On July 24, 2012, the US Bankruptcy Court for the Western District of Pennsylvania held in In re Shubh Hotels Pittsburgh, LLC that funds advanced from a creditor to a debtor must be recharacterized as equity contributions despite the creditor's testimony claiming an intent to classify the transfer as a loan. This ruling provides guidance to parties looking to maximize the likelihood that a bankruptcy court would construe a particular transfer as debt rather than an equity contribution. Courts will ultimately look at all reasonable inferences derived from the facts as they existed at the time of the transaction regardless of the intent of the parties at the time of bankruptcy.

The primary question before the court was whether certain prepetition funds transferred to the debtor should be characterized as debt or equity contributions. If the funds were characterized as debt, the creditor would receive payments on its claim against the debtor's bankruptcy estate pari passu with other similarly situated unsecured creditors. If the funds were characterized as equity contributions, the creditor would receive payments on its claim only after all creditors received full payment on their claims.

Atul Bisaria was the sole managing member of creditor Shubh Hotels, LLC. Bisaria also held interests in various other hotels and transferred funds between these interests.

The debtor, Shubh Hotels Pittsburgh, LLC (transferee), was a limited liability company consisting of two members, Shubh Hotels Pittsburgh Investments, LLC and Shubh Hotels Pittsburgh Acquisitions, LLC. Bisaria held an ownership/equity interest in each of these companies. On September 7, 2010 the debtor filed a voluntary petition for Chapter 11 bankruptcy relief.

Shubh Hotels, LLC (transferor) filed a proof of claim against the debtor asserting a general unsecured claim for $15,227,670.09 for "Loans to corporation," but attached only a list of funds transferred in and out of the debtor's accounts. Certain proponents of the debtor's plan of reorganization (plan proponents) filed motions for summary judgment, alleging that there was no issue of material fact that the transferred funds were equity contributions made to the debtor.

The bankruptcy court followed US Court of Appeals for the Third Circuit precedent in examining the intent of the parties at the time of the transaction to determine whether transferred funds should be treated as debt or equity (see In re SubMicron Sys. Corp., 432 F.3d 448 (3d Cir. 2006)). Rather than giving undue weight to labels, a court may infer intent from a party's actions, the text of its contracts and the economic reality of the surrounding circumstances. Additionally, Third Circuit courts look to the following factors in making a debt versus equity determination, including:

In this case:

Additionally, the debtor lacked adequate capitalization at the time of the transfers in question. Characterizing the transferred funds as debt would have required the debtor to have a substantial amount of "negative capital" at the time of the transaction (which arises when current liabilities outweigh current assets). Moreover, the bankruptcy court recognized that the debtor's inadequate capitalization at the time of the transfers combined with its failure to even attempt to obtain financing from an unrelated source weighed against characterization of the transfers in question as a loan.

The transferor argued that because it received no ownership interest in exchange for the funds, the funds could not be characterized as a capital contribution. However, the bankruptcy court reasoned that the identity-of-interests test weighs strongly against a debt characterization where an individual maintains an interest in both the transferor and the transferee. In this case, Bisaria testified that he was in control of both the transferor and transferee. Therefore an equity characterization was appropriate despite the fact that the transferor, Shubh Hotels, LLC, did not receive additional equity in the transferee, Shubh Hotels Pittsburgh, LLC, as a result of the transfer.

In examining all of the relevant factors, the bankruptcy court found that all reasonable inferences supported a finding that the funds claimed by the transferor were more accurately characterized as an equity contribution than as debt. The court granted the plan proponents' motion for summary judgment, holding that the unsupported and often contradictory testimony of Bisaria was insufficient to support his assertion that the transfers should be characterized as debt.

This case provides guidance to parties looking to maximize the likelihood that a court would characterize transfers between them as debt or equity based on the factors listed under Recharacterization of Debt as Equity. A transferor of funds looking to increase the possibility that a court would characterize a particular transfer as debt and not equity should look to the above referenced factors and ensure that as many of them as possible are present in the transaction. Ultimately a court will look at all reasonable inferences derived from the facts as they existed at the time of the transfer regardless of the wishes of the parties. For a more in depth discussion of the relevant debt versus equity factors, see Practice Note, The Risk of Debt Recharacterization in Bankruptcy.