Business Owners Beware: Document Loans to Your Company or Else- Trends in Debt vs. Equity

Asset Protection Attorney Alert:

Have you ever loaned money to your own company?  Have you ever loaned money from one company to another?  Do you have written loan agreements in place?  Do your accounting records properly document the amount owed, transfers made, regular payments, and accruals of interest? Courts are coming down on these types of arrangements.

It is all too familiar to see when it comes to small and closely held businesses.  The owner puts some of his or her own personal funds into a company or transfers money from one company to the other to cover expenses for that company.  Most owners don’t think twice about it since they don’t have many other shareholders to consider or seek approval from.   Rarely do we see clients who come in who have entered into those kinds of deals that present documented loan agreements or any kind of records, but they think “it’s my company, so it doesn’t really matter” or “I am not publicly traded with the SEC or a big board of directors watching, so who cares.”  What they may not realize is that it can end up hurting the company or the shareholder down the road and, in some cases, in a pretty drastic fashion.

Several recent court cases have emphasized just how much not documenting loans can hurt a company.  Most of these arise in the bankruptcy context, but can be applied to regular state law claims related to loans, which can affect nearly anyone.  Even a minority shareholder could try to use these principles to his or her advantage to avoid loans the company owes to a majority shareholder.

The cases involve an extension of the bankruptcy court’s powers when it comes to debts.  A bankruptcy court has broad equitable powers under Section 105 of the Bankruptcy Code to make changes to carry out a bankruptcy.  On March 4, 2014, the US Supreme Court in Law v. Siegel issued an opinion that put a few restrictions on the recent expansion of those powers, but the concerns for business owners are still there and it is clear that the bankruptcy court’s use of those powers is still valid.

Since this ruling, a bankruptcy appeals panel has held that Law v. Siegel does not go so far as to ban a bankruptcy judge from recharacterizing debt as equity, which is more relevant for business owners.  The case of In Re: Alternate Fuels, Inc. was decided by the 10th Circuit Bankruptcy Appellate Panel on March 18, 2014 finding that loans by a shareholder to the company were equity and not a loan, despite the ruling in Law v. Siegel.

The facts of other recent cases are similar in that the court eventually converted what was claimed to be debts owed by the company to a shareholder/owner into equity.  The shareholder would put money into a company and then claim the company was required to pay it back and make a claim in the bankruptcy court to get paid back.  The courts have found that some of these so-called “debts” were really equity investments by the owner into the company with little to no value.  In a bankruptcy liquidation, if there are assets available, the assets are distributed according to priority to certain liabilities and if all liabilities are paid, then what remains gets distributed to equity holders/owners.  In a bankruptcy repayment or reorganization, such as is common in Chapter 11, the debt holders get paid off over time, but the equity holders do not receive payments.  When the court says that someone with a debt really invested equity and converts it into equity, they are saying that in most cases, that person is out of luck and will probably not get anything.

The cases look to the elements reviewed by state courts when analyzing whether a transfer of an asset could be considered a fraudulent transfer to avoid creditors.  If there is no transfer for something of reasonably equivalent value and there is no real obligation to pay the loan back, it could be considered fraudulent resulting in the loan not being allowed as a legitimate claim and an unwinding of the transaction.  This could result in a company or shareholder loaning money to another company he or she owns and losing that money.

Additionally, these loans have an impact in the context of asset protection planning.  For example, say John Q. Shareholder owns 2 LLCs: Bad Credit, LLC and Money Maker, LLC.  Bad Credit, LLC defaults on some loans and gets sued by a bank.  The bank gets a judgment against Bad Credit, LLC, but learns that Bad Credit, LLC would frequently pay for expenses of Money Maker, LLC.  Mr. Shareholder saw nothing wrong with this and even used one bank account to receive income and pay expenses for both LLCs.  The bank will go to court and try to collect against Money Maker, LLC and Bad Credit, LLC arguing that they are really not different companies due to the commingling (sharing) of assets.  Mr. Shareholder will try to claim the expenses paid by Money Maker, LLC were just loans to Bad Credit, LLC, but when it comes time to prove they are loans, he fails.  The court decides that the two LLCs with common ownership, similar bank account, and shared expenses are really just one company and the bank can go over both LLCs for the debt.  Or even worse, the bank says that both LLCs are really nothing more than Shareholder’s alter ego and the bank can now collect against Shareholder personally.

So what can be done?

A court is more likely to find a valid and enforceable loan when there is a well drafted written loan agreement in place and it is actually treated like a real loan.  This could be an inter-company loan agreement, promissory note, revolving credit line agreement, or other debt document.  The loan has to be for reasonably equivalent value to what is being provided and actually have terms that could be enforced.  If there are regular payments due, those must be paid and documented.  If there is interest due (which there should be at least some minimum amount provided for), it should be regularly accrued and put on the company’s books or accounting records.  These are just some of the actions that need to be taken to protect those dollars you lent to the company.  The more a court would view the arrangement as similar to what a bank or some other outsider lending money would put into place, the more likely the court would enforce the loan or keep liabilities separated from the owner or other companies.  It is also highly recommended to avoid commingling (sharing) funds or bank accounts between companies or owners, but I realize that the day to day needs of a company may not allow that kind of requirement to be kept.  If you have an LLC or corporation, be sure you have a separate bank account in that company’s name and try not to run any personal expenses through it.

A little planning can avoid courts turning your loan into worthless equity or making your personal assets vulnerable to creditors. Avoid these situations altogether with valid legal loan agreements, documented accounting, and segregated accounts and funds, so business owner beware!

What are the life skills a startup CEO must learn to rise to the top?

There are tons of business skills, but life skills translate into good decision making (not always, but most of the time).  Gratitude, humility, and ability to listen (as mentioned) are key, but the ability to take life as it comes and be accepting of those changes, but willing to adapt to survive.  Many CEOs are so convinced in their product/service, that they fail to see the big picture of life and business, which I feel should include acceptance of today, gratitude for tomorrow and doing what you love, and willingness to change, no matter what.

See question on Quora

Entrepreneurs Suffer Credit Problems In Economic Hard Times

Many small business owners or other entrepreneurs start out with a great idea for a new product or service.  They start a business and focus on doing whatever it takes to make the company successful.  Many don’t take the steps necessary to properly protect the business from creditors or don’t really pay much attention to what they sign when they are making deals.  The ones who do read the fine print may just have the attitude that they are so confident in the business’ success, who cares if they use their own personal credit to get some working capital.  With the economic downturn over the last few years, many business owners have had to close their doors because they couldn’t get the funds they needed to even cover the simple things like payroll or rent.

Use of Personal Credit

Many entrepreneurs feel that they should put some ‘skin in the game’ by contributing some of their own money into the business.  In fact, the Small Business Administration backed loans often require the founders to contribute at least a certain percent of their own assets or some other major contribution in order to qualify for a business loan.  When the owner doesn’t have available cash, they look to other sources to get the money to contribute.  That can lead to things like taking out a home equity line of credit or using personal credit cards to help fund the business.  Obviously that is pretty risky, but often necessary to get early access to this seed money to start and grow.  The banks that issued the credit did so based upon the owner’s personal credit rating.  Just because the credit card may have the business’ name on it doesn’t mean the bank hasn’t covered their bases by making sure they can sue the owner personally if the business defaults in payment.

Learn more

What do I look for in a business or startup attorney?

One of the biggest questions small business owners or founders have when it comes to early stage business issues is when do they need to hire an attorney and how do they pick one.  I will explain what I think are important qualities and how an attorney can be invaluable, even before the company is formed.

A good startup (some people spell start-up, some use startup) or business attorney needs to be able to see a wide variety of potential issues the company may face and be able to address those with the company or founders.  If they simply form a corporation and provide some initial shareholder agreements, bylaws, resolutions, or other initial documentation, that is a valuable service, but there is much more to be examined and addressed in an early stage business. There are many legal or business issues, such as what intellectual property protection is or needs to be in place (e.g. patents, trademarks, non-disclosure agreements), advise the founders about securities laws relating to issuing stock or raising money, preparing for human resources and hiring (e.g. explaining that you can’t just call someone an independent contractor or 1099 and avoid payroll tax withholding obligations), and when to get someone involved in drafting or reviewing contracts.  While it is true that “startup law” is really mostly about basic formation and protection of business entities and possibly help with closing initial rounds of funding, the attorney should have a wide general knowledge of many aspects of business and law.

Learn more