Restructuring

In yesterday’s edition of the Weil Bankruptcy Blog, we introduced Keywell, LLC (n/k/a SGK Ventures) and discussed the fraudulent transfer claims brought in an attempt to recover approximately $70 million in prepetition distributions made to Keywell’s equity owners.  Though ultimately unsuccessful on the fraudulent transfer actions, Keywell’s liquidating trustee also raised claims for recharacterization and equitable subordination, which are discussed in this second of a two-part post.  
Additional Background – The NewKey Loans
Immediately following the 2008 distribution, Keywell’s financial condition deteriorated severely and rapidly.  By the end of 2008, Keywell had breached a covenant in its loan agreement with Bank of America and found itself in need of additional liquidity.
To manage the immediate need for liquidity, Keywell offered to issue $20 million in additional equity to its existing equity holders.  Keywell, however, ultimately restructured the capital raise as a loan from a new entity – NewKey, LLC – which would be owned by all the current members of Keywell.  Briefly, the existing members capitalized NewKey with $12.7 million, and NewKey lent a portion of such capital to Keywell. This loan was secured and subordinated only to the Bank of America loan.  Ultimately, NewKey loaned only $3.5 million to Keywell, and the remaining funds were returned to the members of NewKey in 2009.
Keywell’s financial condition did not improve following the first NewKey loan and, in 2011, Keywell repeated the NewKey structure with a newly formed entity named NewKey Group II, LLC, which made a $5 million loan to Keywell.  Again, Keywell’s financial condition did not improve following the new injection of cash and, ultimately, Keywell filed for chapter 11 bankruptcy in September 2013.
To secure better recoveries for Keywell’s trade and other unsecured creditors, the Keywell liquidating trustee sought to recharacterize the NewKey loans as equity contributions instead of debt and, in the alternative, equitably subordinate the claims of the NewKey entities to Keywell’s unsecured creditors.
Recharacterization
The liquidating trustee claimed that recharacterization of the two NewKey loans from debt to equity was appropriate under both federal and state law.  The bankruptcy court disagreed.  It held that recharacterization is not a remedy available under the Bankruptcy Code and concluded that the facts of the case did not support a recharacterization claim under Illinois law.
Courts are split on whether an independent right to recharacterize a loan as equity exists under the Bankruptcy Code, as we have discussed in Tenth Circuit Declares “No Recharacterization Without Justification,” Time is Money: Conversion and Property of the Estate, Debt or Equity? Which Circuit? Recent Cases on Equitable Recharacterization, and If It Walks Like Equity and Talks Like Equity, It … Might Actually Be a Loan?  In finding that recharacterization is not available as an independent remedy under the Bankruptcy Code, the bankruptcy court highlighted that the Seventh Circuit has not followed other circuits in holding that bankruptcy courts have the equitable power to recharacterize debt as equity, and noted that the Seventh Circuit is not likely to do so in light of previous decisions and the United States Supreme Court’s decision in Law v. Siegel.
Recharacterization is, however, a remedy available under Illinois law.  The analysis of a claim for recharacterization is fact-driven and hinges on various factors, including whether the asserted loans were documented as such, whether there was an expectation of repayment, and whether principal and interest payments were required and made.  Based upon these factors, the court found that the NewKey loans were indeed debt because the loans were thoroughly documented, expected to be repaid, and required payment of interest (which was, in fact, paid).  That the loans originally were structured as equity contributions played no role under Illinois law with respect to recharacterization.
No recharacterization?  How about equitable subordination?
Section 510(c) of the Bankruptcy Code allows the bankruptcy court to subordinate all or part of an allowed claim to all or part of other allowed claim(s) under principles of equitable subordination.  The well-established factors for equitable subordination are (1) the party whose claim is allegedly subject to subordination engaged in inequitable conduct, (2) the party’s conduct caused harm to other creditors, and (3) the proposed subordination does not contravene any policies of the Bankruptcy Code.  The SGK liquidating trustee alleged that these principles supported the subordination of the claims associated with the New Key loans to the claims of all unsecured creditors.
Though dismissing certain of the liquidating trustee’s theories regarding why the NewKey loan claims should be subordinated, the court ultimately found that the NewKey loan claims should be subordinated.  Notably, though the court refused to find that Keywell was undercapitalized for purposes of the liquidating trustee’s fraudulent transfer claims, Keywell’s large distributions to its owners during the good times and leaving the company with insufficient equity to weather the bad times was viewed by the court as inequitable conduct.
Moreover, the court found the shift from a planned equity contribution to the ultimate execution of the NewKey secured loans inequitable, concluding that the large distributions had stripped trade creditors of the benefit of the equity cushion.
Finally, the court found that the complete secrecy surrounding Keywell’s finances was inequitable because Keywell’s trade creditors had no knowledge about the distributions to equity, the initial recapitalization plan, and the decision to instead issue secured debt, thus depriving the trade creditors of the knowledge necessary to adequately protect against subordination and the risk of default.
The court found that this conduct was sufficiently inequitable to satisfy the first element of the test for equitable subordination and also found that the other two elements had been satisfied.  Accordingly, where fraudulent transfer and recharacterization claims failed, the liquidating trustee was ultimately successful in improving the recoveries to unsecured creditors through the equitable subordination of the NewKey loan claims against Keywell.
Brenda Funk is an Associate at Weil Gotshal & Manges, LLP in Houston.