This case should sufficiently concern private equity investors who extend secured credit, appoint a board member, are granted an option to purchase the business, and then foreclose and take over the business when the debtor–predictably–defaults.
In this 12/8/17 decision (In re Comprehensive Power, Inc., 2017 WL 6327192, Bankr. D. Mass), Judge Panos notes that the lender (“Moog”) moved to dismiss the Chapter 7 Trustee’s recharacterization / fraudulent transfer complaint because “it is merely a non-insider creditor that extended a loan to the Debtor after the parties executed financing documents memorializing the transaction, which included a security agreement granting Moog a security interest in substantially all assets of the Debtor.”
All Moog did, it argued, was enforce its rights as a secured creditor post-default under the transaction documents by accepting surrender of the collateral through a strict foreclosure and then credit bidding about 1/3 of its $6 million loan at a UCC sale. And sure, its board designee was funneling confidential information, but don’t private equity lenders always designate a board member precisely to ensure they get confidential information given the amount of the lender’s capital that is at risk? What’s wrong with that?
Well, Judge Panos found enough wrong with it to sustain all of the Trustee’s counts against the lender except for equitable subordination. He sustained the Trustee’s recharacterization count because 6 of 11 AutoStyle factors were present, stating:
Here, drawing reasonable inferences in his favor, the Trustee has pleaded sufficient facts in support of at least six of the recharacterization factors, sufficiently stating a plausible claim for recharacterization of Moog’s debt. While the Trustee admits that the names given to the documents align with traditional naming constructs for financial instruments, he argues that, overall, there were components of the transaction that revealed its true nature to be equity rather than debt. With respect to the recharacterization factors, the Trustee points to allegations relating to the presence or absence of a fixed maturity date and schedule of payments and the presence or absence of a fixed rate of interest and interest payments to support his contention that the terms of the instruments and circumstances of the transaction were “atypical.”
Specifically, the Trustee alleges: (i) Moog’s standard practice was to engage in acquisitions, not provide loans, thereby indicating that Moog was implementing a unique “loan-to-own” transaction rather than establishing a true lender-borrower relationship; (ii) monthly interest payments were outside of the norm; (iii) the Debtor could extend maturity if the option was not exercised by Moog in connection with the Option Agreement; and (iv) Moog obtained substantive rights in the context of the transaction which are not typically given to traditional lenders, such as the right to appoint a representative to the Debtor’s Board and an option to acquire the Debtor’s assets or stock. Compl. ¶¶ 24–26, 50.
With respect to the source of repayments, the Trustee alleges that parties contemplated that the Moog financing could be repaid through Moog’s acquisition of the Debtor’s assets or stock, which could potentially support a claim for recharacterization. Id. Exs. A–B. As to the adequacy or inadequacy of capitalization, the Trustee alleges that the Debtor was undercapitalized and/or insolvent during relevant times, including at the time of the Surrender Agreement. Id. ¶¶ 32–34. The Trustee supports the allegation that the Debtor was undercapitalized and/or insolvent by further alleging that the Debtor (i) suffered losses in 2012 and 2013 that would have bankrupted the Debtor if it did not receive cash advances; (ii) encountered cash flow problems just months after receiving “advances” from Becana and others; (iii) had “trouble keeping pace with payments owed to employees, vendors and others”; (iv) depleted the $6 million in funding received from Moog in just a few months; and (v) defaulted on obligations to Moog less than ten months after the financing transaction. Id. ¶ 49. Whether evidence supporting these allegations could contradict the Trustee’s theories regarding the value of the Debtor’s business at the time of the transactions with Moog is a consideration that is more appropriately addressed when the record has been developed.
Regarding the Debtor’s ability to obtain financing from outside lending institutions, the Trustee alleges that the Debtor encountered cash flow problems and required further cash only months after receiving $6 million from Moog, suggesting the Debtor would be unlikely to obtain a traditional loan because of its cash flow issues. Id. ¶¶ 49, 51. The Trustee further alleges that no sinking fund was available to the Debtor to provide repayments, which Moog acknowledges, but argues is a “neutral” factor with respect to recharacterization. Mot. ¶ 61.
In sum, taken together, the factual allegations and the inferences drawn in favor of the Trustee are sufficient to state a plausible recharacterization claim.
In sustaining the actual fraudulent transfer claims against the lender, he stated: