Private Equity Alert

September 2009
Equitable (In)subordination − Considerations for
Weil News
Sponsors Lending to Portfolio Companies
Weil Gotshal advised eTelecare
n
By Ron Landen (ronald.landen@weil.com), Rose Constance
and its controlling stockholders,
(rose.constance@weil.com) and Joe Basile (joseph.basile@weil.com)
Providence Equity Partners and
Ayala Corporation, in connection
with the business combination Private equity sponsors are increasingly providing additional capital to their
of eTelecare with Stream Global portfolio companies either to address liquidity issues at those companies or as part
Services of a negotiated debt restructuring. From a sponsor’s point of view, it is often
Weil Gotshal advised Macquarie
n preferable to invest that additional capital in the form of debt rather than equity.
Group in connection with its $428 However, in structuring that transaction sponsors should be aware that the priority
million acquisition of Delaware of this debt in a portfolio company’s capital structure could be attacked by other
Investments, a diversified asset
creditors if that portfolio company ends up in bankruptcy under the theories of
management firm
equitable subordination or recharacterization. It is important that sponsors
Weil Gotshal advised CCMP
n
structure any such investments to reduce the risk of a successful attack on the
Capital and Bancroft Private
Equity in connection with the priority status of their debt.
€250 million sale of Nowaco to
Bidvest Equitable Subordination
Weil Gotshal advised GMT
n Section 510(c) of the Bankruptcy Code provides that bankruptcy courts may
Communications Partners on exercise principles of equitable subordination to subordinate all or part of one
the acquisition of the Roadside
claim to another claim. Conceptually, this gives the bankruptcy court power to
Assets of Titan Outdoor Adver-
demote a higher priority claim to a lower priority claim under certain circum-
tising Limited
stances. In some instances, this can convert an otherwise first priority secured
Weil Gotshal advised HM Capital
n

in connection with its acquisition

of Earthbound Farms
Weil Gotshal advised Showtime
n
Arabia and its parent Kipco Group
in connection with its merger
with Orbit Group, creating the
leading pay-TV platform in the
Middle East and North Africa
claim into a general unsecured claim ranking pari passu with all other general
unsecured claims. Although the statutory authority for equitable subordination is
clear, the application is not. However, there are some general principles that can
be applied as a guide in properly structuring a credit arrangement.
Generally, the courts consider three factors in determining whether to equitably
subordinate a claim. These factors are (i) whether the creditor was engaged in
inequitable conduct, (ii) whether the misconduct injured other creditors or gave
an unfair advantage to the creditor in question and (iii) whether subordination
would be consistent with the provisions of the Bankruptcy Code. Importantly,
insiders are typically held to a higher standard than are unaffiliated third party
lenders because insiders often have (and exercise) influence over management of
the company. This means that a sponsor who is also an equity holder needs to
use extra caution when loaning money to a portfolio company. The misconduct
of a creditor does not need to be tied to such creditor’s claim – it can arise out of
other actions by the claimant. In an equitable subordination analysis, the court
considers whether a creditor engaged in inequitable conduct and applies subordi-
nation as a remedy only to the extent necessary to counteract any damage to
other creditors.


Private Equity Alert September 2009
The recent bankruptcy case involving
Schlotzky’s, Inc. provided a good
illustration of how courts apply these
principles. In that case, the two
largest shareholders each made
separate loans to the company in an
effort to resolve a liquidity crisis. The
first loan was secured by substantially
all of the company’s intellectual
property and was structured on arms-
length terms. The second loan, made
seven months later, was secured by
the same collateral package; however,
the bankruptcy court more closely
scrutinized this transaction because it
was approved in a hurried, last
minute board meeting where
management reported that the
company could not make payroll
payments without the loan.
Sponsors should structure loans to portfolio companies to
minimize the risk that other creditors could attack the priority
of those loans under the theories of equitable subordination
or recharacterization.
In pursuing the equitable subordi-
nation claim, the unsecured creditors
of the company attempted to show
that the loans contributed to a
deepening insolvency of the company
(see the August 2008 issue of Private
Equity Alert for further discussion of
this legal theory). The bankruptcy
court found that both loans should be
subordinated, holding that the
inequitable conduct consisted of a
combination of the last minute board
meeting in which no alternatives were
discussed (even though all non-
interested directors approved the
loan), a very favorable security
package and a modification of the
shareholders’ personal guarantees.
The bankruptcy court’s failure to
conclude that the loans resulted in
harm to the unsecured creditors led to
a reversal of the bankruptcy court on
the second loan. The Court of
Appeals concluded that because the
proceeds of the second loan were used
to pay unsecured creditors and
equitable subordination is remedial,
not penal, equitable subordination
was not appropriate. As to the first
loan, the Court of Appeals ruled that
there was no evidence of misconduct,
so that loan also should not have
been subordinated.
Recharacterization
Recharacterization of a claim occurs
where a bankruptcy court uses its
equitable powers under Section 105 of
the Bankruptcy Code to convert an
otherwise valid debt claim into an
equity interest. Recharacterization is
a highly unusual remedy, but that
does not mean that sponsors can
ignore the risk that their loans may be
recharacterized as equity. The
recharacterization analysis differs
from that of equitable subordination
in that it considers whether or not an
investment is actually equity instead
of debt. If the answer is yes, then the
effect of the recharacterization is to
subordinate the investment to all
other valid debtor claims and to
provide for repayment of the
investment only to the extent that
there is recovery to equityholders.
Although some courts have taken the
position that bankruptcy courts lack
the power to recharacterize debt
claims as equity interests, the
majority of courts that have
considered the question have deter-
mined that bankruptcy courts may, in
the exercise of their inherent powers
as courts of equity and the powers
granted by Section 105 of the
Bankruptcy Code, recharacterize debt
claims as equity interests.
Courts that consider themselves to
have the power to recharacterize debt
claims as equity interests will exercise
that power when, despite the label
placed by the parties on the particular
transaction, the “true nature” of the
transaction is, in the court’s view, the
creation of an equity interest. In
pursuing the quest to find the “true
nature” of a transaction, most
bankruptcy courts apply a multi-factor
test where no single factor is determi-
native. The factors normally
considered by courts include the
following:
n Undercapitalization. Many courts
view thin or inadequate capital-
ization as strong evidence that
investments are in fact capital
contributions rather than loans.
n Inability to obtain similar outside
financing. Difficulty in obtaining
outside financing on similar terms
or off-market credit terms may lead
to a determination that the
financing was in fact a capital
contribution rather than a loan.
n Presence or absence of fixed terms
and obligations and ability to
enforce payments. The absence of a
fixed maturity date, interest rate
and obligation to repay principal
and interest at fixed times is an
indication that the investments
may be capital contributions and
not loans. Similarly, if the
instrument does not entitle the
holder to enforce payment of
principal and interest when due, the
investment is more likely to be
characterized as a capital contri-
bution and not as a loan. Loans
that require a sinking fund or are
structured as a demand note
payable upon the holders’ request
are more likely to be treated as debt
and not equity.
Weil, Gotshal & Manges llp 
Private Equity Alert September 2009
n Source of repayments. Some courts
have said that if the expectation of
repayment depends solely on the
borrower’s earnings, the transaction
has the appearance of a capital
contribution.
n Failure of the debtor to repay on
the due date or to seek
postponement. If the debtor simply
fails either to repay the investment
on the nominal due date or to seek
postponement, some courts have
said that the investment looks more
like a permanent capital contri-
bution than a loan.
n Identity of interest between the
creditor and the stockholder. If
stockholders make investments in
proportion to their respective
ownership interests, the transaction
has the appearance of a capital
contribution. In a frequently cited
recharacterization case, a
bankruptcy court said that it
considered “this to be the most
critical factor in its determination”.
n Security. The presence of a security
interest and related documentation
is strong indication of a loan and
the absence of security cuts
somewhat in favor of a capital
contribution.
n Extent of subordination. The
subordination of an advance to the
claims of other creditors indicates
that the investment was a capital
contribution and not a loan.
n Participation in management. If
the terms of the transaction give the
investor the right to participate in
the management of the business,
the investment is more likely to be
characterized as a capital contri-
bution and not as a loan.
n Treatment in the business records.
At least one court has said that the
manner in which the investment is
treated in the business records of
the debtor is a factor that is relevant
to the characterization issue.
It is important to note that almost all
the reported decisions in which
bankruptcy courts have concluded that
a right that the parties have called a
claim is in fact an equity interest have
involved “loans” made to a debtor by a
controlling stockholder, director,
officer or other insider. However, the
possibility of recharacterization should
not by itself discourage sponsors from
lending money to their portfolio
companies as this remedy is not often
sought by claimants or granted by
bankruptcy courts and there are steps a
sponsor can take to reduce its risk.
Steps that Reduce Risk of
Equitable Subordination and
Recharacterization Risk
There are some general guidelines that
sponsors can follow to help minimize
the risk of equitable subordination or
recharacterization. The most
important guidance is to treat any
sponsor loan to a portfolio company
as if it is a third party loan being
provided on customary market terms,
including interest rate, payment
terms, fees and other terms. The
obvious challenge is finding
customary terms in an illiquid market.
Also, the sponsor should take extra
care to ensure that the proper internal
governance procedures are followed
by the portfolio company to avoid
any implication of misconduct,
impropriety or control by the sponsor.
To minimize subordination risk,
sponsors should anticipate liquidity
problems as early as possible to allow
their portfolio companies to
adequately consider alternatives. This
means avoiding any last minute
decisions where the only alternative
to an emergency funding transaction
is a liquidation or bankruptcy. Also, a
potent defense to any equitable
subordination claim is that the
unsecured creditors were either not
harmed or helped by the additional
financing. Finally, an insider should
avoid loaning money to any portfolio
company that the insider knows is
undercapitalized or insolvent.
Sponsors should take care to observe
the formalities typically associated with
debt transactions among unrelated
parties. Consideration should be given
to the name of the instrument, which
should indicate that the instrument is
valid, enforceable and is proper
evidence of indebtedness. If possible,
the instrument should include fixed
interest rates, fixed maturity dates and
detailed payment schedule.
Additionally, the instrument should
include rights for the sponsor to enforce
repayment. Moreover, courts will note
whether the portfolio company actually
made the required payments after
execution of the instrument and, if it
did not, what steps the sponsor took to
enforce repayment.
Ideally, any debt instrument should
not reference any related equity
ownership or provide that the loan is
provided in respect of such equity
ownership. If possible, the debt
should be secured. If the debt is
unsecured, the court will be more
likely to consider the investment to be
debt if the parties include a sinking
fund or other similar mechanism in
the instrument.
The sponsor should also make an
effort to distinguish the investment
from characteristics more commonly
associated with equity investments.
Repayment provisions that are tied to
the company’s performance, especially
if the advance is unsecured, will
indicate to a court that the parties
intended the investment to be a
capital contribution. To the extent
possible, the parties should make an
effort to avoid having investments
made in perfect proportion to the
sponsors’ equity ownership. If
Weil, Gotshal & Manges llp 
Private Equity Alert September 2009
accurate, the instrument should also
make clear that the investment is
intended to finance the company’s
daily operating expenses, as opposed
to the purchase of capital assets,
which courts consider a purpose more
indicative of an equity contribution.
Additionally, the instrument should
not grant management or other rights
to control the operations of the
business to the sponsor.
Even where the parties involved are
not insiders, these principles may be
applied. A recent bankruptcy court
case applied the remedy of equitable
subordination to a secured $232
million claim by Credit Suisse against
the estate of Yellowstone Mountain
Club. The court found that although
Credit Suisse was not an affiliate of
Yellowstone (which is typically the
case when equitable subordination is
applied), the court found a level of
misconduct sufficiently egregious to
warrant subordination of Credit
Suisse’s claim. According to the court,
Credit Suisse’s desire for lending fees
contributed significantly to the
demise of Yellowstone. Although this
appears to be an unusual ruling, it
emphasizes that all creditors should
be cognizant of the risks involved and
take steps to mitigate those risks.
Conclusion
In the current environment, it is
increasingly likely that sponsors may
consider lending money to struggling
portfolio companies. With some
additional care and consideration, a
sponsor’s risk of its debt claim being
equitably subordinated or recharac-
terized as equity can be reduced
significantly. Since each of these
remedies is in furtherance of the
court’s equitable powers, however, the
court still has ultimate discretion over
whether to employ these remedies for
the benefit of other creditors.
Letters of Intent and Avoiding the Unintended
By Michael Szlamkowicz (michael.szlamkowicz@weil.com) and Alex Radetsky
(alex.radetsky@weil.com)
Letters of intent or memoranda of
understanding are frequently used in
private equity transactions to
evidence the preliminary under-
standing of a potential transaction
before the parties commit significant
time and resources to the transaction.
Often such documents are prepared
and negotiated by deal professionals
based on the precedent from the last
deal or another similar deal with
limited or no review by outside
counsel. A recent case suggests that
this approach is not without risks and
that careful drafting of letters of
intent and memoranda of under-
standing is important.
In the case of Vacold LLC v. Cerami, a
decision by the United States Court of
Appeals, 2nd Circuit, the court held
that some preliminary agreements,
such as letters of intent or memoranda
of understanding, may bind the
parties and require them to complete
the contemplated transaction even if
the parties are unable to reach
agreement on definitive documents
for the transaction. The court
considered the language of the
agreement, the context of the negotia-
tions between the parties, and the
existence of open terms in deter-
mining whether the preliminary
agreement in question was binding on
the parties. The court concluded that
a preliminary agreement that clearly
manifests the intention of the parties
to be bound will obligate the parties
to fully proceed with the transaction.
The court presented several factors
that, if present, could result in a
preliminary agreement binding the
parties to complete the transaction,
including:
n the failure to draft an expressed
reservation of the right not to be
bound in the absence of a definitive
written agreement;
n the partial performance of the
agreement;
n the parties reaching agreement on
all of the material terms of the
transaction; and
n the transaction is the type that is
usually committed to a more formal
and definitive agreement.
As a result, when drafting a letter of
intent, memorandum of under-
standing or other similar preliminary
agreement it is imperative for private
equity sponsors to always consider that
such an agreement may bind them to
more than they may have intended if
they are not vigilant when negotiating
and drafting the documentation.
The following are tips for private
equity sponsors to consider when
preparing letters of intent,
memoranda of understanding or other
similar documents in order to mitigate
the risk that they will become bound
to complete a transaction when it was
not the sponsor’s intention to do so:
n Use unambiguous language for the
title of the document. Use a title
for the preliminary agreement
containing words such as proposal,
letter of intent or memorandum of
understanding. A document entitled
“letter agreement” may be inter-
preted as manifesting the intent of
the parties to be bound. However,
one should not rely alone on the
title of a document to manifest the
intent of the parties not to be
bound by such agreement.
Weil, Gotshal & Manges llp 
Private Equity Alert September 2009

n Include a conspicuous disclaimer that the document is not intended to be Beijing

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should indicate that the understandings contained therein are for discussion James Westra
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respect to certain provisions which the parties may intend to be binding, such as Budapest
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Letters of intent, memoranda of understanding and similar preliminary documents
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David Aknin
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Karel Muzikar
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