For a distressed company running low on capital, an investment from insiders may represent a
last best hope for survival. Insiders
may be willing to risk throwing
good money after bad for a chance
to save the company even when any
third party would stay safely away.
Insiders of a failing company may also
have an ulterior motive for making
an eleventh-hour capital infusion,
as they may use their control over a
distressed company to enhance their
position relative to the company’s
other creditors. The line between
a good-faith rescue and bad-faith
self-dealing is often a hazy one.
Once a company does file for
bankruptcy, non-insider creditors
often challenge prepetition insider
transactions on multiple grounds,
including fraudulent transfer,
recharacterization of debt into
equity, breaches of fiduciary duty,
and equitable subordination of debt
below claims of other creditors. In
In re SGK Ventures LLC, the U.S.
Bankruptcy Court for the Northern
District of Illinois granted equitable
subordination pursuant to Section
510(c) against a secured loan made
by insiders. The decision, which
applied a relatively low standard to
find “inequitable conduct,” will provide
ammunition to parties nationwide
seeking to reverse insider transactions
to generate a return for creditors.
The Debtor’s Business
Before declaring bankruptcy, SGK
Ventures LLC was named Keywell
LLC and operated as a scrap metal
intermediary. The company bought
scrap metal from a network of more
than 1,000 suppliers, processed it,
and sold it to producers of aerospace
metals and stainless steel. Keywell
was managed by two of its members,
who together owned more than
70 percent of the company.
Stainless steel accounted for the
majority of Keywell’s sales, and the
company’s profitability closely followed
fluctuations in the price of stainless
steel. The company charged purchasers
a premium based on a percentage of the
price of stainless steel. When stainless
steel prices rose, the dollar amount of
Keywell’s profit margin would increase.
For example, a 20 percent rate applied to
scrap purchased at $1 per pound would
generate 20 cents, but if the steel were
purchased at $2 per pound, the same
rate would generate 40 cents of profit.
More importantly, Keywell would
sell scrap an average of 35 days after
purchasing it. If steel prices rose during
that period, Keywell would reap the
windfall. If prices fell, profitability would
plunge. Keywell could have hedged
its exposure to price fluctuations by
purchasing futures contracts, but it did
not do so. In fact, the company often
increased its exposure by holding
inventory longer during price upswings,
substantially enhancing its profits
while steel prices rose, but exacerbating
the damage when prices fell.
While prices of steel rose, Keywell
retained little cash to weather a potential
decline in the market. Keywell’s
operating agreement provided that it
would distribute any available cash
to its members. To provide liquidity,
Keywell maintained a revolving line of
credit with Bank of America secured
by a lien on all assets. The maximum
amount Keywell could borrow under
the revolver was based on a percentage
of its inventory and accounts receivable.
Unfortunately for Keywell, its business
plummeted shortly after a distribution
to members in March 2008. Sharp
declines in the price of stainless steel
and in the company’s sales volume
led to months of net income losses.
By December 2008, the company had
breached a covenant on its revolver.
Keywell needed to convince Bank of
America to continue lending, as no
alternative financing was available.
To do so, Keywell attempted to
raise money from its members.
Keywell initially sought to raise
capital from its members through
a sale of new preferred shares via a
confidential offering memorandum.
Keywell’s managers, holders
of a majority of Keywell equity,
approved the share offering.
Before the transaction could be
completed, however, the managers
asked their attorney how to insulate
the proceeds from the sale of preferred
shares in a bankruptcy. The attorney
advised them that there was no way
to prevent the investment from being
subordinate to claims of creditors
while also allowing the company
access to the proceeds. Several days
after receiving that advice, Keywell
withdrew the preferred stock offering
and instructed its members to
destroy the offering memorandum.
To protect Keywell’s investors’ capital in
the event of bankruptcy, the managers
formed NewKey LLC and offered
Keywell members equity interests in
the new entity, NewKey I, through
a confidential private placement
memorandum. After NewKey I was
funded, it purchased a promissory
note from Keywell dated March 20,
2009, which was secured by a second
lien on the company’s assets.
Keywell used the proceeds of the 2009
note to reduce the balance of its revolver
and to meet short-term capital needs.
The sale of the NewKey I interests
and the purchase of the 2009 note
resulted in a transaction identical to
that proposed in the original preferred
stock offering, except under its terms
the 2009 note would be paid before
unsecured creditors in a bankruptcy.
In 2011, following two years of ups and
downs, Keywell found itself in default
with Bank of America. In response,
Keywell entered into a transaction
similar to the one consummated in
2009. A new entity, NewKey Group
II LLC, and, together with NewKey
I, formed and funded by Keywell
members, purchased another
promissory note on October 18, 2011.
Keywell used the 2011 note to reduce
the balance on its revolver. Ultimately,
Keywell’s business continued to
decline, and the company filed for
bankruptcy in September 2013.
Claims Against Members
During the Chapter 11 case, the
creditors’ committee filed a complaint
seeking avoidance of distributions
Keywell made to members in 2007
and 2008, recharacterization of
the 2009 and 2011 notes as equity,
and equitable subordination of the