In re Borger Hospitality: Bankruptcy Court Declines to Recharacterize Transfers from Insider as Equity Despite Lack of Documentation

Practical Law Legal Update 1-547-1626 (Approx. 5 pages)

In re Borger Hospitality: Bankruptcy Court Declines to Recharacterize Transfers from Insider as Equity Despite Lack of Documentation

by Practical Law Finance

Background

In 2006, Harish Patel (Patel) and another individual formed Borger Hospitality, Inc. (Debtor), which was created to construct and operate two hotels in Texas. The Debtor's stock was primarily held by members of the Patel family and members of the Stiles family. The Stiles family made both capital contributions and loans to the Debtor.

In 2009, the Debtor owed a general contractor and a bank about $274,000 for the work performed on and financing of one of the hotels. The Debtor had no available funds to make this payment and was unable to obtain additional traditional loans. Patel signed checks on behalf of New Fredericksburg, Inc. (NFI), a company owned by the Patel family, transferring:

$100,000 to a general contractor on July 10, 2009.
A $64,000 interest payment to a bank on July 30, 2009.
$110,000 to the general contractor on September 11, 2009.

These transfers (NFI Transfers) were carried as "Shareholder Loans" and as a note payable by the Debtor on the Debtor's books, even though NFI was not a shareholder of the Debtor. The NFI Transfers:

Were not supported by any documentation.
Did not state a time for repayment, an interest rate or any other terms of repayment.
Were not authorized by formal resolutions.

The Debtor filed for bankruptcy on March 12, 2010. On July 14, 2010, Patel filed a proof of claim on behalf of NFI asserting an unsecured claim for $274,000 based on the NFI Transfers (NFI Claim). In their capacity as creditors of the Debtor, the Stiles family objected to the NFI Claim, arguing that the NFI Transfers should be recharacterized as investments or capital contributions subject to subordination, primarily because of the lack of supporting documentation.

On May 21, 2013, the Bankruptcy Court held a hearing to rule on this objection to the NFI Claim. Patel testified that:

The NFI Transfers were short-term loans by NFI to the Debtor.
Because the Debtor was unable to obtain additional, traditional loans to pay the general contractor and the bank, it asked shareholders common to the Debtor and NFI for funding. The shareholders agreed to do so only on the condition that they would be repaid.

Outcome

The Bankruptcy Court overruled the Stiles objection. It ruled that, based on the preponderance of the evidence, NFI was a general unsecured creditor and allowed the NFI Claim as a general unsecured claim.

The Bankruptcy Court noted that in the Fifth Circuit, a bankruptcy court can recharacterize a claim as an equity interest if it does so according to applicable state law. Therefore, the Bankruptcy Court applied a 16-factor test used by Texas courts in federal tax law cases, which includes the following factors:

The intent of the parties.
The identity between creditors and shareholders.
The extent of participation in management by the holder of the instrument.
The ability of the corporation to obtain funds from outside sources.
The formal indicia of the arrangement.
The voting power of the holder of the instrument.
The presence or absence of a fixed maturity date.

(See Fin Hay Realty Co. v. United States).

The Bankruptcy Court also considered the following additional factors adopted from a 13-factor test and an 11-factor test, respectively:

The name given to the instrument evidencing the transaction (if any) (see Estate of Mixon v. United States).
The right to enforce payment of principal and interest (see Jones v. United States).

The Bankruptcy Court stressed that it reviewed the evidence in light of all factors "while realizing that the various factors are not of equal significance and that no one factor is controlling."

The Bankruptcy Court also noted that the Bankruptcy Code's subordination provisions arise from creditors' and investors' basic expectations regarding the solvency or insolvency of the enterprise with which they are dealing. Creditors rely on the equity provided by investors and, if a company does well, they expect only to be repaid their debt. On the other hand, investors seek to share in the profits to the exclusion of creditors. However, investors bear the risk of insolvency.

Next, the Bankruptcy Court considered that the following factors weighed in favor of a finding that the NFI Transfers should be recharacterized as equity:

The lack of documentation evidencing the NFI Transfers.
The Debtor was in financial need at the time of the NFI Transfers.
The Debtor had no available capital.
The risk of the "loans" was great.
The terms of repayment were unspecified.

However, the Bankruptcy Court concluded that, based on the preponderance of the evidence, NFI was a general unsecured creditor. Instead of strictly applying any of the multi-factor recharacterization tests, the Bankruptcy Court held that the facts of this case "subsume the factor-driven analysis" because:

The NFI Transfers flowed by check directly to the Debtor's general contractor and lender.
Equity interests were never issued to NFI.
The NFI Transfers were treated on the Debtor's books as notes payable.
The Debtor did not transfer or purport to transfer any equity interest to NFI.
The NFI Transfers occurred when the Debtor was in dire need of funds, which explains the informal nature of the transfers.

Practical Implications

The unexpected result in Borger Hospitality serves as a reminder that recharacterization disputes are unpredictable because courts may view the various multi-factor tests as guidelines rather than as tests to be strictly applied to determine the economic reality of a transaction. While insider status and undercapitalization alone are generally insufficient to support a claim for debt recharacterization, belated, unconventional or inadequate loan documentation is the most common factor present in cases where courts have recharacterized debt as equity. Therefore, it is surprising that the Bankruptcy Court denied recharacterization, despite the fact that the case involved an insider lender, an undercapitalized borrower and no documentation evidencing the transactions.

This decision also follows the US Court of Appeals for the Fifth Circuit's decision in In re Lothian Oil, Inc., in which it ruled that debt recharacterization is based on the bankruptcy courts' authority to allow and disallow claims, which turns on whether state law classifies the interest as debt or equity (see Legal Update, In the Matter of Lothian Oil, Inc., Fifth Circuit Rejects Per Se Rule that Claim Recharacterization Applies Only to Insiders). This is in contrast to the majority view that debt recharacterization is within the bankruptcy courts' equitable powers.

For more information on debt recharacterization, see Practice Note, The Risk of Debt Recharacterization in Bankruptcy).

In re Borger Hospitality: Bankruptcy Court Declines to Recharacterize Transfers from Insider as Equity Despite Lack of Documentation | Practical Law