In his first published opinion since returning from a well-deserved vacation, Judge Sontchi of the Delaware Bankruptcy Court ruled that facially plausible allegations are sufficient to protect a complaint, which sought to recharacterize another party’s bankruptcy claims, from being dismissed pursuant to Federal Rule of Civil Procedure (“FRCP”) 12(b)(6). Judge Sontchi’s opinion is available here (the “Opinion”).  For the principles of an analysis under FRCP 12(b)(6), please review the posts listed below:

Decision in Tweeter Opco Once Again Reminds Trustees of the Specificity Requirement in Pleading Preference Actions

Decision in Crucible Materials Requires Preference Claims to Contain More Than Just Recitations of the Code

Decision in DBSI Inc., Holds that the “Particularity” Requirement of F.R.C.P. 12(b)(6) and 9(b) was Satisfied, Notwithstanding the Number of Alleged Fraudulent Transfers


In July 2006, Friedman’s Inc. (the “Debtor”) purchased the jewelry chain Crescent following Crescent’s descent into bankruptcy. In order to make this purchase, the Debtor issued an unsecured promissory note (the “Note”) to its shareholders in exchange for their funding of just over $22 million. Opinion at *3-4. The funding was provided to the Debtor by each of its shareholders on a pro rata basis, and was to accrue interest at 8% per annum, with no fixed dates for payment. Following a tax rebate paid to the Debtor in December 2006, the interest on the Note could have been paid in full, but was not. Rather, interest was never paid on the Note. Opinion at *4-5. In January 2008, the Debtor was pushed into an involuntary bankruptcy, which the Court later converted to a voluntary chapter 11 case.

Thereafter, the shareholders who contributed to the Debtor in exchange for the Note filed a claim for its value, including interest. The Debtor filed a complaint objecting to the general unsecured claims of Goldman Sachs Credit Partners L.P., Plainfield Direct Inc., Ramius Value and Opportunity Master Fund Ltd, Parche, LLC and Cadence Master Fund Ltd. (collectively, the “Defendants”) and sought to recharacterize them as equity. The Defendants filed a motion to dismiss the complaint under FRCP 12(b)(6) for failure to state a claim. It was this motion that gave rise to the Opinion.

The Defendants argue that the funding was intended to be a loan and not equity. Opinion at *6. This is evidenced, they argue, by the Debtor’s consideration, and rejection, of raising equity to pay for the acquisition. Opinion at *20. The Debtors allege that the details of the transaction, including the pro rata contribution by the shareholders, the deferred interest payments, the below market interest rate, unpaid interest even when monies were available, and the basis of the contribution being subordinated unsecured, all are indicative of an equity transaction rather than a debt transaction. Opinion at *2.

Judge Sontchi’s Opinion

Judge Sontchi’s legal analysis begins with the standard explanation of the requirements to grant a motion to dismiss under FRCP 12(b)(6) – explained in our previous posts (see the links above). He then moved to a discussion of Third Circuit recharacterization precedent, which focuses on “whether the parties called an instrument one thing when in fact they intended it as something else. That intent may be inferred from what the parties say in their contracts, from what they do through their actions, and from the economic reality of the surrounding circumstances.” Opinion at *9 quoting Cohen v. KB Mezzanine Fund II, LP (In re SubMicron Sys. Corp.), 432 F.3d 448, 456 (3d Cir. 2006).

Judge Sontchi then went through the following factors to determine what the intent of the parties was in providing the financing at issue: (1) Names Given to the Instruments, if any, Evidencing the Indebtedness, at *12; (2) Presence or Absence of a Fixed Maturity Date and Schedule of Payments, at *13; (3) No Fixed Rate of Interest and Interest Payments, at *14; (4) Repayment Dependent on Success, at *15; (5) Inadequacy of Capitalization, at *16; (6) Identity of Interests Between Creditor and Stockholder, at *16; (7) Security, if any, for the Advances, at *17; (8) Ability to Obtain Financing From Outside Lending Institutions, at *17; (9) Extent to Which the Advances Were Subordinated to the Claim of Outside Creditors, at *18; (10) The Extent to Which the Advances Were Used to Acquire Capital Assets, at *18; (11) Presence or Absence of a Sinking Fund, at *19; (12) Presence or Absence of Voting Rights, at *19.

Judge Sontchi is clear to note that the Court does not base its decision on the mechanical exercise of tallying how many of the above factors weigh in favor of determining the funding is equity vs. how many weigh in favor of determining the funding to be debt. He does, however provide the score: Equity 7, Debt 3 and Neither 2. Opinion at *21. In reaching his ultimate decision to deny the motion to dismiss, Judge Sontchi points out that the Defendants may win at trial, but deciding a motion to dismiss requires the judge to take all allegations in the Complaint as true. In this instance, he determined that the Plaintiff alleged sufficient facts that an evidentiary record is necessary for the Court to make a final decision on how to characterize the funding. Opinion at *21-22.

Motions to Dismiss serve a gatekeeping function in court, ensuring that time is not spent developing a factual record when no legal wrong has been committed. Considering that most legal actions are resolved through settlement, it is important to keep in mind that a complaint which survives a motion to dismiss is going to be much more expensive to settle.