in control” language, “it is not necessary that a non-statutory insider have actual control; rather, the question ‘is whether there is a close relationship [between debtor and creditor] and … anything other than closeness to suggest that any transactions were not conducted at arms [sic] length.’”[17] Indeed, while the bankruptcy court acknowledged that VWI “correctly describe[d] the close relationships” between the claimants and the principals of the debtor, it ultimately held that VWI failed to offer enough evidence to establish that the transactions at issue were not conducted at arm’s length.[18] In so holding, the bankruptcy court found that there was no “coercion” by the claimants over the debtor, that these were “simple transactions involving the advance of funds in exchange for either debt or equity,” and that “consideration in the amount of debt or equity was given by each claimant, as any other arm’s length participant would have done.”[19] The bankruptcy court further noted that just because the claimants “may not have used good judgment in offering funding, or did not perform due diligence in examining the transactions,” those factors did not render them non-statutory insiders under the Bankruptcy Code.[20]
Conclusion
While the bankruptcy court did give consideration to a multi-factor test, ultimately an inquiry into the intent of the parties was relied upon to characterize the claims at issue. The approach taken by the bankruptcy court resulted in a mixed outcome for VWI, as four of the noteholders were able to provide “clear and unequivocal statements”[21] regarding their intent and sustain their claims, and roughly $1.5 million of the amount at issue was characterized as debt.[22] Indeed, by demonstrating through competent evidence that their intention was to provide loans and not capital contributions to the debtor, the successful noteholders were able to satisfy the “overarching inquiry”[23] into the intent of the parties with respect to the characterization of their claims. Moreover, because VWI’s motion to designate the challenged claimants as non-statutory insiders was denied, those noteholders were also determined to be eligible to vote on the proposed chapter 11 plan as members of the unsecured class.
[1] In the Matter of Mt. Olive Hospitality LLC, 2014 WL 2040769, at *6 (Bankr. D.N.J. May 16, 2014).
[2] Id. at *6 (citing Fed. R. Bankr. P. 3003(b)).
[3] Id. at *6.
[4] Id.
[5] Id.
[6] Id.
[7] Id. at *9.
[8] Id. at *10.
[9] Id. at *11.
[10] In the example of the Modi promissory note, the debtor had not repaid the principal after the one-year term of the borrowing. Id. at *12.
[11] Id. at *9-10 (citing In re SubMicron Systems Corp., 432 F.3d 448, 456 (3d Cir. 2006)).
[12] Id. at *10.
[13] Id. at *23.
[14] It was undisputed that one of the claimants qualified as a statutory insider under 11 U.S.C. § 101(31)(a)(i) due to the fact that he was the father of one of the debtor’s principals. Id. at *20.
[15] Id. at *22.
[16] Id. at *21.
[17] Id. at *21 (citing In re Winstar Communications Inc., 554 F.3d 382, 396-97 (3d Cir. 2009) (quoting In re U.S. Medical Inc., 531 F.3d 1272, 1277 (10th Cir. 2008)).
[18] Id. at *22.
[19] Id.
[20] Id.
[21] Id. at *13-16, 19.
[22] Id. at *23.
[23] Id. at *9 (quoting In re SubMicron Systems Corp., 432 F.3d at 456).