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:

 The Trustee generally alleges that all payments and transfers of property to Moog are avoidable as having been actually fraudulent, focusing his specific allegations on the transfer of the Debtor’s assets at the secured party sale, facts and circumstances from which the Court could draw an inference that Moog’s intent should be imputed to the Debtor and that Moog intended to transfer assets to hinder delay or defraud the Debtor’s creditors. Specifically, the Trustee alleges that “by October 2013,” presumably at or after the time the Debtor executed and delivered the Surrender Agreement, Moog had assumed “pervasive and full control of the Debtor.” Compl. ¶¶ 33, 37. The Trustee further alleges that the Moog-installed director acted for Moog’s benefit and undertook efforts to extract value from the Debtor for Moog, such that there some connecting allegations that would enable the Court to impute Gartland and Moog’s collective intent to the Debtor in order to demonstrate the Debtor’sactual intent to hinder, delay, or defraud creditors. Id. ¶¶ 27–33, 36–37, 45–47; cf. In re Roco Corp., 701 F.2d 978, 984 (1st Cir. 1983)(finding fraudulent intent of stockholder may be imputed to debtor-transferor in context of stock redemption transaction because as the company’s president, director, and sole shareholder, stockholder was in a position to control the disposition of the debtor’s property).

The Trustee alleges generally that Moog engaged in a “loan to own” strategy to acquire all of the Debtor’s ongoing business and its advantageous relationships for less than fair value without paying the Debtor’s creditors. Compl. ¶¶ 32–47. The Trustee also alleges that the Debtor’s directors abdicated their responsibilities and breached their duties in authorizing the execution and delivery of the Surrender Agreement and thereby “the Debtor had all but ensured that Moog would consolidate its control over the Debtor.” Id. ¶¶ 33–36. Taken together, with reasonable inferences drawn in his favor, the Trustee has alleged sufficient facts to state a plausible claim that Moog’s intent should be imputed to the Debtor through its “control” and that the Debtor was complicit in the transfer of its assets in relinquishing rights and facilitating a purported secured party sale. While it is unclear whether the Trustee will be able to prove these claims or the related “alter ego” theory pursued under Count X of the Complaint, the Trustee has at least met the pleading standard for these claims. Accordingly, the Court denies the Motion as to the § 548(a)(1)(A) count (Count III) and related state law count (Count V) of the Complaint.

And in sustaining the Trustee’s allegation that the lender violated Article 9 of the UCC, the Court stated:

 The Trustee has pleaded sufficient facts to support a claim under Article 9 of the UCC, including that: (i) Moog did not employ a process intended to generate a reasonable sale price and the sale price obtained was substantially less than that which the parties had previously valued the Debtor’s assets and less than the assets would have been appraised for if an appraisal conducted; (ii) Moog conducted the auction sale as a formality to consolidate its control the Debtor’s assets; (iii) Moog failed to adequately market the property; (iv) Moog was the sole bidder at a sale conducted on only fourteen days’ notice and other potential purchasers were deprived from acquiring the Debtor’s assets; and (v) Moog deprived the Debtor of six-month “runway” to obtain alternative financing and the Debtor was damaged as a result. Compl. ¶ 95.
Happy hunting, and thanks for reading!
© Steve Jakubowski 2017