The Bankruptcy Code dictates the priority of distributions to the holders of allowed secured and unsecured claims in accordance with various statutory priority schemes. However, the Bankruptcy Code also provides that consensual pre-bankruptcy agreements between or among creditors that prioritize the right to receive payments from an obligor will generally be enforced in a bankruptcy case subsequently filed by the obligor.

In In re Franklin Bank Corp., 2014 BL 200948 (D. Del. July 21, 2014), a Delaware district court confronted the apparent conflict between the priorities established by the Bankruptcy Code for late-filed claims and a prepetition subordination agreement. The court vacated and remanded a bankruptcy court ruling that: (i) by filing its claims years after expiration of the claims "bar date," a creditor waived its right to enforce the terms of prepetition subordination agreements; or, in the alternative, (ii) the late filings justified equitable subordination of the tardy creditor's claims. According to the district court, the creditor's failure to act in a timely manner did not rise to the level of a "clear manifestation of intent to relinquish a contractual protection" and there was evidence of neither inequitable conduct nor harm to other creditors that would warrant equitable subordination of the late-filed claims.

Bankruptcy Code Priorities

Various provisions of the Bankruptcy Code establish priorities for claims against the debtor or the bankruptcy estate. For example, section 507 specifies 10 categories of unsecured claims (e.g., administrative expense claims, certain employee wage and benefit claims, certain tax claims, and certain personal injury claims) that have priority over the claims of general unsecured creditors. 

Section 726(a) of the Bankruptcy Code establishes the priority scheme for the distribution of estate assets in a chapter 7 liquidation. It provides that, "[e]xcept as provided in section 510," first priority is given to timely filed claims of the kind (and in the order) specified in section 507. Timely filed unsecured claims without priority under section 507 as well as tardily filed unsecured claims submitted by creditors without notice or actual knowledge of the bankruptcy case (if filed in time to permit payment) are conferred with second priority. Other tardily filed unsecured claims are relegated to third priority. Fourth, fifth, and sixth priorities are afforded, respectively, to: (a) certain fines, penalties, forfeitures, and punitive damage claims; (b) claims for postpetition interest; and (c) the debtor's residual interest in the estate. Claims of higher priority must be paid in full before any lower-priority claimant may receive a distribution from the bankruptcy estate.

As noted, section 726(a) expressly states that this distribution scheme is subject to section 510 of the Bankruptcy Code. Section 510(a) provides that "[a] subordination agreement is enforceable in a case under this title to the same extent that such agreement is enforceable under applicable nonbankruptcy law." Section 510(b) "categorically" subordinates certain claims for damages arising from the rescission of a purchase or sale of the securities of a debtor or its affiliate. Finally, under section 510(c), a claim or interest can be subordinated for purposes of distribution to other claims or interests "under principles of equitable subordination." In Franklin, the Delaware district court examined the interplay between sections 726(a), 510(a), and 510(c) of the Bankruptcy Code.

Background

In November 2008, Texas-based savings and loan holding company Franklin Bank Corporation (the "debtor") filed a chapter 7 petition in the District of Delaware. Prior to filing for bankruptcy, the debtor: (a) issued a series of senior notes; and (b) created four capital trusts, issuing a different class of securities to each trust. The Bank of New York Mellon Trust Company, N.A. ("BNY Mellon") served as indenture trustee for the senior notes and three of the capital trusts, whereas Wilmington Trust Co. ("Wilmington Trust") served as indenture trustee for the remaining trust. 

The noteholders and trust security holders were parties to a series of prepetition subordination agreements. Under these agreements, the notes and securities for which BNY Mellon served as indenture trustee held higher priority of payment than the securities for which Wilmington Trust was indenture trustee.

The bankruptcy court established a March 12, 2009, deadline ("bar date") for the filing of proofs of claim in the case. Wilmington Trust timely filed a $25.7 million proof of claim. BNY Mellon, however, filed its $84 million in claims in November 2011—more than two and a half years after the bar date. 

The chapter 7 trustee issued his final report in May 2013. With only approximately $7 million available in the estate for distribution, the trustee allocated the entire amount to pay a portion of Wilmington Trust's $25.7 million claim. BNY Mellon objected, asserting for the first time (more than four years after commencement of the case) that Wilmington Trust's claim was contractually subordinated. 

The bankruptcy court overruled BNY Mellon's objection. First, the court reasoned that BNY Mellon's late-filed claims were junior to Wilmington Trust's timely filed claim pursuant to the priority scheme delineated in section 726(a). Next, the court found that BNY Mellon "waived" its right to enforce the subordination agreements by "sitting on its hands" for years prior to asserting its claims. The court held that this "gross negligence" was detrimental to the estate and prejudicial to estate administration. The bankruptcy court also hedged its ruling, stating that if an appellate court were to find that BNY Mellon's actions did not constitute a waiver of its right to enforce the subordination agreements, the court would equitably subordinate the claims under section 510(c) of the Bankruptcy Code. BNY Mellon appealed the ruling to the district court. 

The District Court's Ruling

The Late Claim Filing Did Not Constitute a Waiver

The Delaware district court first analyzed whether BNY Mellon either prejudiced administration of the debtor's bankruptcy estate or committed "gross negligence" when it filed its claims years after the bar date and thereby waived its right to enforce the subordination agreements. The court ultimately concluded that BNY Mellon's conduct did not constitute a waiver as a matter of law. 

Under New York law, the district court explained, a party may waive contractual rights if such rights are "knowingly, voluntarily and intentionally abandoned" (citing Fundamental Portfolio Advisors, Inc. v. Tocqueville Asset Mgmt., L.P., 850 N.E.2d 653, 658 (N.Y. 2006)). In this context, abandonment requires either: (i) affirmative action; or (ii) a failure to act that manifests a clear intention to relinquish contractual protection. 

In examining whether BNY Mellon waived its rights under the subordination agreements, the district court questioned whether "prejudice to estate administration" is even relevant to the question. Nevertheless, the district court held that, since the chapter 7 trustee had not yet distributed any funds, no such prejudice existed. Because the estate's assets were so small in amount compared to the asserted claim amounts, the court wrote, the trustee merely had to "write a check in the same amount" to BNY Mellon as he would have written to Wilmington Trust. 

Despite frustration caused by the years-late filing, the district court also concluded that BNY Mellon's inaction, though negligent, did not clearly manifest an intent to abandon its rights under the subordination agreements. 

Equitable Subordination of the Late-Filed Claims Was Unwarranted

The district court also determined that the bankruptcy court's alternative ruling equitably subordinating BNY Mellon's late-filed claims was erroneous. In the Third Circuit, the district court explained, three conditions must apply for a court to equitably subordinate a claim: (i) the claimant must have engaged in inequitable conduct; (ii) the claimant's misconduct must have conferred an unfair advantage on the claimant or injured other creditors; and (iii) equitable subordination must not be inconsistent with the Bankruptcy Code (citing Schubter v. Lucent Techs. Inc. (In re Winstar Commc'ns, Inc.), 554 F.3d 382, 411 (3d. Cir. 2009)). The district court held that none of these elements was satisfied in the case before it. 

First, the district court found that BNY Mellon did not engage in inequitable conduct. For noninsiders like BNY Mellon, the court explained, equitable subordination requires egregious conduct, such as "fraud, spoliation or overreaching." Despite the bankruptcy court's finding that BNY Mellon's conduct was "grossly negligent," the district court held that such negligence was not egregious. In the absence of any evidence of inequitable conduct or harm to creditors, the district court ruled that the second element (unfair advantage or creditor injury) was not satisfied.

The district court also held that equitable subordination of a claim based solely upon lateness in filing a proof of claim is inconsistent with the Bankruptcy Code. Under section 726(a), the court reasoned, the Bankruptcy Code already "punishe[s]" late-filed claims by giving them lower priority than timely filed claims. The court noted that all of section 726(a), including the provisions subordinating late-filed claims, is subject to section 510, which specifically provides for the enforcement of subordination agreements. The court concluded that equitable subordination of a claim solely because it is tardily filed is inconsistent with this statutory structure:

To equitably subordinate a claim for tardiness alone, in my mind, is inconsistent with the statutory interplay between sections 726 and 510, and a violation of the contractual framework entered into by the parties for prioritizing the claims in this bankruptcy proceeding. Something more than extreme tardiness is required before [BNY Mellon's] claim can be equitably subordinated.

Conclusion

One takeaway from Franklin is that provisions in intercreditor agreements governing payment priority are durable and will generally be enforced by bankruptcy courts. Creditors, however, should not view the decision as a license to ignore claims bar dates. In its decision, the district court considered, in part, that no actual prejudice to the estate occurred because no claim distributions had yet been made by the chapter 7 trustee, and it was a simple matter under the circumstances to substitute the creditor that would receive a distribution. Circumstances may vary in other cases. Moreover, although the district court ruled that mere negligence in filing a late proof of claim is insufficient by itself to warrant equitable subordination, it remains unclear what other factors (or knowledge) might be deemed to justify the equitable subordination of a claim.