In re SGK Ventures, LLC: Debt Investment Equitably Subordinated, Not Subject to Avoidance or Recharacterization

Practical Law Legal Update w-001-1746 (Approx. 8 pages)

In re SGK Ventures, LLC: Debt Investment Equitably Subordinated, Not Subject to Avoidance or Recharacterization

by Practical Law Bankruptcy & Restructuring and Practical Law Finance

Background

Prior to its Chapter 11 bankruptcy, debtor Keywell, LLC (Keywell) engaged in purchasing scrap metal, primarily stainless steel, as an intermediary in the metal recycling business. Keywell's business was dependent on two factors:

The price of stainless steel, which was largely dependent on the price of nickel.
The volume of its sales compared to its purchases.

Generally, as nickel prices decreased, Keywell's profits declined. Conversely, when nickel prices increased, Keywell's profits rose. Keywell could have limited the cyclical nature of its business by hedging the price of nickel, but chose not to do so.

Keywell's profit was also largely dependent on its sales volume and how long it held inventory (how much scrap it purchased compared to how much it sold over a given period of time). Longer holding periods would magnify the effects of nickel price fluctuations while shorter holding periods would minimize the effect. Therefore, as nickel prices rose, Keywell would strive to hold inventory longer to maximize profits, and as nickel prices fell, it strove to sell inventory more quickly to minimize losses.

Keywell held little cash on hand, with funding for new purchases and operations largely coming from its substantial revolver facility.

Through the beginning of 2008, Keywell's business thrived. However, with the financial crisis of 2008, nickel prices dropped, and Keywell's success faltered. Eventually, on September 24, 2013, Keywell was eventually forced to file for Chapter 11 bankruptcy.

From its profitable year in 2007 to its eventual demise, Keywell engaged in five transactions that were eventually called into question by the Chapter 11 trustee, which included:

A special distribution in May 2007 of almost $40 million. The distribution was consistent with Keywell's practice of distributing virtually all of its net income to its members during profitable periods of increasing nickel prices. However, Keywell did not have the necessary cash on hand for the distribution and instead renegotiated its existing financing agreements to fund the distribution by both increasing its revolver amount and taking out a $25 million term loan. Depending on the accounting method used, this resulted in a June 2007 balance sheet showing either:
- net liabilities of nearly $8.5 million, if Last In First Out (LIFO) accounting methods were used; or
- net equity of $54.5 million if First In First Out (FIFO) inventory accounting methods were used.
While cash reserves remained low, the company had $65 million available under its revolver, and the expert witnesses for both the defense and trustee agreed that Keywell's assets well outweighed its liabilities as a going concern.
A 2008 tax distribution of $29.3 million. Although Keywell was organized as a pass-through tax entity and the distribution was part of Keywell's ongoing policy of automatic tax distributions, this specific distribution was not necessary to cover any member taxes at the time.
Both experts opined that Keywell's assets continued to outweigh its liabilities after the distribution. However, due to falling nickel prices, the financial health of Keywell continued to deteriorate and in October 2009, Keywell's CEO stated that, on account of certain factors, including the distributions, Keywell was significantly undercapitalized based on industry benchmarks. Despite this, Keywell was able to continue paying its debts and trade creditors as they became due from the funds available to it under its revolver.
A loan made by NewKey Group LLC (NewKey) to Keywell in 2009 (the NewKey I Loan). In 2008, Keywell's financial condition continued to suffer, and it required additional funds to continue its operations. However, without a capital infusion, Keywell could not secure further bank financing due to its failing financial condition. Initially, Keywell's management considered funding in the form of a preferred stock purchase, offered in proportion to existing equity shares, and sent an offering memorandum to its members. However, upon realizing that its additional contributed capital could immediately be forfeited to creditors if its bank revolver was not extended, Keywell's management cancelled the offering memorandum and opted instead to structure the capital infusion as subordinated unsecured debt. This would allow its members to recover newly invested funds on par with other unsecured creditors instead of as equity holders.
To issue the debt to Keywell, Keywell's members organized NewKey, an entity capitalized with $12.7 million, contributed in proportion to each member's interest in Keywell.
However, when NewKey actually lent Keywell the $3.5 million required to secure extended bank financing, that debt was secured by a second lien on Keywell's assets. In the event of bankruptcy, this would allow the NewKey members to recover funds before the unsecured creditors. In other respects, the debt closely resembled the previously proposed preferred stock investment. A portion of NewKey's capitalization was also returned to its members.
A loan made by NewKey II, LLC to Keywell in 2011 (NewKey II Loan). While Keywell's financial prospects had improved by the middle of 2009, it was estimated that Keywell still required an additional $25 million to overcome its undercapitalization. Its improved outlook prompted interest from outside investors, but Keywell opted instead to use the remainder of NewKey I's capitalization to fund a preferred share purchase in Keywell. However, due to changed circumstances at the end of 2009, even with the new equity infusion, Keywell finished 2009 with a net operating loss, negative membership equity, and poor financial ratios compared to industry benchmarks.
By October 2010, Keywell's poor financial condition had triggered an event of default in its bank lending documents that required Keywell to report its fixed charge covenant on a monthly basis. Keywell failed to meet this covenant in both June and September of 2011.
To cover Keywell's continued financial difficulty, Keywell's members set up a new lending entity, Keywell II, through which Keywell's members could offer additional funding for the company in the amount of $5 million. The NewKey II loan documents were substantially similar to the NewKey I documents, offering secured subordinated loans. Although the company planned to use the funds for expanded operations, the company was required to use them to pay down its revolver to free up additional operating cash. This was necessary, as Keywell continued to suffer operating losses and shortly thereafter, Keywell had availability under its revolver of less than it had raised through Keywell II.
The Lozier 2013 loan. In 2012, Keywell suffered a net loss of $6 million. In early 2013, Keywell's financial condition continued to deteriorate and the company had, according to the bank loan officer, only $50,000 available under its revolver (Keywell management disputed this number, but acknowledged that the amount available was low). This prompted Lozier, the CEO of Keywell's management company and the president of Keywell itself, to make a bridge loan to Keywell. Initially, Lozier offered a subordinated unsecured note with a term of two weeks, which was approved by the bank officer. When consummated three days later, the $1 million loan was instead a secured subordinated loan with a term of 30 days. The security agreement referenced in the loan was executed two days after the loan proceeds were advanced to Keywell.

At all times, Keywell's members were instructed to keep the finances of Keywell strictly confidential and to share no information regarding Keywell's funding. Keywell continued to experience financial difficulty through the beginning of 2013 and, in March, obtained bankruptcy counsel. In May 2013, Keywell received an offer to purchase the majority of its equity and receive a capital infusion in exchange for 70% of its equity and the conversion of the two NewKey loans to preferred stock rather than subordinated secured debt. Keywell's management rejected the offer and, on September 24, 2013, Keywell filed for bankruptcy.

The bankruptcy trustee sought to, among other things:

Avoid the special tax distributions made in 2007 and 2008 as either constructively or intentionally fraudulent transfers.
Recharacterize the NewKey I Loan and NewKey II Loan (collectively, the NewKey Loans) from debt to equity.
Avoid the lien securing the Loizer 2013 Loan.
Equitably subordinate the NewKey Loans.

Outcome

The Court found that the NewKey loans should be equitably subordinated, but ruled for the defendants on all other causes of action.

Fraudulent Transfer

First, the Court declined to allow the bankruptcy trustee to avoid the 2007 and 2008 tax redemptions as a fraudulent transfer. Under the Illinois constructive fraudulent transfer (740 Ill. Comp. Stat. Ann. 160/5(a)(2) (West 2014)) and intentional fraudulent transfer statutes (740 Ill. Comp. Stat. Ann. 160/5(a)(l) (West 2014)), among other things, the debtor must not be left insolvent or with an unreasonably small amount of assets with which to carry on its business in relation to the business transaction so that it would become insolvent shortly after the transaction was completed. Here, after the tax distributions were made, Keywell was not left insolvent or unable to pay its obligations. On the contrary, even after the 2008 transfer, the bankruptcy trustee's expert found that Keywell still had at least $3.5 million in equity, or 4.7% more assets than liabilities, despite the fact that the company was struggling. Even if the 4.7% asset cushion was inadequate, the trustee's expert failed to offer any reasons why that amount was inadequate, what an adequate capital cushion would have been, or the expert's basis for knowing that information.

Debt Recharaterization

Second, the Court rejected the trustee's request to recharacterize the NewKey Loans as equity contributions. The Court examined recharacterization under both federal and state law, and found that:

The Seventh Circuit had never formally recognized a claim for recharacterization, and it was unlikely to opine that a bankruptcy court's equitable powers extended to remedies that are beyond the scope of those addressed in the Bankruptcy Code as at least one other circuit had done. The Court noted that the Bankruptcy Code does not provide for recharacterization and therefore would not apply that equitable remedy under federal law.
Even under Illinois state law, recharacterization is difficult to establish and requires examination of whether the alleged loan was:
- evidenced by a note;
- bore interest;
- was expected to be repaid only out of future profits; and
- was subordinated to all creditors.

The Court rejected recharacterization because, here:

The loan documentation was complete.
The amounts were evidenced by notes that bore interest and required payment on specific dates.
Repayment was not contingent on company earnings.
The notes evidenced the expectation that the amounts would be repaid in full.

Preference

Third, the Court declined to avoid the lien securing the Loizer 2013 Loan. The trustee did not contest the legitimacy of the loan itself, but sought to avoid the lien because the security agreement was executed two days after the funds were advanced under the note. The trustee argued that this caused the loan to be unsecured, and the subsequent grant of security acted as a preference relative to other unsecured creditors. However, because the note itself stated that it was intended to be secured, and only two days passed between executing the note and the security agreement, the court concluded that those events happened "substantially contemporaneously."

Interest

Fourth, because the loan was not subject to recharacterization, interest on the loan was appropriate. The trustee's allegation to avoid the interest payments was dismissed.

Fiduciary Duty

Fifth, the court found no evidence that the defendants breached their fiduciary duty to creditors. Even if there had been a breach of fiduciary duty, the court's grant of equitable subordination is a sufficient remedy. The court dismissed the allegations of breach of fiduciary duty.

Equitable Subordination

The Court did, however, find merit in one of the trustee's allegations. The court entered judgment in favor of the trustee for equitable subordination of the NewKey Loans.

Under section 510(c) of the Bankruptcy Code, equitable subordination requires that:

The party against whom the subordination is sought has acted inequitably.
The conduct caused harm to other parties with claims.
Subordination does not contradict other policies of the Bankruptcy Court.

The major issue was whether inequitable conduct occurred. The court rejected certain allegations by the trustee of inequitable conduct by Keywell. The court found that inadequate capitalization and the decision for owners to supply debt financing instead of equity were not, alone, inequitable because creditors are free to lend and charge interest based on the risk of a particular borrower.

On the other hand, the combination of certain other factors taken together led the Court to find Keywell's conduct inequitable, including:

Keywell was aware that its business model would create a surplus of cash in times of increasing nickel prices and a shortage in times of decreasing prices, and failed to either hedge for those price fluctuations or retain its cash surplus to account for potential prolonged decreases in nickel price. Instead, Keywell paid out virtually all of its earnings during its profitable years.
Upon hardship, Keywell's directors organized a capital contribution for $15 million of preferred stock, which would have adequately capitalized the company.
That transaction was never consummated, primarily because the members of Keywell were concerned about their recovery of their own funds. The transaction was restructured to guarantee the return of their newly invested funds. By doing so, Keywell replaced funds that were paid out for a tax distribution with secured debt, which, in both cases, further diluted funds available to repay trade creditors.
Keywell's finances were kept completely secret, which did not allow its trade creditors and other business partners to appreciate the risks involved with lending to Keywell or that Keywell issued secured debt to recapitalize itself in the face of hardship.

Because the remaining elements of equitable subordination were clearly met, the Court equitably subordinated the NewKey Loans.

Practical Implications

This case demonstrates the difficulty that plaintiffs will encounter when attempting to recharacterize debt to equity and to avoid transfers that are made before a company has actually encountered difficulty meeting its current debt obligations. While there is little dispute that the 2008 tax distribution forced Keywell into a financial situation that eventually led to its bankruptcy, the fact that the distribution did not render it insolvent precluded avoidance. Additionally, recharacterization largely turns on corporate and loan formalities, and a correctly documented loan that includes regularly scheduled interest payments and that demonstrates an intention to be repaid in full will generally be respected as such.

However, this case also demonstrates the equitable remedies that a court has available to it when it believes that the conduct of an equity holder or the structure of a transaction was designed to wrongfully shield assets from creditors. Equitable subordination benefits and protects unsecured and secured creditors by negating equity holders' attempts to restore depleted equity capitalization with secured loans. By transforming themselves into secured creditors, the equity holders, which generally have the lowest priority under the Bankruptcy Code, have placed themselves in the front of the repayment line (see Practice Note, Order of Distribution in Bankruptcy: Order of Payment). Equitable subordination ensures that shareholders cannot do this by disguising what should be an equitable contribution as another loan vehicle. And unlike recharacterization, equitable subordination is not prohibited under the Bankruptcy Code.

Either way, creditors must conduct their own diligence and will generally be held accountable for their own business decisions. At the same time, insiders that lend their own company funds instead of making capital contributions must give the lenders the tools to adequately evaluate their company and make an informed decision, or else risk exposing themselves to equitable subordination.

For more information on debt recharacterization and equitable subordination, see the following Practice Notes:

In re SGK Ventures, LLC: Debt Investment Equitably Subordinated, Not Subject to Avoidance or Recharacterization | Practical Law