Weil, Gotshal & Manges
Source o repayments
. Some courtshave said that i the expectation o repayment depends solely on theborrower’s earnings, the transactionhas the appearance o a capitalcontribution.
Failure o the debtor to repay onthe due date or to seek postponement
. I the debtor simplyails either to repay the investmenton the nominal due date or to seekpostponement, some courts havesaid that the investment looks morelike a permanent capital contri-bution than a loan.
Identity o interest between thecreditor and the stockholder
. I stockholders make investments inproportion to their respectiveownership interests, the transactionhas the appearance o a capitalcontribution. In a requently citedrecharacterization case, abankruptcy court said that itconsidered “this to be the mostcritical actor in its determination”.
. The presence o a securityinterest and related documentationis strong indication o a loan andthe absence o security cutssomewhat in avor o a capitalcontribution.
Extent o subordination
. Thesubordination o an advance to theclaims o other creditors indicatesthat the investment was a capitalcontribution and not a loan.
Participation in management
. I the terms o the transaction give theinvestor the right to participate inthe management o the business,the investment is more likely to becharacterized as a capital contri-bution and not as a loan.
Treatment in the business records
.At least one court has said that themanner in which the investment istreated in the business records o the debtor is a actor that is relevantto the characterization issue.It is important to note that almost allthe reported decisions in whichbankruptcy courts have concluded thata right that the parties have called aclaim is in act an equity interest haveinvolved “loans” made to a debtor by acontrolling stockholder, director,ocer or other insider. However, thepossibility o recharacterization shouldnot by itsel discourage sponsors romlending money to their portoliocompanies as this remedy is not otensought by claimants or granted bybankruptcy courts and there are steps asponsor can take to reduce its risk.
Steps that Reduce Risk ofEquitable Subordination andRecharacterization Risk
There are some general guidelines thatsponsors can ollow to help minimizethe risk o equitable subordination orrecharacterization. The mostimportant guidance is to treat anysponsor loan to a portolio companyas i it is a third party loan beingprovided on customary market terms,including interest rate, paymentterms, ees and other terms. Theobvious challenge is ndingcustomary terms in an illiquid market.Also, the sponsor should take extracare to ensure that the proper internalgovernance procedures are ollowedby the portolio company to avoidany implication o misconduct,impropriety or control by the sponsor.To minimize subordination risk,sponsors should anticipate liquidityproblems as early as possible to allowtheir portolio companies toadequately consider alternatives. Thismeans avoiding any last minutedecisions where the only alternativeto an emergency unding transactionis a liquidation or bankruptcy. Also, apotent deense to any equitablesubordination claim is that theunsecured creditors were either notharmed or helped by the additionalnancing. Finally, an insider shouldavoid loaning money to any portoliocompany that the insider knows isundercapitalized or insolvent.Sponsors should take care to observethe ormalities typically associated withdebt transactions among unrelatedparties. Consideration should be givento the name o the instrument, whichshould indicate that the instrument isvalid, enorceable and is properevidence o indebtedness. I possible,the instrument should include xedinterest rates, xed maturity dates anddetailed payment schedule.Additionally, the instrument shouldinclude rights or the sponsor to enorcerepayment. Moreover, courts will notewhether the portolio company actuallymade the required payments aterexecution o the instrument and, i itdid not, what steps the sponsor took toenorce repayment.Ideally, any debt instrument shouldnot reerence any related equityownership or provide that the loan isprovided in respect o such equityownership. I possible, the debtshould be secured. I the debt isunsecured, the court will be morelikely to consider the investment to bedebt i the parties include a sinkingund or other similar mechanism inthe instrument.The sponsor should also make aneort to distinguish the investmentrom characteristics more commonlyassociated with equity investments.Repayment provisions that are tied tothe company’s perormance, especiallyi the advance is unsecured, willindicate to a court that the partiesintended the investment to be acapital contribution. To the extentpossible, the parties should make aneort to avoid having investmentsmade in perect proportion to thesponsors’ equity ownership. I