The power to alter the relative priority of claims due to the misconduct of one creditor that causes injury to others is an important tool in the array of remedies available to a bankruptcy court in exercising its broad equitable powers. However, unlike provisions in the Bankruptcy Code that expressly authorize a bankruptcy trustee or chapter 11 debtor-in-possession (“DIP ”) to seek the imposition of equitable remedies, such as lien or transfer avoidance, the statutory authority for equitable subordination—section 510(c)—does not specify exactly who may seek subordination of a claim. This ambiguity has spawned confusion and inconsistency in court rulings on the issue, with some courts holding that “standing” to seek equitable subordination is limited to the trustee or DIP , at least in the first instance, while others have ruled that creditors’ committees or individual creditors can invoke the remedy directly. The Second Circuit Court of Appeals recently had an opportunity to weigh in on the issue. In Official Comm. of Unsecured Creditors v. Halifax Fund, L.P. (In re Applied Theory Corp.), the court ruled that, without bankruptcy-court approval under the doctrine of “derivative standing,” a creditors’ committee does not have standing to seek equitable subordination of a claim.

Equitable Subordination

Equitable subordination is a common-law doctrine predating the enactment of the Bankruptcy Code designed to remedy misconduct that causes injury to creditors (or shareholders) or confers an unfair advantage on a single creditor at the expense of others. The remedy is now codified in section 510(c) of the Bankruptcy Code, which provides that “the 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.” The statute, however, does not define the circumstances under which subordination is warranted, leaving the development of such criteria to the courts.

In 1977, the Fifth Circuit Court of Appeals in In re Mobile Steel Co. articulated what has become the most commonly accepted standard for equitably subordinating a claim. Under the Mobile Steel test, a claim can be subordinated if the claimant engaged in some type of inequitable conduct that resulted in injury to creditors (or conferred an unfair advantage on the claimant), and if equitable subordination of the claim is consistent with the provisions of the Bankruptcy Code. Courts have since refined the test to account for special circumstances. For example, many make a distinction between insiders (e.g., corporate fiduciaries) and noninsiders in assessing the level of misconduct necessary to warrant subordination. For insiders, inequitable conduct is generally found if the claimant has: (i) committed fraud or illegality or breached its fiduciary duties; (ii) left the debtor undercapitalized; or (iii) used the debtor as a mere instrumentality or alter ego. By contrast, subordination of the claim of a noninsider creditor requires a showing of gross misconduct tantamount to fraud, misrepresentation, overreaching, or spoliation.

Standing

Standing is the ability to commence litigation in a court of law. It is a threshold issue—a court must determine whether a litigant has the legal capacity to pursue claims before the court can adjudicate the dispute. In the bankruptcy context, various provisions of the Bankruptcy Code confer standing on various entities (e.g., the debtor, a bankruptcy trustee, creditors, equity interest holders, committees, or indenture trustees) to, among other things, participate generally in a bankruptcy case or commence litigation involving causes of action or claims that either belonged to the debtor prior to filing for bankruptcy or are created by the Bankruptcy Code.

The right to participate in a chapter 1 1 case is explicit. Section 1109 of the Bankruptcy Code provides that any “party in interest,” including the debtor, the trustee, a committee of creditors or equity interest holders, a creditor, or an indenture trustee, “may appear and may be heard on any issue” in a chapter 11 “case.” This general right to participate, however, does not confer standing upon every party in interest to engage in litigation expressly contemplated by other provisions of the Bankruptcy Code, such as lien and transfer avoidance. Many of these provisions deal with claims or causes of action belonging to the debtor prior to filing for bankruptcy, which become part of its bankruptcy estate on the petition date. Standing to prosecute estate claims is expressly given by statute to a bankruptcy trustee (or DIP , by operation of section 1107(a) of the Bankruptcy Code).

Although the Bankruptcy Code does not expressly authorize anyone other than a trustee or DIP to prosecute claims belonging to the estate, many courts will allow committees or individual creditors to commence litigation on behalf of the estate under narrowly defined circumstances. In one of the seminal cases addressing this issue, the Second Circuit Court of Appeals held in In re STN Enterprises that, in considering a creditors’ committee’s request for leave to sue a director for misconduct, a court is required to consider whether the debtor unjustifiably failed to initiate suit against the director and whether the action is likely to benefit the debtor’s estate.

The Second Circuit later refined the doctrine of “derivative standing” in In re Commodore Int’l Ltd., which involved litigation brought by a creditors’ committee against various officers and directors for fraud, waste, and mismanagement. Unlike in STN Enterprises, the debtor in Commodore had not unreasonably refused to bring suit but agreed to permit the committee to litigate the claims on behalf of the estate. The court of appeals ruled that a committee may bring suit even if the debtor does not unjustifiably refuse to do so as long as: (i) the trustee or debtor consents; and (ii) the court finds that the litigation is (a) in the best interests of the estate, and (b) necessary and beneficial to the fair and efficient resolution of the bankruptcy proceedings. The Second Circuit’s approach represents the majority view.

Standing to Seek Equitable Subordination

Unlike other provisions in the Bankruptcy Code that specifically authorize a bankruptcy trustee (or DIP ) to challenge liens or transfers, section 510(c) does not specify who may seek the equitable subordination of a claim or interest. Given the remedy’s fundamental aim to undo or offset any inequality in relative priorities that will produce injustice, however, many courts have concluded that a trustee (or DIP ), as the representative of the estate, is the proper party to raise claims of equitable subordination. Many of these courts liken equitable subordination to an avoidance action, reasoning that because both remedies are invoked against creditors, only the trustee or DIP should have the capacity to sue. Some courts have permitted an individual creditor, acting on its own without first obtaining court authority, to seek equitable subordination, particularly if it is attempting to redress a specific injury to itself, rather than damage to the estate or other creditors. Finally, some courts have adopted an approach whereby either a creditor or a committee can seek equitable subordination, provided it satisfies the requirements for “derivative standing.” The ability of a creditors’ committee to assert an equitable subordination claim was the subject of the Second Circuit’s ruling in Applied Theory Corp.

Applied Theory Corp.

Applied Theory Corporation, a provider of managed webhosting, internet, and security services, filed for chapter 11 protection in 2002 in New York. Having consummated a sale of substantially all of its assets six weeks after the petition date, the debtor sought to convert its chapter 11 case to a chapter 7 liquidation. The court, however, denied the motion, instead ordering the appointment of a chapter 11 trustee.

The official creditors’ committee appointed in the case sought court authority to commence litigation against various prepetition lenders. The proposed complaint stated causes of action for avoidance of preferential and fraudulent transfers, equitable subordination, and aiding and abetting breach of fiduciary duty. The chapter 11 trustee later issued a report in which he concluded that, of the claims asserted in the committee’s complaint, only the fraudulent transfer claim was colorable. He accordingly sued the lenders on that basis but lost.

Shortly thereafter, the lenders sought a court order clarifying that the committee did not have standing to prosecute the equitable subordination claim. The bankruptcy court granted that request, emphasizing that the trustee “would ordinarily” be the proper party to prosecute the claim and that the committee required court approval before it could do so. Finding that the equitable subordination claim “would seek to redress injuries allegedly inflicted upon the [debtor and its] creditors generally, and that it would not be directed toward any particularized injury suffered by any specific creditor,” the court ruled that the trustee “has the sole and exclusive right to assert” the claim. The court then applied the STN factors to the committee’s request to prosecute the claim, concluding that the committee should not be granted derivative standing to seek equitable subordination of the lenders’ claims. The district court upheld the ruling on appeal.

The Second Circuit’s Ruling

The court of appeals also affirmed. It rejected the committee’s contention that it was not obligated to seek court approval before prosecuting an equitable subordination claim. According to the Second Circuit, while section 1109 gives a committee the general right to participate in a chapter 11 case, it does not allow the committee “to usurp the trustee’s role as a representative of the estate with respect to the initiation of certain types of litigation that belong exclusively to the estate.” Moreover, the court emphasized, the Bankruptcy Code does not explicitly authorize a committee to initiate an adversary proceeding.

Only under the circumstances specified in STN and Commodore, the Second Circuit observed, does a committee have standing to commence litigation involving estate causes of action. In this case, both the trustee and the bankruptcy court concluded that litigation for the purpose of subordinating the lenders’ claims was not likely to benefit the estate. Allowing litigation to proceed without court authority based upon benefit to the estate, the court of appeals explained, would frustrate important policy objectives:

[S]ound reasons underlie the requirement of court authorization that STN and Commodore insist upon. Reorganizations would routinely spin out of control if decisions that would commit the time and limited resources of the estate could be taken without the consent of the bankruptcy court, the entity charged by law with controlling and regulating such matters. Requiring bankruptcy court approval conditioned upon the litigation’s effect on the estate helps prevent committees and individual creditors from pursuing adversary proceedings that may provide them with private benefits but result in a net loss to the entire estate.

Finally, the Second Circuit rejected the committee’s argument that STN and Commodore did not apply because those cases involved “derivative” claims brought on behalf of a trustee or DIP , whereas the committee’s claim for equitable subordination was “direct.” Both lower courts, the court of appeals noted, found that the committee’s equitable subordination claim was not directed toward any particularized injury suffered by any creditor but alleged harm to the debtor generally, belying any argument that the claim was “direct” rather than “derivative” of the estate or creditors. Moreover, the Second Circuit remarked, “[s]ince the Committee is not itself a creditor, it does not have any rights held by any creditor to assert such a claim against another creditor.”

Analysis

The Second Circuit’s approach in Applied Theory Corp. to the issue of standing to bring an equitable subordination claim comports with its previous rulings in STN and Commodore—all three decisions are premised upon the importance of allowing the court to be the gatekeeper in regulating litigation that will drain estate assets. The court of appeals refused to adopt a “bright line” rule under which subordination claims may be brought directly by a creditor or committee without court approval, opting instead for a more flexible and utilitarian approach involving scrutiny of the nature of the alleged misconduct, against whom it was directed, and who stands to benefit from the remedy. If the entity seeking subordination does not complain of any direct injury to itself that can be remedied by subordination, but alleges harm to the estate or creditors generally, the claim is derivative and can be asserted only by the trustee or DIP, unless the court orders otherwise.

The Second Circuit rejected contentions that the Bankruptcy Code itself does not support such an approach. Even so, the argument for conferring standing under section 510(c) upon parties other than a trustee or DIP is not specious. Lawmakers’ express limitation of standing to a particular entity in other provisions of the statute indicates, as a matter of basic statutory construction, that they meant to include no such limitations under section 510(c). Furthermore, equitable subordination is arguably a creditor or shareholder remedy— it is designed to compensate for misconduct by one creditor or shareholder that injures others or confers an unfair advantage upon the bad actor. The bankruptcy estate generally has nothing to gain by subordination because it merely reorders the priorities of creditors or stockholders, rather than relieving the estate of a debt (as does the remedy of recharacterization).

Many equitable subordination claims are premised upon the allegation that one creditor’s misconduct resulted in injury to the debtor, which in turn harmed other creditors by preventing them from receiving full payment of their claims. For such claims, it would be rare for a single creditor to be able to demonstrate that it holds a “direct” equitable subordination claim. The rationale for denying standing to individual creditors is questionable not only because the statute provides for no such restriction, but for practical reasons—if an individual creditor is willing to bear the time and expense litigating such a difficult claim (with the possibility, perhaps, of later recouping its costs upon a showing to the court of “substantial contribution”), why should it be prevented from doing so? The case is much stronger for applying a more restrictive approach to standing to litigate such claims by a committee, whose expenses and professionals are paid by the estate.