Business Law

Equity Kicker Does Not “Warrant” §510(b) Subordination of Venture Debt

October 21, 2024

Dear constituency list members of the Insolvency Law Committee, the following is a case update written by Patrick Costello, analyzing In re Point 360, 2024 WL 2862577 (9th Cir. June 6, 2024), a recent case of interest:

SUMMARY

In In re Point, the Ninth Circuit affirmed the ruling of the District Court holding that a venture loan secured debt was not subject to subordination pursuant to 11 U.S.C. § 510(b) simply because the loan terms included “equity kicker” warrants issued by the debtor “in consideration of the” loan.

To read the full published decision, click here.

FACTS

The factual background provided in the opinion is sparse: the Ninth Circuit found a detailed recitation of the facts unnecessary as they were familiar to the parties. The District Court’s opinion (Point 360 v. Medley Cap. Corp., 2023 WL 4359472 (C.D. Cal. June 6, 2023), aff’d sub nom. In re Point 360, 2024 WL 2862577 (9th Cir. June 6, 2024) provides a more detailed factual recital.

In July 2015, the debtor and lender entered into a Term Loan Agreement (the “TLA”), pursuant to which lender agreed to lend debtor up to a total of $6 million in secured loans. In addition to the stated interest, the debtor agreed to issue the lender five-year warrants to purchase 500,000 shares of the debtor’s common stock at an exercise price of $0.75 per share. The TLA stated that the warrants were issued in consideration of the loans advanced.  In the year from the initial closing under the TLA, the debtor borrowed the entire $6 million available under the TLA, with the various advances evidenced by secured promissory notes (the “Term Loans”).

In October 2017, the debtor filed a Chapter 11 petition.

In January 2018, lender filed its proofs of claim based on the secured promissory notes. In the period from January 2018 to June 2019, the debtor sought reorganization, ultimately seeking confirmation of a Second Amended Plan (the “Plan”). The Plan proposed (1) to reinstate the Term Loans and accordingly treat the lender’s secured Term Loan claims as unimpaired and therefore not entitled to vote on the Plan; and (2) to cancel the lender’s warrants as part of the cancellation of all equity securities. The lender objected to confirmation of the plan on grounds that cancellation of warrants rendered its secured claim impaired, thereby entitling the lender to a presumably dispositive vote on the Plan. Significantly, the debtor’s counterargument was that the warrants were not sufficiently linked to the Terms Loans debt such that extinguishment of the warrants did not result in a material default in the Term Loans to be reinstated by the Plan.

As confirmation approached, the debtor and the lenders’ committee in May 2019 filed an adversary proceeding seeking mandatory equitable subordination of the Term Loans alleging that the TLA expressly linked the issuance of the warrants to the Term Loan debt such that the entirety of the Term Loans debt should be deemed to arise from the sale of a security of the debtor for purposes of §510(b) and subordinated (the “Adversary Proceeding”).

In June 2019, the bankruptcy court entered an order confirming the Plan without evidently disposing of the Adversary Proceeding.

In January 2021, the lender moved for summary judgment in the Adversary Proceeding on grounds that there was no evidence of a nexus to support subordination, and that reinstatement of the Term Loans under the Plan judicially estopped the debtor from pursing subordination.

The bankruptcy court agreed with both of the lender’s arguments, finding that the debtor had failed to satisfy its burden on the summary judgment motion.  It granted summary judgment to the lender and found that the debtor was judicially estopped from seeking subordination given its position on the lender’s plan objection.

The district court found it unnecessary to rule on judicial estoppel and affirmed on the grounds that the debtor had failed to sustain its burden under the shifting burdens of summary judgment.

Reasoning

The Ninth Circuit succinctly affirmed the District Court because the debtor had failed to show a triable issue as to whether the Term Loan’s debt was sufficiently connected to the sale or purchase of securities. The mere acknowledgment in the TLA that the warrants were issued in consideration of the Term Loans failed to establish the requisite nexus between the debt and the sale/purchase of a security required for mandatory subordination: if such acknowledgment were deemed sufficient to subordinate the Term Loans debt, then every venture loan would be subject to subordination. To subordinate a secured loan “simply because the lender had an option to make an equity play in the future would ‘unfairly shift to lender risks associated with stock ownership’.”

While stating that it need not reach the issue of judicial estoppel, the Ninth Circuit nonetheless observed that the bankruptcy court approved the debtor’s Plan reinstating the Term Loans obligation (and presumably leaving the lender unimpaired with no vote on the Plan); to subsequently subordinate (and ultimately disallow) such claims post-confirmation would “vitiate that very plan.”

AUTHOR’S COMMENTARY

The result is indubitably correct. A venture debt loan (typically secured by all assets) cannot be subject to mandatory subordination pursuant to §510(b) merely because it provides an “equity kicker” in the form of warrants: a contrary result would derail all of venture debt financing. That said, the opinion is less than fully satisfying because – due to the debtor’s “all or nothing” strategy – the Ninth Circuit never addresses how equity kickers may materially affect the treatment of such a venture debt loan in bankruptcy. A very quick read of the opinion might lead one to conclude equity kickers have no material effect on the treatment of the related debt—that is incorrect and by no means what the Ninth Circuit held. The warrants issued in connection with the TLA clearly had some value at the time issued: otherwise, the lender would not have insisted on their issuance and the TLA would not have stated that the warrants were issued in consideration for the Term Loans. Moreover, accounting principles generally require that the value of such warrants at the time of issuance be treated as a loan commitment or access fee, i.e. a form of additional interest or effecting an original issue discount. Whether such “equity kicker” warrants may have material significance to ultimate treatment of the venture debt in the bankruptcy case depends on the specifics of the case. In this case, because the debtor adopted an “all or nothing” strategy, the Ninth Circuit never had to address such matters: its inquiry ended at whether subordination was required. The Ninth Circuit’s decision should by no means be interpreted as an assurance as to how “equity kicker” may affect the treatment of venture debt in different circumstances.

These materials were written by Patrick Costello of Vectis Law (pcostello@vectislawgroup.com). Editorial contributions were provided by Maggie E. Schroedter of Robberson Schroedter LLP (maggie@thersfirm.com).  Thank you for your continued support of the Committee.


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