A recent decision of the Court of Appeals for the Seventh Circuit appears to have further raised the hurdle to equitably subordinate claims. Continuing what appears to be a move toward a narrower interpretation of equitable subordination, the Seventh Circuit held that misconduct alone does not provide sufficient justification to equitably subordinate a claim; injury to the interests of other creditors is required as well.

Equitable subordination, a court-created doctrine that has been incorporated into Section 510(c) of the United States Bankruptcy Code, allows a court to "subordinate for purposes of distribution" all or part of an allowed claim or interest to all or part of another allowed claim or interest, "under principles of equitable subordination." The Bankruptcy Code does not provide guidance as to when such subordination should take place; courts generally apply a test created by the Court of Appeals for the Fifth Circuit in In re Mobile Steel1, which requires three conditions to be satisfied in order to equitably subordinate a claim: (i) the claimant must have engaged in some type of inequitable conduct; (ii) the misconduct must have resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant; and (iii) equitable subordination of the claim must not be inconsistent with bankruptcy law.

Although all three conditions are required to be met under the Mobile Steel test, courts have, on certain occasions, subordinated claims even where no finding of inequitable conduct was made (generally, with respect to penalty/punitive damages claims or claims resulting from the redemption of stock). Such subordination has been limited by the Supreme Court, however, pursuant to several decisions that have been interpreted to limit the ability of courts to equitably subordinate claims on a categorical basis without a showing of inequitable conduct2.

Further, in several recent decisions, courts have expressly refused to equitably subordinate a claim under Section 510(c) of the Bankruptcy Code, even in the face of inequitable conduct, if the other two conditions to equitable subordination had not been met. In June 2008, the Court of Appeals for the Fifth Circuit, in In re SI Restructuring, overturned a district court decision which had held that the secured claims of several shareholders of a financially unstable company, who had made loans to the company to relieve a critical cash crunch, should be subordinated to the claims of the company's unsecured creditors, on the basis of such shareholders' allegedly inequitable conduct3. The Court declined to make a determination regarding the inequity of the shareholder/claimant's conduct. Instead, assuming that the conduct was inequitable, the court found that subordination under Section 510(c) of the Bankruptcy Code was inappropriate where no finding had been made by the bankruptcy court that either the debtor or the unsecured creditors had been harmed by the claimants' actions.

In a more recent decision, the Court of Appeals for the Seventh Circuit went even further. In re Kreisler and Erenberg, No. 06-3881, 2008 WL 4613880 (7th Cir. Oct. 20, 2008), involved two individual chapter 7 debtors, Barry Kreisler and Marsha Erenberg, who together had formed a separate corporation to purchase a secured claim in their Chapter 7 cases at a significant discount. The debtors, who were real-estate developers, directly or indirectly owned certain real properties located in Chicago. The properties were encumbered by three mortgage liens, including a junior lien in favor of Community Bank of Ravenswood on account of loans made to an affiliate of the Debtors.

In 2002, each debtor filed for protection under Chapter 11 of the United States Bankruptcy Code. Several months later, the cases were converted to Chapter 7 and a bankruptcy trustee was appointed to jointly administer the debtors' bankruptcy estates. Community Bank filed secured claims for nearly $900,000 in each case. As the bankruptcy proceedings threatened to drag out, Community Bank ultimately decided that it wanted to get out of the bankruptcy proceedings. According to the trustee, Community Bank approached her to make a deal and proposed to reduce its claim to $15,000 in exchange for the trustee's help in obtaining court approval to foreclose on another property; however, no agreement was ever reached.

The debtors ultimately decided to try to purchase Community Bank's claim for themselves. They formed a separate company, Garlin Mortgage Corporation, for that purpose and ultimately Garlin purchased the claim at a deep discount for $16,500 with funds loaned from another corporation controlled by one of the debtors. The debtors did not disclose their relationship with Garlin to either the bankruptcy court or the trustee. Further, Garlin's organizational documents listed a family member of one debtor and a close friend of the other as the owners and directors of such corporation, although neither had contributed any capital to the corporation or participated in any of Garlin's operations. Most of the negotiations with Community Bank were conducted by Kreisler himself, and he was to receive a $35,000 fee from Garlin payable upon settlement of Garlin's claim against the debtors' estates.

Community Bank assigned its note and secured claim to Garlin. The bankruptcy court subsequently entered orders in the debtors' cases granting a motion by the Trustee to sell the properties, with any liens to attach to the sale proceeds. Garlin, as assignee of Community Bank, filed a claim, as did the first priority mortgage holder on the properties. After the sale and payment in full of the first priority mortgage holder's lien from the proceeds thereof, Garlin asserted that it was entitled to payment in full of its secured claim from the remaining proceeds. Payment of Garlin's claim would leave effectively no funds for payments to unsecured creditors.

The chapter 7 trustee objected, among other things, on the basis that Garlin failed to comply with Rule 3001(e)(2) of the Bankruptcy Code governing transfers of claims4 and argued that Garlin's claims met all of the requirements of equitable subordination, such that equity demanded that the debtors not benefit from their behavior. The trustee argued that had she known that Community Bank was willing to sell its claims against the estate for such a reduced amount, she would have attempted to more favorably resolve Community Bank's claims, which would have resulted in the removal of a secured creditor from the pool of creditors, thus enhancing the dividends paid to the unsecured creditors.

The bankruptcy court agreed with the trustee's objections, finding that Garlin's failure to file notice of the transfer of Community Bank's claim to it in accordance with Bankruptcy Rule 3001(e)(2) constituted cause for equitable subordination. The court held that Garlin's actions had prejudiced the unsecured creditors of the debtors' estates, whose potential dividends from the remaining sale proceeds of the properties would be eliminated if Garlin's claims were paid from such proceeds. Further, despite finding that the facts of the case were not typical of situations in which courts generally equitably subordinate claims (i.e., upon a showing of breach of fiduciary duty, fraud, illegality, undercapitalization, or use of the debtor as a mere instrumentality or alter-ego), the bankruptcy court determined that equitable subordination was appropriate. Characterizing Garlin's purchase of Community Bank's junior mortgage as "an elaborate scheme" by the debtors to receive proceeds from the sale of their property "to the exclusion of their unsecured creditors," the bankruptcy court equitably subordinated Garlin's secured claim to the claims of unsecured creditors, thus placing it behind all unsecured claims. And, since there was not enough money in the debtors' estates to pay all of the unsecured claims, Garlin received no distribution on its claim. The district court affirmed the bankruptcy court ruling, and Garlin appealed.

On appeal, the Seventh Circuit reversed the bankruptcy court and the district court, addressing only the issue of whether the lower courts had properly subordinated Garlin's claim under Section 510(c) of the Bankruptcy Code.

Noting that "[e]quitable subordination is remedial, not punitive, and is meant to minimize the effect that the misconduct has on other creditors," the Court of Appeals found, in applying the criteria for equitable subordination to the facts presented, that, even if it accepted that the debtors, through Garlin, had committed misconduct as contemplated by Section 510(c) of the Bankruptcy Code, such misconduct alone did not justify subordination of Garlin's claim since the Court found no evidence that the debtors' scheme had harmed any of their creditors.

In applying the equitable subordination standard to the facts presented, the Court of Appeals, like the SI Restructuring court, stated that even accepting that the debtors had committed misconduct within the contemplation of the doctrine of equitable subordination, misconduct alone did not justify subordination of Garlin's claim. The Court of Appeals further noted that Community Bank was not before them complaining as it had voluntarily sold its claim at a deep discount after negotiating directly with Kreisler. The Court of Appeals acknowledged that Garlin's decision to purchase Community Bank's claim might have disadvantaged the other creditors if it interfered with the trustee's own settlement with Community Bank, but the record did not set forth any evidence that any deal between Community Bank and the trustee had been imminent or even likely. The Court of Appeals further stated that "Debtors generally do not owe fiduciary duties to their creditors."

As for the trustee's contention that Garlin failed to properly notify the court when it acquired Community Bank's claim, as required by Rule 3001(e)(2) of the Federal Rules of Bankruptcy Procedure, the Court of Appeals stated that there was no evidence that the Rule 3001(e)(2) violation harmed other creditors. The Court of Appeals noted that Rule 3001(e)(2) requires the purchaser of a claim to notify the bankruptcy court after the purchase so that the bankruptcy court can allow the purported seller the opportunity to object before the claim is irrevocably deemed to be transferred. It found that Community Bank, the creditor protected by the rule, had not claimed the transfer was fraudulent and had not otherwise complained about the transaction.

Although noting that there was, "no doubt, a certain underhanded quality to [the debtors'] conduct; their effort to hide their involvement suggests that they thought they were doing something wrong," the Court of Appeals found that the bankruptcy rules allow claims trading, and the debtors' use of Garlin to purchase Community Bank's claim did not harm other creditors. Since the debtors' creditors remained in the same position regardless of whether Community Bank or Garlin owned the secured claim, the Court found that the creditors were not affected by the debtors'/Garlin's alleged misconduct, and thus that the equitable subordination of Garlin's claim was improper. Although the Court of Appeals for the Seventh Circuit issued a ruling based on reasoning similar to that of SI Restructuring, the decision of the Kreisler court is more surprising, and may be viewed as a more telling example of the narrowing application of the doctrine of equitable subordination. In SI Restructuring, although there may have been some question as to the equity of the claimants' actions, the claimants at a minimum appeared to follow procedure and obtained board approval thereof. Moreover, the shareholders were arguably acting to help the company, as the lenders of last resort. Furthermore, despite making its ruling on the assumption that the claimants' actions constituted inequitable conduct, the court appears to dismiss such allegations as unlikely. In In re Kreisler, on the other hand, the claimants appeared to act solely in their own interest and for their own benefit themselves, and did so pursuant to a deliberately misleading scheme.

As mentioned above, attempts to expand the doctrine of equitable subordination to apply to "no fault" situations (i.e., where creditors have been disadvantaged, but a creditor has not engaged in "bad acts") have been limited by courts in recent decisions. The decisions of the Court of Appeals for the Seventh Circuit, as well as of the Court of Appeals for the Fifth Circuit earlier this year, have reiterated that equitable subordination is an extraordinary remedy, and appear to indicate that a broad application of equitable subordination to situations where there is no harm to creditors, even where misconduct by the claimant may be proven, should also not be permitted. The full implications of this are not yet apparent.