By Allan L. Hill and Nickolas Karavolas, originally published in Law360 on 7/9/15.

Equitable Subordination Considerations For Creditors

A secured lender generally enjoys a relative position of priority when a borrower runs into financial distress. Assuming that the lender’s security interest in the borrower’s collateral is appropriately documented and properly perfected, and that the lender’s claim is oversecured, the secured lender can take some comfort in the fact that bankruptcy principles generally ensure that the secured lender is afforded the same priority that such lender would receive in a nonbankruptcy liquidation of the borrower’s assets, and there is a strong likelihood that its claim will be satisfied in full.

However, in certain situations, the actions taken by a creditor prior to a bankruptcy case to impact or control the borrower’s operation of its business can lead a bankruptcy court to reduce the lender’s priority status below that of other secured creditors, or even below unsecured creditors, a doctrine known as equitable subordination. This article analyzes the bankruptcy doctrine of equitable subordination and its implications on secured creditors that have the ability to exert an impermissible degree of control over the debtor’s operation of its business.

A Brief History of Equitable Subordination

While equitable subordination is a judicially created doctrine with roots as far back as the early 1900s,[1] the doctrine was codified by Section 510(c) of the Bankruptcy Code.[2] Section 510(c) of the Bankruptcy Code codified the prior case law while allowing courts to further develop the principles of equitable subordination.[3]

The objective of equitable subordination is to achieve fairness in the bankruptcy process as a whole, rather than between particular creditors.[4] It is a remedial, rather than a penal, measure that is intended to be used sparingly.[5] Specifically, courts have cautioned that the doctrine of equitable subordination is not to be used to engage in categorical reordering of statutory priorities.[6]

Section 510(c) also provides that when a secured claim is subordinated, the lien securing the claim is transferred to the debtor’s estate.[7] Accordingly, the subordinated claim becomes unsecured.

Equitable Subordination of Claims of Secured Lenders

Generally, three conditions must be satisfied in order for a secured creditor’s claim to be equitably subordinated: (1) the creditor must have engaged in some type of inequitable conduct; (2) the misconduct must have resulted in injury to other creditors of the bankrupt party or conferred an unfair advantage on the creditor; and (3) equitable subordination must not be inconsistent with the provisions of the Bankruptcy Code.[8] The term “inequitable conduct” is not defined by the Bankruptcy Code, but courts determining whether a claim should be equitably subordinated have generally required that the movant show evidence of egregious conduct by the claimant such as fraud, spoliation, overreaching or similar behavior.[9]

Where a creditor exerts a high level of control over the debtor to the extent that it dominates the debtor’s free will, a secured creditor may be deemed a fiduciary of the debtor and will be subject to a higher level of scrutiny.[10] Control can be in any of three common forms: (1) management control; (2) voting control; or (3) control through financial domination.

While the typical case of equitable subordination based on control involves a corporate insider, such as an officer, director or general partner of the debtor,[11] a noninsider secured creditor’s claim can also be equitably subordinated where the creditor maintains a high level of control over the debtor and there is evidence that any transactions between the parties were not conducted at arm’s length.[12] The rationale behind this exception is that if a lender usurps its power to make business decisions for the debtor, then it must also undertake those fiduciary obligations that the debtor’s officers and directors owe to the entity.

Control sufficient to warrant equitable subordination typically is established by facts and circumstances demonstrating that the lender either dictated the day-to-day management and operation of the debtor, affected corporate policies of the debtor, or influenced decisions regarding disposition of the debtor’s assets in an effort to better the creditor’s position at the expense of other creditors.[13] Other forms of noninsider control involve close relationships between the lender and the debtor whereby the lender is either privy to otherwise proprietary business information of the debtor or has some other bargaining advantage that suggests that the parties are not dealing at arm’s length.[14]

For example, in In re American Lumber Co., the bankruptcy court held that a secured lender exercised a substantial level of control over the debtor due to, among other things, the lender’s (1) ability to obtain a controlling interest of the debtor’s stock; (2) de facto control over the debtor’s cash flow; (3) ability to force termination of the debtor’s employees; and (4) unilateral control over which other creditors of the debtor would be paid.[15]

Conversely, a secured creditor who merely seeks to enforce the terms of its loan to the debtor and exercises its rights in accordance with such terms does not act with a level of domination and control giving rise to an equitable subordination claim.[16] Nor is a secured creditor with mere financial leverage over the debtor subject to equitable subordination.[17]

Conclusion

Equitable subordination provides the debtor or other parties in interest in bankruptcy cases with an additional tool to challenge a secured creditor’s claim. Secured lenders should be wary of developing a close financial or managerial relationship with their borrowers in the event that a borrower gradually slips into a state of financial distress.

While bankruptcy courts applying the doctrine of equitable subordination have set heavy burdens on parties seeking to equitably subordinate claims, especially claims of noninsiders, a secured creditor’s financial position and ability to control various managerial and operational elements of a borrower’s business, even if the secured lender’s underlying objectives are not to seek an unfair advantage at the expense of the debtor or other creditors, can result in the secured creditor losing its secured status and being treated as, at best, a general unsecured creditor.

A secured creditor should be cautious to avoid crossing the line from avidly enforcing its contractual and legal rights to impermissibly using bargaining leverage to control the borrower’s business affairs. In addition, loan documentation should be negotiated and drafted appropriately to ensure that a transaction is not susceptible to subsequent challenge for having not been transacted at arm’s length.

—By Allan L. Hill and Nickolas Karavolas, Phillips Lytle LLP

 

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] See In re Prince Frederick Inv. LLC, 516 B.R. 778, 782 (Bankr. D. Md. 2014).

[2] Section 510(c) provides, in pertinent part, that “after notice and a hearing, the court may … (1) 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.” 11 U.S.C. § 510(c).

[3] H.R. Rep. No. 95-595, at 359 (1977).

[4] In re QuVIS Inc., 469 B.R. 353, 366 (D. Kan.), aff’’d, 504 F. App’x 747 (10th Cir. 2012).

[5] In re U.S. Abatement Corp., 39 F.3d 556, 561 (5th Cir. 1994).

[6] See United States v. Noland, 517 U.S. 535, 543 (1996) (“in the absence of a need to reconcile conflicting congressional choices the circumstances that prompt a court to order equitable subordination must not occur at the level of policy choice at which Congress itself operated in drafting the Code”); United States v. Reorganized CF&I Fabricators of Utah. Inc., 518 U.S. 213,229 (1996) (“categorical reordering of priorities that takes place at the legislative level of consideration is beyond the scope of judicial authority to order equitable subordination under § 510(c).”)

[7] See 11 U.S.C. § 510(c)(2)(2015).

[8] See Noland, 517 U.S. at 535.

[9] See In re Sentinel Mgmt. Group Inc., 728 F.3d 660, 670 (7th Cir. 2013); In re Winstar Commc’ns, 554 F.3d 382, 412 (3d Cir. 2009); In re Castletons Inc., 990 F.2d 551, 559 (10th Cir. 1993); In re 604 Columbus Ave. Realty Trust, 968 F.2d 1332, 1360 (1st Cir. 1992); In re Baker & Getty Fin. Servs. Inc., 974 F.2d 712, 718 (6th Cir. 1992); In re Clark Pipe and Supply Co., 870 F.2d 1022, 1030 (5th Cir. 1989).

[10] In re 604 Columbus Ave. Realty Trust, 968 F.2d 1332, 1360 (1st Cir. 1992).

[11] In re Think3 Inc., 529 B.R. 147, 205 (Bankr. W.D. Tex. 2015).

[12] See In re U.S. Med. Inc., 531 F.3d 1272, 1277 (10th Cir. 2008).

[13] In re Exide Techs, 299 B.R. 732, 743 (Bankr. D. Del. 2003).

[14] See, e.g., In re Winstar Commc’ns Inc., 348 B.R. 234 (Bankr D. Del. 2005), aff’d, 2007 WL 1232185 (D. Del. Apr. 26, 2007).

[15] In re Am. Lumber Co., 5 B.R. 470, 477-78 (D. Minn. 1980).

[16] See, e.g., Kham & Nate’s Shoes No. 2 Inc. v. First Bank of Whiting, 908 F.2d 1351, 1357-58 (7th Cir. 1990) (refusing the subordinate the claim of a lender who provided debtor with prepetition and postpetition financing that ceased provided financing to debtor two months after the petition date where loan agreement provided for cancellation of the credit line on five days’ notice).

[17] In re Prince Frederick Inv. LLC, 516 B.R. 778, 784 (Bankr. D. Md. 2014).

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Nickolas Karavolas is an associate in the firm’s New York City office.