IN RE THE HOG FARM, INC.

No. 09-17778.

In re: The Hog Farm, Inc., Chapter 7, Debtor.

United States Bankruptcy Court, S.D. Ohio, Western Division.


ORDER RE: TRUSTEE'S OBJECTION TO CLAIMS 3, 4, AND 11

BURTON PERLMAN, Bankruptcy Judge.

This is a corporate chapter 7 bankruptcy case. M. Richard Doyle is the incorporator, President, and agent for Debtor, The Hog Farm, Inc. (the "Corporation"). His wife is Tanya Lynn Doyle, the Secretary-Treasurer of the Corporation. His business partner is Kevin Leland, the Vice President of the Corporation. These three individuals comprise the Corporation's Board of Directors and each owns one third (1/3) of the common stock of the Corporation. Each of these three individuals ("claimants") has filed a proof of claim. The trustee in the case has objected to each claim on the basis that the claims are for capital contributions and not for unsecured debt (doc. 15). Claimants have filed a memorandum in response to the trustee's objection, filing identical responses (docs. 17-19). The matter came on for hearing before the Court. The trustee argued for his position. Claimant Doyle presented the position of claimants.

I. Jurisdiction.

This Court has jurisdiction of this matter pursuant to 28 U.S.C. § 1334(b) and the General Order of Reference entered in this district. This is a core proceeding arising under 28 U.S.C. § 157.

II. Summary of the claims at issue.

The claim of M. Richard Doyle, claim number 4, is for $222,572.00. His proof of claim is accompanied by twenty-two instruments, the content of each being summarized as follows:

DATE AMOUNT PURPOSE TERMS SIGNATURES 9/17/09 $9,372 Operational expenses, legal To be reimbursed in full on Kevin Leland, M. (loaned between fees, accounting fees, demand or in trade for parts Richard Doyle, Tanya 1/1/08 and miscellaneous expenses and equipment or assets Doyle 12/31/08) 12/28/07 $26,500 Operational expenses, legal To be reimbursed in full on Kevin Leland, M. (loaned between fees, CPA costs, miscellaneous demand or in trade for parts Richard Doyle, Tanya 1/1/07 and expenses and equipment or assets Doyle 12/28/07) 5/12/06 $3,000 Bills and operating expenses To be reimbursed in full on Kevin Leland, M. (loaned on date demand or in trade for parts Richard Doyle, Tanya of instrument) and equipment or assets Doyle 3/1/06 $22,500 Bills and operating expenses To be reimbursed in full on Kevin Leland, M. (loaned on date demand or in trade for parts Richard Doyle, Tanya of instrument) and equipment or assets Doyle 1/18/06 $4,000 Bills and operating expenses To be reimbursed in full on Kevin Leland, M. (loaned on date demand or in trade for parts Richard Doyle, Tanya of instrument) and equipment or assets Doyle 2/22/06 $6,500 (loaned Bills and operating expenses To be reimbursed in full on Kevin Leland, M. on date of demand or in trade for parts Richard Doyle, Tanya instrument) and equipment or assets Doyle 3/2/06 $20,000 (loaned Pending kit bike purchase To be reimbursed in full on Kevin Leland, M. on date of demand or in trade for parts Richard Doyle, Tanya instrument) and equipment or assets Doyle 10/18/05 $7,500 (loaned Bills and operating expenses To be reimbursed in full on Kevin Leland, M. on date of demand or in trade for parts Richard Doyle, Tanya instrument) and equipment or assets Doyle 10/5/05 $3,500 (loaned Bills and operating expenses To be reimbursed in full on Kevin Leland, M. on date of demand or in trade for parts Richard Doyle, Tanya instrument) and equipment or assets Doyle 9/07/05 $4,000 (loaned Bills and operating expenses To be reimbursed in full on Kevin Leland, M. on date of demand or in trade for parts Richard Doyle, Tanya instrument) and equipment or assets Doyle 8/19/05 $18,750 (loaned Pending kit bike purchase To be reimbursed in full on Kevin Leland, M. on date of demand or in trade for parts Richard Doyle, Tanya instrument) and equipment or assets Doyle 8/15/05 $7,500 Bills and operating expenses To be reimbursed in full on Kevin Leland, M. (loaned on date demand or in trade for parts Richard Doyle, Tanya of instrument) and equipment or assets Doyle 7/12/05 $13,250 Purchase of kit bike, custom To be reimbursed in full on Kevin Leland, M. (loaned on date parts and materials demand or in trade for parts Richard Doyle, Tanya of instrument) and equipment or assets Doyle 6/27/05 $9,600 Bills and operating expenses To be reimbursed in full on Kevin Leland, M. (loaned on date demand or in trade for parts Richard Doyle, Tanya of instrument) and equipment or assets Doyle 3/28/05 $6,000 Bills and operating expenses To be reimbursed in full on Kevin Leland, M. (loaned on date demand or in trade for parts Richard Doyle, Tanya of instrument) and equipment or assets Doyle 3/21/05 $4,000 Bills and operating expenses To be reimbursed in full on Kevin Leland, M. (loaned on date demand or in trade for parts Richard Doyle, Tanya of instrument) and equipment or assets Doyle 3/8/05 $9,100 (loaned Bills and operating expenses To be reimbursed in full on Kevin Leland, M. on date of demand or in trade for parts Richard Doyle, Tanya instrument) and equipment or assets Doyle 3/7/05 $9,500 (loaned Bills and operating expenses To be reimbursed in full on Kevin Leland, M. on date of demand or in trade for parts Richard Doyle, Tanya instrument) and equipment or assets Doyle 2/9/05 $4,000 (loaned Bills and operating expenses To be reimbursed in full on Kevin Leland, M. on date of demand or in trade for parts Richard Doyle, Tanya instrument) and equipment or assets Doyle 12/31/04 $18,500 (loaned Pending purchase of new To be reimbursed in full on Kevin Leland, M. between 1/1/04 model year kit bike on loan for demand or in trade for parts Richard Doyle, Tanya and 12/31/04) display purposes by the and equipment, assets or Doyle Corporation. vehicle 11/14/02 $10,000 (loaned Bills and start-up operating To be reimbursed in full on Kevin Leland, M. on date of expenses demand or in trade for parts Richard Doyle, Tanya instrument) and equipment or assets Doyle 8/15/02 $5,500 (loaned Bills and start-up operating To be reimbursed in full on Kevin Leland, M. on date of expenses demand or in trade for parts Richard Doyle, Tanya instrument) and equipment or assets Doyle

The claim of Tanya Lynn Doyle, claim number 3, is for $14,320.00. Her proof of claim is accompanied by four instruments, the content of each being summarized as follows:

DATE AMOUNT PURPOSE TERMS SIGNATURES 11/15/09 $2,000 (loaned on Retainer for attorneys To be reimbursed in M. Richard Doyle, date of instrument) fees to file bankruptcy full on demand or in Tanya Doyle for the Corporation. trade for parts and equipment or assets 6/4/09 $4,840 (loaned on Attorneys fees for the To be reimbursed in M. Richard Doyle, date of instrument) Corporation full on demand or in Tanya Doyle trade for parts and equipment or assets 12/28/07 $4,380 (loaned Operational expenses, To be reimbursed in Kevin Leland, M. between 1/1/07 and legal fees, CPA costs full on demand or in Richard Doyle, Tanya 12/28/07) and other trade for parts and Doyle miscellaneous equipment or assets expenses 12/29/06 $3,100 (loaned Operational expenses, To be reimbursed in Kevin Leland, M. between 1/1/06 and legal fees, CPA costs full on demand or in Richard Doyle, Tanya 12/29/06) and other trade for parts and Doyle miscellaneous equipment or assets expenses

Finally, the claim of Kevin Leland, claim number 11, is for $22,730.00. His proof of claim is accompanied by two instruments and two checks with the notation "Check acts as Promissory Note" written thereon. These instruments are summarized as follows:

DATE AMOUNT PURPOSE TERMS SIGNATURES 12/10/06 $2,500 (loaned on Legal fees to "RG" To be reimbursed in Kevin Leland, M. date of instrument, full on demand or in Richard Doyle, Tanya evidently by both M. trade for parts and Doyle Richard Doyle and equipment or assets Kevin Leland) 12/31/03 $8,230 ((loaned Advertising, tools, To be reimbursed in Kevin Leland, M. between 1/1/03 and equipment, shop full on demand or in Richard Doyle, Tanya 12/31/03, evidently by supplies and office trade for parts and Doyle both M. Richard Doyle supplies equipment or assets and Kevin Leland) 12/13/02 $1,000 (check with Illegible, but appears n/a n/a notation) to say ". . . for shop" 10/5/02 $11,000 (check with Illegible, but appears n/a n/a notation) to say ". . . bills"

All of the instruments submitted to support the claims of claimants are titled "Promissory Notes." All but two are signed by all three directors. All but two are payable on demand. None of the instruments are notarized.

III. Applicable law.

A. Objection to claim.

The burdens with respect to objections to claims are as follows:

When an objection to claim is made, the party objecting to the claim bears the initial burden of producing sufficient evidence to rebut the prima facie effect of the proof of claim. In re Hughes, 313 B.R. 205, 208 (Bankr. E.D. Mich. 2004) (citations omitted). Once the objecting party produces facts sufficient to demonstrate that an actual dispute exists regarding the validity or amount of the claim, the burden of going forward shifts to the claimant to submit evidence to sustain the claim. Id. (citations omitted). Although the burden of going forward shifts during the claims objection process, the ultimate burden of persuasion is always on the claimant to establish entitlement to the claim. See Fed. R. Bankr. P. 3001(f).

In re Plastech Engineered Products, Inc., 399 B.R. 1, 10 (Bankr. E.D. Mich. 2008).

B. Debt v. Equity.

The power to recharacterize debt as equity is rooted in § 105. As a function of the broad power given to bankruptcy courts to deal with the administration of cases, courts have used § 105 to "regulate unspecified areas of the claim assertion process," which includes recharacterization. 4-510 Collier on Bankruptcy ¶ 105.02[3]. See also 2 Bankr. Service L. Ed. § 12:512. As contrasted with subordination under § 510, recharacterization involves a determination by the bankruptcy court that a claim is properly treated as either a "debt" under § 101(12) or as an "equity security" under § 101(16). 4-510 Collier on Bankruptcy ¶ 501.02[3].

Although no express provision in the Bankruptcy Code deals with recharacterization of claims, "[e]very circuit court that has considered the issue has upheld the power of the bankruptcy court to recharacterize claims." In re Felt Mfg. Co., Inc., 371 B.R. 589, 628-29 (Bankr. D. N.H. 2007) (listing decisions). See also in re Airadigm Communications, Inc., 616 F.3d 642, 653 (7th Cir. 2010) (not reaching the issue, but noting that recharacterization has been "adopted by the overwhelming majority of courts to have considered the questions"). The Sixth Circuit is firmly in this majority. Recharacterization may properly be employed in the Sixth Circuit "where the circumstances show that a debt transaction was `actually [an] equity contribution [ ] ab initio.'" Bayer Corporation v. MascoTech, Inc. (In re Autostyle Plastics, Inc.), 269 F.3d 726, 748 (6th Cir. 2001) (quoting In re Cold Harbor Assocs., 204 B.R. 904, 915 (Bankr. E.D. Va. 1997))

The court in Autostyle stated the following test to analyze whether recharacterization is warranted (from Roth Steel Tube Co. v. Comm'r of Internal Revenue, 800 F.2d 625,630 (6th Cir. 1986)):

The factors are: (1) the names given to the instruments, if any, evidencing the indebtedness; (2) the presence or absence of a fixed maturity date and schedule of payments; (3) the presence or absence of a fixed rate of interest and interest payments; (4) the source of repayments; (5) the adequacy or inadequacy of capitalization; (6) the identity of interest between the creditor and the stockholder; (7) the security, if any, for the advances; (8) the corporation's ability to obtain financing from outside lending institutions; (9) the extent to which the advances were subordinated to the claims of outside creditors; (10) the extent to which the advances were used to acquire capital assets; and (11) the presence or absence of a sinking fund to provide repayment. Roth Steel, 800 F.2d at 630. No one factor is controlling or decisive. Ibid. The factors must be considered within the particular circumstances of each case Ibid.

In re Autostyle, 269 F.3d at 749-750.

DISCUSSION

In this case, the trustee relied for his evidence upon the instruments filed with the proofs of claim by claimants to make his case that the claims should be regarded as equity contributions. Claimants rely on the same attachments to the proofs of claim contending that they represent debt of the Debtor. The trustee, in effect, is asking the Court to recharacterize the documents as signifying equity rather than debt. As shown above in the Autostyle case, it is proper for the Court to recharacterize in appropriate circumstances.

We turn then, to the application of the eleven part test prescribed by the court in Autostyle. Several of the criteria in Autostyle are not dealt with in the evidence in regard to the present evaluation. That is, there is no evidence regarding the ability of Debtor to obtain outside financing, nor is there evidence with respect to the extent to which advances were subordinated to claims of outside creditors.

Upon an examination of the instruments supporting the proofs of claim, the first criterion, names given to the instruments, is favorable to claimants' position with respect to virtually all of the instruments, for they are entitled "Promissary Note." This would support claimants' position that the instruments represent debt.

The remaining criteria, however, overwhelmingly support the position that the transactions which are the subject of the instruments are for equity. Thus, there is an "absence of a fixed maturity date and a fixed obligation to repay [which] is an indication that the advances were capital contributions and not loans." In re Autostyle, 269 F.3d at 750. A very strong indication in the view of this Court that the transactions represent equity rather than debt is "the absence of a fixed rate of interest and interest payments." Id.

The Court was informed that at the outset there was paid in capital of debtor of $5,000.00. That this was inadequate to enable the debtor to operate was clear, for the infusion of funds, represented by the instruments, was necessary in order for the business to operate. As stated by Autostyle: "Thin or inadequate capitalization is strong evidence that the advances are capital contributions rather than loans." Id. at 751.

The court in Autostyle addresses as another factor, the identity of interest between the creditor and stockholder. That identity indicates an equity contribution. In this case, in each instance the instrument was signed on behalf of Debtor by the three claimants. Claimants were also the equity owners of Debtor. This factor weighs in favor of a finding of equity. Next, Autostyle states: "The absence of a security for an advance is a strong indication that the advances were capital contributions rather than loans." Id. at 752. In the case at hand, no evidence suggests the existence of security for any of the advances. The court in Autostyle then dealt with a criterion, the extent to which advances were used to acquire capital assets. It is plain from the discussion in Autostyle that the use of funds to acquire capital assets is to be regarded as equity. That is true particularly with the instruments dated December 31, 2004, July 12, 2005, August 19, 2005, and March 2, 2006. Finally, there is no evidence of a sinking fund to provide repayment, and "the failure to establish a sinking fund for repayment is evidence that the advances sustain their burden of going forward and were capital contributions rather than loans." Id. at 753.

* * *

Having reviewed the record before the Court, the Court finds that there is sufficient evidence as contended by the trustee to rebut the prima facie presumption of validity of the proofs of claim of claimants. The burden of going forward then shifts to claimants. The Court finds that claimants have failed to establish entitlement to their claims.

The objection of the trustee to the claims of all three claimants is sustained.

So ordered.


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