The recent equitable subordination cases of In re Kreisler and Erenberg, 546 F.3d 863 (7th Cir. 2008) and Credit Suisse v. Official Committee of Unsecured Creditors (In re Yellowstone Mountain Club, LLC), Bankr. D. Mont., No. 09-00014 show a possible deviation in the courts regarding the proper application of the doctrine of equitable subordination. Accordingly, secured lenders should stay abreast of these different interpretations and possibly consider adjusting their lending practices. Those who fail to do so could see their claims in bankruptcy move further down the chain of priority.

The doctrine of equitable subordination allows a bankruptcy court, using principles of equity, to subordinate all or part of one creditor’s claim to all or part of another creditor’s claim where the inequitable conduct of one creditor has caused injury to the interests of another creditor. Codified at 11 U.S.C. § 510(c), the doctrine is simple to state and yet, at least it would appear, is rather difficult to apply.

Courts have adopted the Mobile Steel Test as a method to decide when it is appropriate to invoke the doctrine of equitable subordination. The Mobile Steel Test, as its name suggests, originates in the case of In re Mobile Steel Co., 563 F.2d 692 (5th Cir. 1977). The Mobile Steel Test lays out three conditions that must be satisfied before exercising the power of equitable subordination. They are as follows:

  1. The creditor making the claim on the debtor in bankruptcy must have engaged in some sort of inequitable conduct;
  2. That inequitable conduct must have resulted in either injury to the other creditors or an unfair advantage to the creditor who engaged in such inequitable conduct; and
  3. The reordering of the claims must be consistent with the provisions of the Bankruptcy Code.

Within conditions 1 and 2 above, courts have developed standards of measurement. For example, when the claims involve a non-insider and non-fiduciary, the inequitable conduct must have been gross and egregious. In re First Alliance Mort. Co., 471 F.3d 977, 1006 (9th Cir. 2006). Also, the purpose of the doctrine is remedial not punitive. That is to say, the claims of the inequitable-acting creditor should be subordinated only to the extent necessary to offset the harm suffered by other creditors; it is not meant as a source of punishment. In re Mobile Steel, 563 F.2d at 701.

Kreisler:

In Kreisler, two Chicago real estate developers in Chapter 7 proceedings formed a new corporation and purchased the first priority secured claim of Community Bank. They then asserted the secured claim in the name of the newly formed corporation, essentially to ensure that the bulk of the assets went to them and not to any other creditors standing in line. The bankruptcy judge discovered their actions and subordinated their claim to that of all the other creditors in the proceeding, secured and unsecured. The appellate court affirmed, but Seventh Circuit reversed. The Seventh Circuit held that there is no evidence that the actions of the two developers harmed any other creditors in the proceeding. Despite using their insider status and knowledge that Community Bank was willing to sell its claim, their purchase of that claim did not change anyone’s place in line or alter any other creditors’ claims. Community Bank could sell the claim to anyone, so it simply did not matter that the “anyone” were the debtors themselves. Put simply, even if you concede that condition 1 was satisfied, condition 2 was not.

Yellowstone:

In Yellowstone, a high-end golf and ski development in Montana went under after the developer refinanced the entire project through Credit Suisse and then used the proceeds for personal purposes. In the bankruptcy judge’s recent order deciding the ordering of the claims, the judge criticized the lack of due diligence on the part of Credit Suisse. The judge found that Credit Suisse had acted recklessly in loaning against the project when a fair amount of due diligence would have uncovered that it was doomed for failure. Further, the judge held that the fact that the project went into bankruptcy was, itself, a harm to the other creditors. In short, condition 1 was satisfied by Credit Suisse’s negligent lending, and condition 2 was satisfied by the resultant bankruptcy. The judge subordinated Credit Suisse’s first priority secured claim to that of all the other creditors in the proceeding, secured and unsecured.

Analysis:

It would be easy to simply dismiss Yellowstone out of hand because the case involves extremely bad facts. The resort development was an enormous undertaking for the area, to the point where nearly every contractor within the region had invested its time and resources on the project and was awaiting payment. Because of Credit Suisse’s large financing of the project, it took a first priority position with collateral insufficient to cover even its own credit extensions. If it remained in first position, virtually no contractor or other creditor would receive a dime. The judge simply used the doctrine of equitable subordination as a tool to ensure that all of the other contractors and various creditors of the project would receive some payment. Thus, one could consider this an outlier case and instead choose to view Kreisler as the standard bearer on the doctrine of equitable subordination. But, while such a view may be reasonable when discussing these cases as theory or policy, adopting such a view in practice could be a dangerous course of action for secured lenders.

Whether or not Yellowstone stands, the case clearly shows that secured lenders must consider with their legal counsel whether or not their current lending practices, including underwriting, collateral review and other front-end activities, will sufficiently protect them from the Yellowstone-type application of the doctrine of equitable subordination. Otherwise, any bankruptcy judge looking to protect the businesses of the surrounding area could follow Yellowstone’s lead and use the doctrine of equitable subordination as a means to an end.