A bankrupt jewelry retailer can proceed past the pleading stage with a lawsuit seeking to recharacterize funds loaned to it by stockholders as equity, a Delaware bankruptcy judge has ruled.
Several stockholders, including Goldman Sachs Credit Partners LP, sought dismissal of the adversary complaint, saying the parties intended the funds to be debt.
However, Judge Christopher Sontchi of the U.S. Bankruptcy Court for the District of Delaware said the liquidating trustee for Friedman’s Inc. has made “facially plausible allegations” regarding recharacterization of the funds from debt to equity.
Friedman’s has twice filed for bankruptcy protection in recent years. It filed its first case in January 2005 in the Southern District of Georgia.
After emerging from that proceeding, the retail chain obtained more than $22 million in financing from its shareholders in order to purchase another jewelry retailer, according to Judge Sontchi’s opinion.
The July 2006 financing agreement called for the shareholders to contribute funds on a prorata basis equal to their equity interest in Friedman’s. In return, Friedman’s gave the shareholders an unsecured promissory note due no more than four years later, the opinion said.
Less than two years later, Friedman’s again filed for Chapter 11 protection, this time in the District of Delaware.
A group of shareholders subsequently filed general unsecured claims, saying the funds they provided were debt. Friedman’s responded with an adversary complaint seeking to recharacterize the funds as equity.
The shareholders asked Judge Sontchi to dismiss the complaint, saying the parties intended the funds to be a loan.
The judge disagreed, concluding under the plaintiff-friendly light of a pleading-stage motion to dismiss that Friedman’s had alleged facts sufficient to support a finding that the funds were equity.
Judge Sontchi reached this decision after citing the following allegations, all of which he said could weigh in favor of a finding that the funds were equity:
- There was a pro rata contribution by the shareholders.
- Interest payments were deferred.
- The promised interest rate was below market.
- Interest was not paid when funds were available.
- The contributions were made on a subordinated unsecured basis.
The judge noted the shareholders ultimately may prevail on the merits of their defense, saying certain other factors weigh in favor of characterizing the funds as debt.
In particular, Judge Sontchi said, the parties’ agreement identifies the funds as “unsecured subordinated loans.”
Nevertheless, he said that “while the defendants’ arguments may ultimately prevail regarding intent, at this stage of the proceedings … the plaintiff has alleged plausible facts that require a further evidentiary record.”
In re Friedman’s Inc., No. 08-10161; Friedman’s Liquidating Trust v. Goldman Sachs Credit Partners LP et al.; Adv. No. 09-51010, 2011 WL 2787241 (Bankr. D. Del. July 12, 2011).