Suppose you gave Bill Gates $1,000 to help him start a small company in his garage. When that company turned out to be Microsoft, you would prefer that the money be treated as an equity investment, so that you could share in the increased value of the company, instead of a loan, in which case you would only be entitled to repayment of the $1,000 principal. On the other hand, imagine that you are a part owner of a company that is having cash flow problems. You provide money to help pay its debts but it later declares bankruptcy. In that case, you would prefer that your contribution be deemed a loan, because such loans are paid off in full before shareholders of a bankrupt company receive anything. The proper characterization of funds provided to corporations, as debt or equity, is a recurrent subject of litigation.
Greensleeves, Inc. is an environmentally aware business specializing in the production of formal wear made entirely of plant foliage. Abe and Alice are short on money to start Greensleeves. Having failed to obtain loans from two banks, they approach Jackson Banana Plantations for help in funding the new company. Jackson agrees to do so, anticipating that Greensleeves would purchase a great number of its, until then, useless banana leaves. Without the money provided by Jackson, Greensleeves would not have been able to cover its operating expenses.
It is agreed that Jackson would own 40% of the Greensleeves stock. However, because Jackson wants to conceal its involvement with Greensleeves, it is further agreed that the funding will be provided in the form of personal loans to Abe and Alice, evidenced by demand promissory notes. All stock will be held by Abe and Alice, but they agree, on demand, to transfer 40% of the stock to Jackson.
Correspondence between the parties sometimes refers to the Jackson funding as loans, but at other times makes clear that the stock in Greensleeves being held by Abe and Alice is actually owned by Jackson. Jackson never demands payment of any of the notes and no payments are ever made.
After a dispute between the parties, Greensleeves attempts to terminate its relationship with Jackson. Jackson demands transfer of the stock, but Greensleeves refuses to make the transfer. Letters from attorneys ensue.
Jackson files suit demanding full repayment of all of the “loans” it had made to Greensleeves by the demand notes. Greensleeves responds that the so-called loans are, in fact, equity investments; and are nearly worthless as Greensleeves is close to insolvent, its banana leaf undergarments having failed to generate much consumer interest. The Court must decide whether the Jackson funding was debt or equity.
B. Massachusetts law.
Massachusetts cases identify a number of factors which a court should consider when determining whether a purported loan is, in reality, a capital contribution (equity investment). In Yankee Microwave, Inc. v. Petricca Communications Systems, Inc., 53 Mass. App. Ct. 497 (2002), the Massachusetts Appeals Court recharacterized as capital contributions alleged loans made by shareholders to their corporation, holding that repayment of those “loans” prior to payment of the company’s other creditors was, therefore, fraudulent. Emphasizing the corporation’s initial undercapitalization, the Yankee Court stated:
“Whether an advance should be treated as a capital contribution to, rather than creating a debt of, the bankrupt depends to some extent on the objective intention of the contributor, and in part on whether, in particular circumstances, equitable considerations require treatment of the advance as a capital contribution.” Where a corporation is formed with initial capital that is grossly inadequate to the purposes of the corporation’s business, requiring immediate shareholder loans in order to operate, shareholders’ so-called debt should be treated as equity capital, and given no preference over creditors in the distribution of assets…. We think that where the loans are indeed a substitute for capital to the extent necessary to the operation of the business, they must be treated as capital and be subordinate to claims of creditors…. Here, … careful scrutiny … leaves no doubt that these loans from Basil and Robert were in effect capital contributions.
Id. at 522-23. (Emphasis added, citation omitted, footnote references omitted). See also, Buchanan v. Warner, 2006 WL 4119791, *9 (Mass. Super. 11/8/06); TLP Leasing Programs, Inc. v. Northern Light Tech. LLC, 2005 WL 3605414, *1 (Mass. Super. 11/1/05); Garvey v. Lemle, 2005 WL 2009552, *8 (Mass. Super. 7/29/05); Milliken & Co. v. Duro Textiles, LLC, 2005 WL 1791562, *13 (Mass. Super. 6/10/05); American Twine Limited Partnership v. Whitten, 392 F.Supp.2d 13, 21-22 (D. Mass. 2005).
In Overnight Transportation Co. v. Commissioner of Revenue, 54 Mass. App. Ct. 180 (2002), the Appeals Court noted additional factors indicating that a loan is really a capital contribution, holding that, for tax purposes, a promissory note in favor of the corporate taxpayer’s parent company was not a true debt such that interest on the note would qualify as a deductible expense. According to the Court, the fact that the company lacked the resources to pay back the alleged loan, and that repayment was, therefore, dependent “upon the success of the recipient corporation, … suggests that the amounts were in fact an equity investment.” The Overnight Court explained that a “person ordinarily would not advance funds likely to be repaid only if the venture is successful without demanding the potential enhanced return associated with an equity investment.”
The Court also found significant the lack of security for the loan. The “absence of security for the advances is a strong indication that the advances were capitalcontributions rather than loans.” According to the Court, “[a]lthough some loans are made ‘on signature,’ … the absence of provision for security in a loan of this scale is telltale that a ‘loan’ is not real, … and so, also, for the absence of meaningful enforcement mechanisms.” See also Kimberly-Clark Corp. v. Commissioner of Revenue, 83 Mass. App. Ct. 65 (2013) (the absence of default provisions and the failure of the “debtor” to make any payments on the “loan” supported the conclusion that funds advanced were capital contributions, not debt).
Also relevant, according to the Court in Overnight, is whether a third party lender would have made the alleged loan.
What is assumed here is a hypothetical independent lender willing to make a ten-year advance of $600 million in cash to Overnight without exacting security in specific assets of the company (at best the approximately $300 million). … Agreeing with the board, we think the hypothetical willing lender could not be found in the flesh. The point can also be made by asking whether anyone could be found to buy the existing note from Holding (or Union Pacific) and at what point in time and at what discount.
54 Mass. App. Ct. 189-90.
Federal cases, usually decided in the bankruptcy context and usually involving purported “loans” made by corporate insiders to their companies, identify additional factors to be used in determining whether a loan is really a capital contribution. Relevant factors include:
(1) the adequacy of capital contributions;
(2) the ratio of shareholder loans to capital;
(3) the amount or degree of shareholder control;
(4) the availability of similar loans from outside lenders;
(5) certain relevant questions, such as,
(a) whether the ultimate financial failure was caused by undercapitalization;
(b) whether the note included payment provisions and a fixed maturity date;
(c) whether a note or other debt document was executed;
(d) whether advances were used to acquire capital assets; and
(e) how the debt was treated in the business records.
In re: Shamus LLC, 2008 WL 3191315, *12 (D. Mass. 8/6/08), quoting In re: Atlantic Rancher, Inc., 279 B.R. 411 (Bankr. D. Mass. 2002). See also American Twine, 392 F. Supp.2d at 22-23; In re: Felt Mfg. Co., Inc., 371 B.R. 589, 629-32 (D.N.H. 2007). These are the factors applied by federal courts in the First Circuit.
Federal courts elsewhere examine additional factors:
These are: “(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 regular corporate creditors; (7) the intent of the parties; (8) ‘thin’ or adequate capitalization; (9) identity of interest between creditor and stockholder; (10) source of interest payments; (11) the ability of the corporation to obtain loans from outside lending institutions; (12) the extent to which the advance was used to acquire capital assets; and (13) the failure of the debtor to repay on the due date or to seek a postponement.
In re: Blevins Concession Supply Co., 213 B.R. 185, 187-88 (Bktcy. S.D. Fla. 1997).
In our hypothetical, many relevant factors support a finding that the funds transferred from Jackson to Greensleeves were capital contributions or equity investments rather than loans. First, the funds were needed to initially capitalize Greensleeves, which would have been severely undercapitalized without the Jackson funds. As the Yankee Court said: “We think that where the loans are indeed a substitute for capital to the extent necessary to the operation of the business, they must be treated as capital.” 53 Mass. App. Ct. at 523.
Second, Jackson took no security for the “debt”. This, in itself, is indicative of an equity investment as opposed to a loan. Overnight, 54 Mass. App. Ct. at 189.
Third, because Greensleeves had little capital other than what Jackson had provided, and because Jackson took no security, repayment of Jackson’s advances was dependent upon the success of Greensleeves, again indicative of an equity investment. Overnight, 54 Mass. App. Ct. at 190. Jackson could not reasonably expect to be paid back regardless of the performance of Greensleeves.
Fourth, the notes did not provide for a fixed maturity date and no payments were ever demanded by Jackson or made by Greensleeves.
Fifth, there is no reason to believe that a third party lender would have made the same loan to Greensleeves. Two banks declined to extend credit. Jackson might claim that it was a third party lender, not an insider of Greensleeves, but Jackson funded Greensleeves in return for equity. It seems highly unlikely that a disinterested third party lender would have given Greensleeves, a penniless start-up company with a questionable product line, significant unsecured loans.
Perhaps most importantly, the parties themselves treated the funds as an equity investment rather than a loan. Although Jackson at one time referred to the funding as personal loans, other correspondence between the parties shows that they believed Jackson had purchased a 40% equity interest in Greensleeves. Indeed, when Greensleeves refused to transfer the stock certificates to Jackson, Jackson threatened to sue.
Certain other factors support the view that Jackson’s funding of Greensleeves was a loan transaction: (1) there is no evidence that Jackson exerted any management or control over Greensleeves; (2) the notes were executed; and (3) Jackson was not an insider of Greensleeves. To the extent that the Jackson funds were used for operating expenses rather than capital purchases (e.g. equipment), that would also support a finding that the funding was debt rather than equity.
On balance, the factors support the conclusion that the alleged “loans” were actually equity investments or capital contributions. Thus, Greensleeves is likely to succeed in its defense of Jackson’s suit for payment of the notes.
Whether funds provided to a business constitute debt or equity is often a difficult question requiring a detailed factual analysis. Parties entering into such funding transactions should take steps to make clear whether the source of the funds is making an investment or merely lending money. They should be aware, however, that the ultimate characterization of the funding depends not just on how the parties refer it, but also on the financial circumstances of the business, the terms of any alleged loan, the parties’ course of conduct, and many other factors.