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Avoiding Recharacterization of Debt to Equity

Spring 2007Cole Schotz Docket

When an investor is asked to infuse capital or additional capital into a company, it is important that the cash infusion be treated as a loan, as opposed to an equity investment, in the event the company ultimately files a bankruptcy case.  Bankruptcy courts are frequently being called upon to recharacterize loans as equity interests, resulting in the total subordination of the investor’s claim to all other obligations of the company.  Recharacterization involves a determination of whether a debt actually exists, and requires no finding of inequitable conduct.  The chance of an otherwise valid loan being recharacterized can be minimized by structuring the cash infusion in accordance with some of the following basic criteria reviewed by the courts.  Courts review these factors on a case-by-case basis, no single factor is controlling and not all courts review every factor. 

First, the issuance of a bond, debenture, note or the existence of a lien securing the advance is indicative of a loan, whereas the issuance of a stock certificate in exchange for the cash infusion will more likely result in the advance being deemed an equity contribution.  The presence of a fixed maturity date, fixed interest rate and a fixed schedule for payments are also characteristic of debt obligations as opposed to equity.

If repayment of the obligation is not dependent upon the success of the business and the existence of corporate earnings but will be made from cash flow, the transaction will likely be deemed a loan rather than equity.  The presence of a sinking fund to provide repayment is also indicative of a loan, but the existence of a security interest may obviate the need for a sinking fund.  If the cash infusion is used for day-to-day working capital and not for the acquisition of capital assets, this too supports a finding that it is a loan.

Inadequate capitalization of the company is strong evidence of a capital contribution.  The determination of undercapitalization is highly factual and may vary substantially by industry and company.  Additionally, if the company is unable to borrow funds from other lending institutions at the time the cash infusion is made, the transaction is more likely to be deemed an equity interest.  However, it is unlikely that either inadequate capitalization or inability to borrow from other sources, alone, will result in recharacterization since it would prevent investors from loaning money to a company in financial distress.

If further advances are made by existing shareholders of a company in proportion to their respective stock ownership, the court is more likely to deem the investment as an equity contribution as well.  Finally, if an investor is given increased voting power or participation in the management of the company as a result of the cash infusion, courts will favor characterization of the obligation as equity, and not a loan.

While there is no foolproof way to avoid recharacterization, following these guidelines will certainly minimize the risk in the event of a future bankruptcy.

 

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