Equitable Subordination

Bankruptcy courts are special courts. They are neither Article III courts (Northern Pipeline Constr. Co. v. Marathon Pipe Line Co., 458 U.S. 50 (1982)) nor their adjuncts (Stern v. Marshall, 564 U.S. 462 (2011)), but nonetheless have inherent powers (Law v. Siegel, 134 S. Ct. 1188, 1194, 571 U.S. __ (2014)) and—pursuant to 11 U.S.C. § 105—certain equitable powers. This means that they have broad powers to order equitable remedies—such as specific performance—where no adequate remedy at law exists, to the extent not inconsistent with any other provisions of the Bankruptcy Code. See Law v. Siegel, 134 S. Ct. at 1194, 571 U.S. at __. This is the backdrop against which inequitable conduct by a creditor may lead to subordination of its claim in a bankruptcy proceeding under established, codified, equitable principles. Subordination means that a claim, by judicial decree, is lowered, in whole or part, in priority relative to its ordinary position in respect of one or more other claims.
 
Sources of Authority

The source of a bankruptcy court’s power to subordinate claims flows from its “general equitable power to adjust equities among creditors in relation to the liquidation results[,] . . . viewing claims through the eyes of equity and dealing with them on the basis of equitable considerations to prevent injustice or unfairness in the bankruptcy situation.” 80 Nassau Assocs. v. Crossland Fed. Savs. Bank (In re 80 Nassau Assocs.), 169 B.R. 832, 837 (Bankr. S.D.N.Y. 1994) (internal citations and quotations omitted). This power is codified in section 510(c) of the Bankruptcy Code: “after notice and a hearing, a court may[,] under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or part of another allowed interest; or order that any lien securing such a subordinated claim be transferred to the estate.” 11 U.S.C. § 510(c).

Elements of an Equitable Subordination Claim: The Mobile Steel Formulation

The leading case discussing equitable subordination lays out, in practical terms, the requirements for its implementation: “(i) The claimant must have engaged in some type of inequitable conduct[;] (ii) [t]he misconduct must have resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant[;] and (iii) [e]quitable subordination of the claim must not be inconsistent with the provisions of the Bankruptcy Act.” Benjamin v. Diamond (In re Mobile Steel Co.), 563 F.2d 692, 700 (5th Cir. 1977) (internal citations omitted).

Inequitable Conduct

In U.S. v. Noland, 517 U.S. 535 (1996), the Supreme Court held that broadly subordinating a “category of claims” (Noland, 517 U.S. at 537) — in that case, tax penalties—“was inappropriately categorical in nature” because it had “occur[ed] at the level of policy choice at which Congress itself operated in drafting the [Bankruptcy] Code” and declined to “decide . . . whether a bankruptcy court must always find creditor misconduct before a claim may be equitably subordinated.” Id. at 543. Nonetheless, courts continue to follow the Mobile Steel doctrine and apply an inequitable conduct requirement except as to tax penalties—nonpecuniary-loss claims—which are routinely subordinated (in curious defiance of Noland). 

By way of example, the Tenth Circuit places “special emphasis on whether inequitable conduct has occurred . . . and recognize[s] three categories of such conduct: (1) fraud, illegality, and breach of fiduciary duties; (2) undercapitalization; [and] (3) claimant’s use of the debtor as a mere instrumentality or alter ego[.]” Alternate Fuels, Inc. v. Jenkins (In re Alternate Fuels, Inc.), 789 F.3d 1139, 1154 – 55 (10th Cir. 2015) (internal quotations and citation omitted). For insiders or fiduciaries, however, “the party seeking subordination need only show some unfair conduct, and a degree of culpability, on the part of the insider.” Alternate Fuels, 789 F.3d at 1155. This is similar to the Fifth Circuit’s recent formulation that “[i]nequitable conduct exists in three categories of cases: (1) those in which a fiduciary of the debtor misuses his position to the disadvantage of other creditors; (2) those in which a third party, in effect, controls the debtor to the disadvantage of others; and (3) those in which a third-party defrauds other creditors.” Asmarbunkers Consultadoria E. Paricipacoes Unipessoal LDA v. U.S., 2013 WL 407898 at *335, No. 12-40246 (5th Cir. Feb. 1, 2013) (internal quotations and citation omitted). These two examples illustrate that courts generally look to fraud, improper control, and breach of fiduciary duty as indicia of inequitable conduct.

Virtually all equitably-subordinated claims involve the claims of insiders. Kham & Nate’s Shoes No. 2, Inc. v. First Bank, 908 F.2d 1351, 1356 (7th Cir. 1990) (Easterbrook, J.) (“[c]ases subordinating the claims of creditors that dealt at arm’s length with the debtor are few and far between”). Where the debtor is a corporation or partnership, the Bankruptcy Code defines “insider” to include a “person in control of the debtor” (11 U.S.C. § 101(31)(B) – (C)); “person,” in turn, is broadly defined to “include[ an] individual, partnership, and corporation” (§ 101(41)). Thus, a lender’s control of a borrower becomes an issue in determining whether the lender may be held to the higher standard of conduct applicable to insiders. Where a lender assumes the role of corporate directors and officers to make business decisions on their behalf, their fiduciary duty may be imputed to the controlling lender. Herzog v. Leighton Holdings, Ltd., (In re Kids Creek Partners, L.P.), 200 B.R. 996, 1015 – 16 (Bankr. N.D. Ill. 1996). This means that a creditor in control of a debtor must avoid self-dealing. Bergquist v. First Nat’l Bank (In re Am. Lumber Co.), 5 B.R. 470 (D. Minn. 1980) (holding that a creditor who caused a borrower it controlled to give it security interests in its only assets, on account of antecedent debts owed to it, to the detriment of other unsecured creditors, for the purpose of subsequently foreclosing on the security interests, had not acted in good faith). Indicia of control include ownership of voting stock, managerial control, non-arms-length qualities of the relationship between lender and borrower, and whether the lender was the borrower’s sole source of credit. Courts nonetheless require a “merger of identity . . . [to such an extent that] the creditor . . . become[s] . . . the alter ego of the debtor” (Anaconda-Ericcson, Inc. v. Hessen (In re Teltronics), 29 B.R. 139, 171 (Bankr. E.D.N.Y. 1983)) and that “a creditor must exercise virtually complete control to be treated as a fiduciary” (Bank of New Richmond v. Production Credit Ass’n (In re Osborne), 42 B.R. 988, 997 (W.D. Wis. 1984) so that the debtor becomes a “mere instrumentality” (Smith v. Associates Commercial Corp. (In re Clark Pipe & Supply Co., Inc.), 893 F.2d 693, 699 (5th Cir. 1990)). In addition, where governing loan documents provide for the exercise of certain specific rights or remedies, adopting such remedies within the purview of the agreements provides a sort of safe harbor for lenders. Smith, 893 F.2d at 701 (“[t]he purpose of equitable subordination is to distinguish between the unilateral remedies that a creditor may properly enforce pursuant to its agreements with the debtor and other inequitable conduct such as fraud, misrepresentation, or the exercise of such total control over the debtor as to have essentially replaced its decision-making capacity with that of the lender”); Kham & Nate’s Shoes No. 2, 908 F.2d at 1356 – 57 (rev’g the bankruptcy court’s order subordinating the bank’s claim where the bank had exercised certain contractual rights, even where doing so converted its claim from unsecured to secured: “we are not willing to embrace a rule that requires participants in commercial transactions not only to keep their contracts but also do ‘more’”); and United States Abatement Corp. v. Mobil Exploration & Producing U.S., Inc. (In re United States Abatement Corp.), 39 F.3d 556, 562 (5th Cir. 1994) (defendant’s “act of withholding [certain payments from plaintiff] was made pursuant to [its] contractual right to do so[, so that its] economic leverage, asserted . . . pursuant to the terms of the contracts, did not give [it] inequitable control over” plaintiff).

Inequitable conduct is not limited, despite the “inadvertent[]” use in older cases of such language, to conduct in “acquiring or asserting” a claim (Mobile Steel, 563 F.2d at 700 – 01), but reaches the totality of a creditor’s conduct.

Injury or Unfair Advantage: Remedial Scope of Subordination

“Equitable subordination is a remedial, not penal, measure which is used only sparingly.” United States Abatement Corp., 39 F.3d at 561. Accordingly, a party in interest, such as a creditor, pleading an equitable subordination claim must, on account of its remedial nature, demonstrate that it suffered actual injury, and a penalty will not be enforced. “[C]laims should be subordinated only to the extent necessary to offset the harm which the bankrupt and its creditors suffered on account of the inequitable conduct[]” (Mobile Steel, 563 F.2d at 701), and “courts must take care not to subordinate claims where doing so will operate only to penalize a claimant” (Trone v. Smith (In re Westgate-Cal. Corp.), 642 F.2d 1174, 1178 (9th Cir. 1981)). This means that a claim may be subordinated, in whole or in part, to some or all other claims. “To satisfy the second prong [relating to injury], the proponent of equitable subordination need only allege that general creditors are less likely to collect their debts as a result of the allegedly inequitable conduct[,]” and “[i]f misconduct results in harm to the entire creditor body the objecting party need not identify the injured creditors or quantify their injury, but need only show that the creditors were harmed in some general concrete manner.” Official Committee of Unsecured Creditors of the Debtors v. Austin Fin. Servs., Inc. (In re KDI Holdings, Inc.), 277 B.R. 493, 509 (Bankr. S.D.N.Y. 1999) (internal citation and quotations omitted). “Once an objectant in an insider case supports allegations of impropriety with a substantial factual showing, the burden shifts to the insider creditor to prove the good faith and inherent fairness of its actions. However, the burden remains on the objectant in cases involving non-insider creditors.” Bank of New Richmond, 42 B.R. at 996 (citations omitted).

Equitable subordination, circumscribed as it is by statute, may not, on its face, be used to disallow claims altogether. See 80 Nassau Assocs., 169 B.R. at 837. One bankruptcy court, however, ruled “that authority [caselaw predating the enactment of section 510] exists which would authorize the court to disallow a claim based upon [other] equitable principles.” In re Outdoor Sports Headquarters, Inc., 168 B.R. 177, 182 (Bankr. S.D. Ohio 1994)).

Consistency with the Bankruptcy Code

It had been—perhaps prematurely—speculated that the third prong of the Mobile Steel test had “likely [become] moot due to the enactment of § 510(c) of the Bankruptcy Code.” KDI, 277 B.R. at 509 (quoting 80 Nassau Assocs., 169 B.R. at 841: “since the Bankruptcy Code, unlike its predecessors, expressly authorizes the remedy of equitable subordination, the third prong of the Mobile Street test is likely to be moot”). The Supreme Court laid this notion to rest in Noland, opining with approval that “[t]his last requirement has been read as a reminder to the bankruptcy court that although it is a court of equity, it is not free to adjust the legally valid claim of an innocent party who asserts the claim in good faith merely because the court perceives that the result is inequitable.” Noland, 517 U.S. at 539 (citation and internal quotations omitted).

Conclusion

In sum, lenders, particularly insiders, must take care in their business relations, and stakeholders in bankruptcy proceedings should be aware of the circumstances that might give rise to equitable subordination.