District Judge Thomas M. Durkin of Chicago wrote an opinion laying out everything you need to know about recharacterization and equitable subordination.
The case involved a closely held company that had been historically profitable until the financial collapse in 2008. The company had a practice of distributing available cash to its owners, using a secured bank line of credit for liquidity.
The company needed additional outside capital because it was near default on the bank credit. The owners formed LLCs that made secured loans to the company in 2009 and 2011 that in part paid down the bank loan and kept the company afloat. In mid 2013, the company suspended payment on its existing unsecured trade debt and was thereby able to pay off the bank debt in full. The company filed bankruptcy in September 2014.
The trustee sued the insiders for recharacterization of the loans as equity and equitable subordination, among other things. After trial, the bankruptcy court found no basis to recharacterize but equitably subordinated the loans from the LLCs. The insiders and the trustee both appealed.
In his June 20 opinion, Judge Durkin upheld the decision on recharacterization but reversed on equitable subordination. He said that both theories raised questions of law to be reviewed de novo. He first addressed recharacterization, because there would be no debt to subordinate if the LLC’s claims were treated as equity.
Judge Durkin pointed out how the circuits are split on following federal or state law on recharacterization. He said it didn’t matter, because Illinois law has the same standards as Section 105, the authority used by courts employing federal law.
On recharacterization, Judge Durkin said the primary question is whether, in the words of the Third Circuit, “‘the parties called an instrument one thing when they in fact intended it as something else.’” Courts are most prone to recharacterize, he said, when there are no documents to support the creation of a loan and interest was not paid. Here, the loans were professionally documented and interest was paid, although at a rate about eight percentage points higher than the bank credit.
Extending the maturity dates was legitimate and not compelling evidence of equity, because calling the loan on maturity would have precipitated bankruptcy.
Adopting the trustee’s theory, Judge Durkin said, would result in recharacterization “for any purported loan from insiders of a financially struggling company.” He said that “insiders must be permitted to make loans to their company” when credit is not available elsewhere.
Judge Durkin upheld the bankruptcy court on recharacterization because the trustee had shown nothing more than the company’s financial distress and the insider status of the lenders.
On equitable subordination, Judge Durkin reversed, because the trustee had not shown inequitable conduct by the insiders. He cited the Seventh Circuit for the proposition that undercapitalization alone does not justify equitable subordination.
Endeavoring to show inequitable conduct, the trustee pointed to the company’s practice of distributing available cash to the owners and relying on the bank credit or the LLC’s loans for liquidity. He said that “hindsight criticism” of the business model did not amount to inequitable conduct, because the company “had successfully operated for many years distributing its excess cash” to the owners. Judge Durkin could not fault management because the business failed “only in the face of the worst economic recession in more than 70 years.”
Even if the company were insolvent when the LLCs made loans, Judge Durkin said the trustee would not have shown the breach of fiduciary duty necessary to underpin equitable subordination because the loans enabled the company to pay its creditors and pay down the bank debt. Indeed, he said, loans from the LLCs “ensured” that the company could pay trade creditors for four years before bankruptcy eventually occurred.
Likewise, keeping the company’s financial problems a secret from creditors was not inequitable conduct because a non-public company has no obligation to disclose.