Frequent and Favorite Topics: Fraudulent transfer, recharacterization and equitable subordination

Tuesday, January 5, 2016 - 15:42
Brenda Funk

Brenda Funk

In re SGK, a recent case out of the bankruptcy court for the Northern District of Illinois, touches upon a number of frequent and favorite topics, including fraudulent transfer, recharacterization and equitable subordination.  



Before its Chapter 11 filing in 2013 and before changing its name to SGK Ventures, Keywell, LLC was a metal scrap processing and recycling business, focusing on stainless steel, titanium and high-temperature metal alloys. The profitability of Keywell’s primary business – stainless steel – was highly dependent on the commodity price of nickel and monthly sales volumes. Keywell chose not to hedge its exposure to the price of nickel and instead focused on rapid inventory turnover. When nickel prices were rising, Keywell was very profitable. Keywell struggled, though, when nickel prices experienced rapid or prolonged decline.

From 2006 through 2013, Keywell experienced both boom and bust. During the boom, Keywell made large distributions to its equity owners, including approximately $40 million in 2007 and an additional $29 million in 2008. During the bust, which started shortly after the 2008 distribution, Keywell took out loans from those same equity owners to support the business (see “The NewKey Loans”). To increase recoveries to creditors in Keywell’s bankruptcy case, Keywell’s liquidating trustee filed suit against, among others, Keywell’s equity owners in connection with these transactions. Among other causes of action, the liquidating trustee for Keywell sought to 1) avoid the 2007 and 2008 distributions to Keywell’s equity owners as actual and constructive fraudulent transfers under state law, 2) recharacterize the loans from Keywell’s equity owners as equity instead of debt and 3) equitably subordinate the loan claims to those of Keywell’s unsecured creditors.

Actual and Constructive Fraudulent Transfer

In addition to Section 548 of the Bankruptcy Code, debtors, or their liquidating trusts, have another avenue through which to bring fraudulent transfer causes of action. Section 544(b)(1) of the Bankruptcy Code allows the debtor to avoid prepetition transfers that would be avoidable by an unsecured creditor under applicable state law, which in this case, means the Uniform Fraudulent Transfer Act (UFTA) as adopted and codified by Illinois.

Like Section 548 of the Bankruptcy Code, the UFTA includes causes of action for both actual and constructive fraudulent transfer. The UFTA, unlike Section 548, includes two separate actions for constructive fraudulent transfer: one that can be brought by existing or future creditors and one that can only be brought by creditors who existed at the time of the transfer in question. The difficulty with relying upon a statutory provision that requires a creditor to have existed at the time of the transfer is that the bankruptcy trustee also must demonstrate that the same creditor existed as of the petition date.

The SGK liquidating trustee, therefore, sought to rely upon a state remedy that allows future creditors to attack transfers. Under the UFTA, that remedy requires a showing that the debtor made the transfer without receiving reasonably equivalent value and that, at the time of the transfer, the debtor either 1) was “engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction” or 2) “intended to incur, or believed or reasonably should have believed that [it] would incur, debts beyond [its] ability to pay as they became due.”

Notably, insolvency is not a factor under the formulation of constructive fraudulent transfer under which the liquidating trustee was proceeding. Proof of insolvency is also not necessary in dealing with a claim of actual fraudulent transfer “made with actual intent to hinder, delay or defraud any creditor of the debtor,” although insolvency before or shortly after a transfer is one of the 11 enumerated “badges of fraud” under the UFTA that may indicate actual intent.

Noting that a constructive fraudulent transfer only requires a showing based upon the preponderance of the evidence, the court found that the liquidating trustee nevertheless failed to establish that Keywell had unreasonably small capital to conduct its business. The liquidating trustee’s expert witness, the court concluded, did nothing more than offer a conclusory opinion that the equity cushion at the time of the 2008 distribution was insufficient – leaving the court with more questions for than answers from the liquidating trustee’s expert.

With respect to actual fraudulent transfer, the liquidating trustee was required to prove the claim by clear and convincing evidence. For its actual fraudulent transfer claims, the liquidating trustee relied upon insolvency as the key “badge of fraud.” Here, too, though, the court found the evidence lacking. The court concluded that not only had the liquidating trustee’s expert failed to establish insolvency, but the expert instead proved that Keywell was solvent following the 2008 distribution.

Accordingly, the failure to establish either unreasonably small capital or insolvency was fatal to the liquidating trustee’s claims for constructive and actual fraudulent transfer, respectively.



In addition to the fraudulent transfer action, the Keywell liquidating trustee sought to recharacterize the NewKey loans as equity contributions instead of debt and, in the alternative, equitably subordinate the claims of the NewKey entities to Keywell’s unsecured creditors.

The liquidating trustee claimed that recharacterization of the two NewKey loans from debt to equity was appropriate under both federal and state law. The bankruptcy court disagreed. It held that recharacterization is not a remedy available under the Bankruptcy Code and concluded that the facts of the case did not support a recharacterization claim under Illinois law.

Courts are split on whether an independent right to recharacterize a loan as equity exists under the Bankruptcy Code. In finding that recharacterization is not available as an independent remedy under the Bankruptcy Code, the bankruptcy court highlighted that the Seventh Circuit has not followed other circuits in holding that bankruptcy courts have the equitable power to recharacterize debt as equity and noted that the Seventh Circuit is not likely to do so in light of previous decisions and the United States Supreme Court’s decision in Law v. Siegel.

Recharacterization is, however, a remedy available under Illinois law. The analysis of a claim for recharacterization is fact driven and hinges on various factors, including whether the asserted loans were documented as such, whether there was an expectation of repayment, and whether principal and interest payments were required and made. Based upon these factors, the court found that the NewKey loans were indeed debt because the loans were thoroughly documented, expected to be repaid and required payment of interest (which was, in fact, paid). That the loans originally were structured as equity contributions played no role under Illinois law with respect to recharacterization.

Section 510(c) of the Bankruptcy Code allows the bankruptcy court to subordinate all or part of an allowed claim to all or part of other allowed claim(s) under principles of equitable subordination. The well-established factors for equitable subordination are 1) the party whose claim is allegedly subject to subordination engaged in inequitable conduct, 2) the party’s conduct caused harm to other creditors and 3) the proposed subordination does not contravene any policies of the Bankruptcy Code. The SGK liquidating trustee alleged that these principles supported the subordination of the claims associated with the New Key loans to the claims of all unsecured creditors.

Though dismissing certain of the liquidating trustee’s theories regarding why the NewKey loan claims should be subordinated, the court ultimately found that the NewKey loan claims should be subordinated. Notably, though the court refused to find that Keywell was undercapitalized for purposes of the liquidating trustee’s fraudulent transfer claims. Keywell’s large distributions
to its owners during the good times and leaving the company with insufficient equity to weather the bad
times was viewed by the court as inequitable conduct.

Moreover, the court found the shift from a planned equity contribution to the ultimate execution of the NewKey secured loans inequitable, concluding that the large distributions had stripped trade creditors of the benefit of the equity cushion.

Finally, the court found that the complete secrecy surrounding Keywell’s finances was inequitable because Keywell’s trade creditors had no knowledge about the distributions to equity, the initial recapitalization plan, and the decision to instead issue secured debt, thus depriving the trade creditors of the knowledge necessary to adequately protect against subordination and the risk of default.

The court found that this conduct was sufficiently inequitable to satisfy the first element of the test for equitable subordination and also found that the other two elements had been satisfied. Accordingly, where fraudulent transfer and recharacterization claims failed, the liquidating trustee was ultimately successful in improving the recoveries to unsecured creditors through the equitable subordination of the NewKey loan claims against Keywell.


Brenda FunkAssociate in the Business Finance & Restructuring Department in the Houston office of Weil, Gotshal & Manges

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