An interesting decision from the Bankruptcy Court in the Eastern District of Tennessee shows how a defendant tried to defeat a preference claim by recharacterizing debt on the debtor’s balance sheet as a capital or equity contribution.  In Paris v. SSAB Enterprises, LLC (In re SIAG Aerisyn, LLC), the defendant tried to render the debtor balance sheet solvent by recharacterizing a significant portion (approximately $9.9 million) of the debtor’s debts as equity contributions.  By rendering the debtor solvent, the defendant could, in turn, defeat the preference claim.

The debtor in this case, SIAG Aerisyn, LLC (“Debtor”), manufactured and distributed towers used to mount turbines for the generation of electricity through the use of wind energy.  Over a two-year period leading up to the Debtor’s bankruptcy case, SIAG Schaaf Industrie AG (“Parent”), a parent affiliate of the Debtor, loaned the Debtor approximately $9. 9 million.   After filing for bankruptcy on April 2, 2012, the chapter 7 trustee sued SSAB Enterprises LLC (“SSAB”), one of the Debtor’s suppliers, for payments made by the Debtor to SSAB within 90 days of the bankruptcy filing date.  The chapter 7 trustee sought to avoid payment transfers to SSAB in the amount of $2.5 million under section 547(b) of the Bankruptcy Code.

One of the elements of a preference claim is that the debtor must have been insolvent at the time of the purported preferential transfer.  While there is a presumption of insolvency within 90 days preceding a bankruptcy filing, there is no requirement that an entity be insolvent to file for bankruptcy protection.  Thus, defendants who are sued by debtors-in-possession or trustees are wise not to presume that just because the debtor filed for bankruptcy, it is insolvent.

Recharacterizing debt as equity in a bankruptcy case is not for the timid.  It is a fact-heavy endeavor involving an 11 part test that is designed to understand whether the parties called an instrument one thing when in fact they intended it as something else.  The 11 factors are:

  1. name given to the instruments evidencing the indebtedness;
  2. presence or absence of a fixed maturity date and schedule of payments;
  3. presence of absence of a fixed rate of interest and interest payments;
  4. source of repayment (i.e. there must be a reasonable expectation of repayment based on something other than equity upside);
  5. adequacy or inadequacy of capitalization;
  6. identity of interest between the creditor and stockholder and whether the advances were in proportion to its equity interest in the borrower;
  7. security, if any, for the advances (with an absence of security leaning in favor of an intention to contribute capital rather than lend);
  8. borrower’s ability to obtain financing from outside lending institutions;
  9. extent to which advances were subordinated to the claims of outside creditors;
  10. extent to which advances were used to acquire capital assets (which suggests a capital contribution) versus to fund the operation of the business (which suggests a loan); and
  11. the presence or absence of a sinking fund to provide repayments.

In this case, the Bankruptcy Court found that there were genuine issues of material fact regarding whether the advances were intended to be a debt.  On the one hand, there was a note and an interest rate and calculation of interest.  Further, the Debtor made two significant repayments on the advances and there was some capitalization of the Debtor at its inception.  In addition, the advances were used for operations and not to purchase capital assets.   On the other hand, there was no fixed maturity date and fixed obligation to repay; there was no evidence of outside financing; there was no security for the advances; the lender was the Parent of the Debtor; and the Debtor was substantially undercapitalized.

Whether or not the litigation over the Debtor’s solvency in connection with its preference claim against SSAB goes to trial is an open question.  The take-away, however, is clear: first, defendants should not assume that the debtor has met the insolvency prong of a preference (or fraudulent transfer) claim just because they are litigating claims in a bankruptcy court;  and second, seeking recharacterization of debt to equity may be one way to defeat the presumption of insolvency during the 90 day prepetition period.