Guarding Your Character: Demonstrating Intent in Private-Equity Funding

Private-equity funds typically provide capital to portfolio companies through equity infusions and debt financing depending on the fund’s investment strategy and the needs of the portfolio company. These strategies utilized by private-equity funds often unlock value for investors, but in the case of bankruptcy may make the fund a target of a recharacterization action by the trustee or other investors and creditors of a debtor. Fund principals should be mindful of the structure of the financing utilized, the documentation of those transactions, and the choice of law specified in order to avoid future recharacterization.

The federal circuits are currently split on the question of whether state law or federal bankruptcy law “provides the correct rule of decision regarding recharacterization,”[1] which complicates any fund’s evaluation of the risks it faces. However, a number of decisions do provide guidance as to what represents a strong claim that can withstand a recharacterization challenge. Consistently, courts have considered multi-factor tests to frame a recharacterization inquiry.[2] This piece will review the Third Circuit’s decision in Cohen v. KB Mezzanine Fund II, L.P. to provide guidance to private-equity funds and other investors considering the risks of a recharacterization challenge.

SubMicron

In Cohen v. KB Mezzanine Fund II L.P., the fund (KB) held senior subordinated notes of the debtor (SubMicron).[3] In connection with these notes, KB received a seat on SubMicron’s board of directors. Over the course of several years, SubMicron issued several other notes to KB. In 1999, SubMicron was “insolvent, undercapitalized, had no ability to pay cash interest on any of its debt and no third parties other than [KB] … would have been willing to loan SubMicron more money.”[4] On Sept. 1, 1999, SubMicron filed for chapter 11.[5] After the close the § 363 sale of the company’s assets, SubMicron’s plan administrator sought several remedies against KB and other defendants, including the recharacterization of KB’s earlier fundings as equity instead of debt.[6]

In the appeals court’s review of the district court’s decision, the court acknowledges and provides examples of the multifactor tests utilized by various courts in previous recharacterization inquiries. The court points out that consideration of these factors “devolve[s] to an overarching inquiry: the characterization as debt or equity is a court’s attempt to discern whether the parties called an instrument one thing when in fact they intended it as something else (emphasis added).”[7] “Form is no doubt a factor,” the court states, “but in the end it is no more than an indicator of what the parties actually intended and acted on.”[8]

The circuit court affirmed the district court’s determination. In support of the characterization as debt, the court identified the following as positive evidence of the intent of the parties:

• Lending Documents: The district court found “beyond dispute in the record that … the name given to the 1999 fundings was debt … and … the 1999 fundings had a fixed maturity date and interest rate.”[9] Additionally, the district court noted that “[t]he record is clear that SubMicron’s accounting department made numerous mistakes and errors when generating notes … [t]he fact that notes were generated for some fundings and not others is not sufficient, in and of itself, to recharacterize … the fundings as equity.”[10]
• Public Filings: The district court noted that “[t]he … notes were recorded as secured debt on SubMicron’s 10Q SEC filing and UCC-1 financing statements.”[11]

The court in SubMicron emphasized that “[n]o mechanistic scorecard suffices,” pointing out instead that “intent 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.

Demonstrating Intent

The insights from SubMicron are instructive. As the court points out, an inquiry into the question of recharacterization is, at least in part, an attempt to understand the intent of the parties. Therefore, funds should be careful with both documentation and conduct when providing funds to portfolio companies. Provided below are several examples of the types of documentation that may be found in a debt funding, along with illustrative content based on the themes articulated in SubMicron.

• Notes, Facility and Security Agreements: These documents memorialize a portfolio company’s borrowings and should clearly state the nature of the funding, amount of funding, interest rates, repayment dates, covenant terms and lender’s recourse in the event of default. These agreements should also specify the purposes for which funds may be used. As articulated in SubMicron, form is only an indicator of intent; the parties must act in a manner consistent with documented terms. Borrowers should make reasonable efforts to make timely payments of principal and interest, and lenders should take appropriate reasonable recourse when a borrower is delinquent, consistent with other borrowers, circumstances or industry norms. Because of disparities among the various circuits as to whether courts’ ability to recharacterize debt is controlled by state or federal law, parties should also give appropriate consideration to choice-of-law clauses when drafting all agreements.
• Books and Records of Lenders and Borrowers: In addition to transaction documents, funds should be able to rely on underlying accounting records of the borrowing portfolio company as well as their own to provide evidence of intent. Borrowers’ accounting records should include debt funding as “notes payable” or a similar classification reflecting that the funding is debt. Periodic disbursements to the lender should be recorded as interest expense and reduction to the note balance consistent with the terms of the note or facility, rather than as dividends charged against equity. The corresponding asset should be recorded by the lender as a “note receivable” with recognition of periodic interest income and scheduled amortization of the note balance. Conversely, fundings recorded by the lender as assets described as “Investment in Subsidiary/Portfolio Company” are likely to be construed to represent equity investments rather than lending arrangements.
• Company Filings and Disclosures: The borrowing portfolio company may be required by banks, the SEC and other regulatory authorities to provide periodic reports or disclosures of specific transactions or financing activities. These disclosures often contain financial statements and other disclosures identifying sources of financing. Consistent with the discussion of books and records above, Courts may look to the characterization of fundings in these disclosures as evidence of the parties’ intent. Financial statements, including the notes therein, UCC financing statements, business plans, etc., may all contain descriptions of the relevant fundings that may be indicative of intent.

Conclusion

Private-equity funds and their portfolio companies enter into a variety of financing arrangements in order to achieve investing and operational goals. Some arrangements are distinctly debt or equity, while others may contain attributes of both. When entering into such arrangements, funds and their portfolio companies should be aware of the risk of recharacterization challenges. Lending funds can look to the recharacterization analyses of courts, including SubMicron, to understand how courts evaluate the intent of the parties. By affording due attention to the form and substance of an arrangement, private-equity funds and other investors can help to ensure that their claims withstand recharacterization challenges.