Colorado Bar Association
Colorado Bar Association
Section Newsletter
Ed Naylor, Editor

IN THIS ISSUE

Re-Characterizing Loans to Small Businesses as Equity

By Tim Swanson, Esq., Moye White LLP

Business bankruptcy filings have significantly decreased each year in Colorado since 2009.1 Notwithstanding this decrease, legal counsel should still be mindful of the bankruptcy principle of re-characterization when advising closely-held business owners who loan money to their entities. In a bankruptcy proceeding, the loan could be re-characterized as equity.

For a variety of strategic business and legal reasons, owners may choose to loan their own money or property to their businesses. While the owner may be adamant to label the loan as debt instead of equity in order to put repayment of the obligation on par with other creditors—and ahead of other equity holders—the savvy practitioner should nevertheless advise the owner that if the business ends up in bankruptcy, the label does not control, and the bankruptcy court can equitably re-characterize the loan as an equity contribution. 2

The power to re-characterize debt into equity ensures that controlling equity owners of a troubled company do not jump the line of the bankruptcy process, which would allow repayment of their debt, and thwart the company’s outside creditors’ and investors’ priority rights. Thus, re-characterization is the application of the equitable principle that holders of debt be paid before holders of equity.

Re-characterization usually enters the picture when there are limited assets left for distribution to creditors and the owner of the bankrupt entity asserts a claim to those assets based upon a contribution of debt. As can be imagined, creditors and bankruptcy trustees can be motivated to challenge the nature of the owner’s debt as true equity in order to increase the amount of assets available for distribution.

Law in the Tenth Circuit

There is no specific bankruptcy code section that authorizes a bankruptcy court to re-characterize debt into equity. Instead, the power to re-characterize debt is inherent in the bankruptcy court’s power as a court of equity and is essential to its ability to properly implement the priority scheme in the bankruptcy code. The law governing re-characterization in the Tenth Circuit has long been based upon the thirteen (13) factor test set forth in In re Hedged-Investments and as recently affirmed in the In re Alternate Fuels, Inc. case:

(1) the names given to the certificates evidencing the indebtedness;
(2) the presence or absence of a fixed maturity date;
(3) the source of payments;
(4) the right to enforce payment of principal and interest;
(5) participation in management flowing as a result;
(6) the status of the contribution in relation to other corporate creditors;
(7) the intent of the parties;
(8) “thin” or inadequate capitalization;
(9) the identity of interest between the creditor and stockholder;
(10) the source of interest payments;
(11) the ability of the company to obtain loans from outside lenders;
(12) the extent to which funds were used to acquire capital assets; and
(13) the failure of the debtor to repay on the due date or to seek a postponement.3

As can be imagined, the decision to re-characterize putative debt as disguised equity is highly fact intensive and no single factor is outcome determinative.4

Practical Guidance

When advising owners, the practitioner must be mindful of the foregoing factors and that the purpose of re-characterization is to ignore form over substance as to the particular transaction. The practitioner’s goal should be to have the entity treat the particular transaction with the owner as true debt from the outset, and should follow these guidelines: (1) the debt obligation should be documented with a promissory note and/or credit agreement that is valid under applicable state law; (2) to the extent possible, a reasonable rate of interest should be charged; (3) if collateral is to be given for the loan, the owner should perfect the necessary security interest in the collateral;5  (4) the entity’s decision to incur debt from an owner, or any insider of the entity, should be authorized by the required corporate or company formalities under the entity’s governing documents, i.e., resolution or other appropriate consent; (5) the particular debt instrument should contain appropriate default remedies;6 and (6) the entity’s books, records, and financial statements, should properly reflect the loan. Again, the goal at the outset for the practitioner should be to have the transaction viewed, in both form and substance, as a true debt obligation of the entity.

1 According to the American Bankruptcy Institute, business bankruptcy filings in Colorado have decreased each year since 2009 with the following number of filings: 2009 (1,421 filings), 2010 (1,361 filings), 2011 (1,162 filings), 2012 (906 filings), 2013 (740 filings), 2014 (475 filings), 2015 (442), 2016 (402 filings), 2017 through Q2 (201 filings).
2 In re Hedged-Investments, 380 F.3d 1292, 1297 (10th Cir. 2004).
3 In re Alternate Fuels, Inc., 789 F.3d 1139, 1149 (10th Cir. 2015).
4 Id.
5 The practitioner should be mindful of the entity’s other existing covenants or conditions with other lenders.
6 The practitioner should further be mindful that the owner’s subsequent decision not to enforce the particular debt instrument, in the event of a default, could be viewed as an indication that the obligation was in the nature of equity and not debt.

Business Law Section Activities

Bankruptcy Subsection Programs

Judicial Local Bankruptcy Rules Review
The CBA Bankruptcy Subsection is presenting a Local Bankruptcy Rules review with all of our sitting bankruptcy judges as presenters. With a recent overhaul of the Local Bankruptcy Rules in Colorado to take effect at the end of 2017, your judges will review and highlight certain changes to the Local Bankruptcy Rules for the District of Colorado. Please attend to learn about the changes to the rules before they are implemented, and share your ideas, suggestions, questions, issues and concerns, as the judges are seeking input from you. This event will be held on Tuesday, Oct. 3, 2017 from 4 to 6 p.m. at the Colorado Bar Association, 3rd Floor, 1900 Grant Street, Denver, CO 80203.
This program has been submitted for 2 general CLE credits, with a complementary networking reception to follow.

Register

Save the Date: Denver Bankruptcy Bar Brown Bag CLE
The CBA Bankruptcy Subsection and the U.S. Bankruptcy Court for the District of Colorado are co-sponsoring a Denver brown bag lunch with our bankruptcy judges. With the annual changes to the Federal Bankruptcy Rules, and a recent overhaul of the Local Bankruptcy Rules in Colorado to take effect at the end of 2017, a panel will cover the recent revisions of the Local Bankruptcy Rules.  Please attend to learn about the changes to the rules before they are implemented, and share your ideas, suggestions, questions, issues and concerns, as the judges are seeking input from the bar. This brown bag event will be held on Wednesday, Dec. 6, from noon to 1 p.m. at the United States Bankruptcy Court for the District of Colorado, Room 183, 721 19th Street, Denver CO 80202. There is no cost for this program.

Winter Bankruptcy Case Law Update
The next update is on Wednesday, Dec. 6, from 4 to 6 p.m. at the CBA-CLE, 3rd Floor, 1900 Grant Street, Denver, CO 80203. The following will present at this Update:
Hon. Judge Elizabeth E. Brown (U.S. Bankruptcy Court)
Anne Zoltani (Bankruptcy Appellate Panel of the Tenth Circuit)
Katherine S. Sender (Lindquist & Vennum LLP)
This program has been submitted for 2 general CLE credits, with a complementary networking reception to follow.

Register

Bankruptcy Subsection Co-Chairs
Matthew Faga (Markus Williams Young & Zimmermann LLC) and Timothy Swanson (Moye White LPP) are the current co-chairs of the Bankruptcy Subsection (July 2017 – June 2019). If you have ideas, suggestions or comments for future subsection events or CLEs, please contact Matt at mfaga@markuswilliams.com and Tim at tim.swanson@moyewhite.com.

Financial Institutions Subsection Programs

Consumer Financial Protection Bureau: Rule Changes, Recent Developments and the Future
Live Program & Live Webcast
Wednesday, Oct. 18, Noon – 1 p.m.
CBA-CLE Classroom, 1900 Grant Street, Suite 300, Denver, CO 80203
Since its implementation, the Consumer Financial Protection Bureau (CFPB) has pursued 179 companies, resulting in 12 billion dollars in consumer refunds. Attend this program and learn what CFPB rule changes are close at hand along with additional rule changes happening in 2018. Also get up to speed on recent CFPB actions and cases and look at the CFPB of the future.
Offered for 1 General CLE credit.

Register
Hot Topic: Statute of Limitations (Sword or Shield?)
Live Program & Live Webcast
Wednesday, Nov. 15, noon – 1 p.m.
CBA-CLE Classroom, 1900 Grant Street, Suite 300, Denver, CO 80203
In recent months, several Colorado borrowers have filed lawsuits seeking to extinguish deeds of trust on their residences based upon the expiration of the statute of limitations. The fact scenarios involve one or more prior withdrawn foreclosures, repeated loss mitigation efforts and a last payment more than six years prior to the lawsuit. While statute of limitations issues are frequently raised by borrowers in connection with Rule 120 hearings, the latest filings can be attributed to one borrower’s success in an unpublished appellate ruling on a motion to dismiss based upon the 1909 Colorado Supreme Court case. This presentation will discuss the statute of limitations, tolling and re-starting of the statute of limitations and case law developments.
Offered for 1 General CLE credit
Register

Ethical Pitfalls – Save the Date!
Live Program & Live Webcast
Wednesday, Dec. 20, noon – 1 p.m
CBA-CLE Classroom, 1900 Grant Street, Suite 300, Denver, CO 80203
Representing servicers and lenders can lead to a number of ethical issues including, but not limited to, conflicts of interest, prior representation issues, communicating with pro se litigants and other ethical concerns that will be addressed in this presentation.
Offered for 1 General CLE credit including 1 Ethics credit.

International Transactions Subsection Programs

Save the Date: International Transactions Subsection Luncheon
Live Program & Live Webcast
Tuesday, Nov. 14, noon – 1 p.m.

M&A Subsection Programs

M&A Subsection Breakfast CLE Series: Securities Law Implications in M&A Transactions
Live Program & Live Webcast
Tuesday, Oct. 3, 8 – 9 a.m.
CBA-CLE Classroom, 1900 Grant Street, Suite 300, Denver, CO 80203
This one-hour program prepares you to better structure, negotiate, and finalize M&A transactions from the securities law perspective. Included are how to assess whether or not federal or state securities laws are implicated in an M&A transaction. Securities law issues raised when finders and intermediaries are used are also specifically addressed. Additionally, planning tips and traps to avoid are shared.
Offered for 1 General CLE credit.

Register

How to Optimize Long-Term Success
Live Program & Live Webcast
Tuesday, Nov. 7, 8 – 9 a.m.
CBA-CLE Classroom, 1900 Grant Street, Suite 300, Denver, CO 80203
Take an hour, and learn how to best help your clients maximize the value of their businesses for a sale. Learn what your clients need to be doing today and every day to receive top dollar for their businesses. Know, and provide your business clients, with their “to do’s” before considering an exit and how to orderly exit. Plus, gain insights on what impacts a business’ purchase price. Attend this session and come away with information you need and can use right away.
Offered for 1 General CLE credit.

Register

Save the Date for December’s M&A Program!
Live Program & Live Webcast
Tuesday, Dec. 12, 8 – 9 a.m.


CBA-CLE Upcoming Programs

How to Understand and Analyze Financial Statements

Live Program & Live Webcast
Wednesday, Oct. 11, 9 a.m. – 4 p.m.
CBA-CLE Classroom, 1900 Grant Street, Suite 300, Denver, CO 80203

Complex financial issues are involved in nearly every area of law, and it is your responsibility to master the skills and knowledge necessary to handle those issues effectively. This detailed program will provide you with the financial literacy required to protect yourself and your clients by guiding you through an understanding of accounting concepts, terminology, and financial statements. Beginning with an examination of Generally Accepted Accounting Principles and continuing with an overview of an actual financial statement, you will gain hands-on experience from Doug Smith, one of the nation’s leading experts in the field.

Submitted for 6 General CLE credits.

Register

CBA-CLE Business Law Homestudies

2017 Business Law Institute: Institute highlights include Case Law, Legislative and Secretary of State Updates; Colorado–s Economic Outlook; Staying out of the In-House Dog House! An In-House Counsel Panel Presentation; Improve Your Skill at the Bargaining Table; and Third Party Legal Opinions and Customary Practice: Offering Advice to One Not Your Client — Learn more
2017 Securities ConferenceLearn more
2017 Institute on Advising Nonprofit OrganizationsLearn more
Bankruptcy Case Law UpdateLearn more
Business Contracts: The FundamentalsLearn more
2017 Cannabis SymposiumLearn more
Limited Liability Companies in ColoradoLearn more

View our complete catalog of CLE Homestudies on our website and search by practice area or credits!

View Homestudies

Contributions for future newsletters are welcome.
Contact Ed Naylor at ed.naylor@moyewhite.com, 303-292-2900.
This newsletter is for information only and does not provide legal advice.

Colorado Bar Association
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