The Bottom Line:
In Machne Menachem, Inc. v. Yaakov Spritzer (In re Machne Menachem, Inc.), No. 11-1496 (3d Cir. Jan. 3, 2012), the Third Circuit affirmed a bankruptcy court's use of its equitable power to recharacterize as gifts advances made to a not-for-profit corporation by one of its directors where there was a failure to abide by New York law regarding insider corporate transactions and insufficient indicia of intent on behalf of the parties at the time of the transaction to repay the funds. While recharacterization is typically used to convert debt into equity, here the obligations were converted into gifts, since non-profits do not have equity interests.
What Happened:
The debtor, a not-for-profit corporation (“Machne”), operated a summer camp. After facing financial difficulties, one of the four directors made substantial financial advances over a several year period. During this time, the remaining three directors – upset with the advances and the level of control being exercised by the fourth director – passed a board resolution condemning that director’s conduct and prohibiting him from undertaking any further activities on behalf of Machne. This, in turn, led to litigation in the District Court for the Eastern District of New York over the management and control of Machne. Before resolution of this litigation in New York, the funding director caused Machne to issue a mortgage in his favor in the amount of $1,000,000. Shortly thereafter, he caused Machne to file for Chapter 11 protection in the United States Bankruptcy Court for the Middle District of Pennsylvania and filed a proof of claim in the bankruptcy case in the amount of the mortgage. In re Machne Menachem, Inc., No. 01-04926 (Bankr. M.D. Pa. 2001). Following the bankruptcy petition, the New York litigation proceeded and the District Court concluded that the three opposing directors had not abandoned their positions as directors, and that the funding director ignored a valid corporate resolution removing him as a director of the corporation: The affairs of the corporation were “conducted by [the funding director] as though it was his personal fiefdom” with a complete disregard for the Not-For-Profit Corporation Law of New York. Machne Menachem, Inc. v. Hershkop, 237 F. Supp. 2d 227, 238 (E.D.N.Y. 2002).
Meanwhile, in the bankruptcy case, using his status as a creditor, the funding director proposed a plan of reorganization, which was eventually confirmed, whereby Machne's real estate was to be purchased by a new not-for-profit corporation controlled by that director. The debtor, however, objected to the funding director’s proof of claim on the ground that any advances were either donations with no expectation of repayment or not authorized by the corporation. Relying upon Cohen v. KB Mezzanine Fund II (In re SubMicron Systems Corp.), 432 F.3d 448 (3d Cir. 2006), the bankruptcy court ruled that its equitable power to recharacterize debt into equity applied equally to advances made to a not-for-profit corporation. The bankruptcy court found insufficient evidence of intent to create a loan for the vast majority of the funds advanced and reduced the funding director’s claim to $76,000. The Court focused on the absence of documentation and official corporate action, and the resolution ordering the funding director to cease activities on behalf of the corporation, stating that “[s]ince [he] continued to advance funds to the Debtor after that date, aware of the position of the majority directors, a fair conclusion would be that [he] made those advances at his peril.”
On appeal, the Third Circuit affirmed, noting that the funding director “provide[d] no evidence of intent on behalf of [the corporation] to accept or authorize the purported loans, such as a resolution from the board of directors, or evidence that the board was aware of the loans.” The Third Circuit held, therefore, that “the lack of any documentation relating to the terms of the loan and the lack of intent on behalf of [the corporation] to accept a loan” is sufficient to support the recharacterization of the advances as gifts to Machne.
Why the Case is Interesting:
This case is notable for its application of the court’s equitable recharacterization power to advances made to a not-for-profit corporation. While the facts here may present themselves in the extreme, insolvent not-for-profit entities often have few options to address liquidity needs, which may prompt insider loans. The case underscores the need to properly document and address the formalities of any such loans and demonstrates that the pitfalls of debt-to-equity recharacterization apply equally to debt-to-gift status.