The U.S. Court of Appeals for the Seventh Circuit ruled in October that a creditor’s misconduct must result in harm to other creditors to justify the equitable subordination of a claim under Section 510(c) of the Bankruptcy Code.  

The decision in In re Kreisler, 546 F.3d 863 (7th Cir. 2008) arose from a set of facts that cried out for a remedy against debtors who attempted to profit from covertly purchasing a junior secured claim against their bankruptcy estates. Two real estate developers filed jointly administered chapter 7 cases. The debtors each owned an interest in two properties in Chicago that were fully encumbered by several mortgages.  

After it became apparent that the bankruptcy proceedings would be protracted, the bank holding the junior mortgage approached the bankruptcy trustee in an attempt to negotiate a deal for its interest. The bank reportedly proposed reducing its claim against one of the properties to $15,000 if the trustee would allow the automatic stay to be modified on the other property so that the bank could foreclose on it. The trustee and the bank, however, never reached agreement.  

The debtors made their own deal with the bank instead. They formed a new entity, Garlin Mortgage Corporation (“Garlin”), whose nominal owners and directors were a sister and a close friend of the debtors. One of the debtors, who was an attorney, successfully negotiated on behalf of Garlin to purchase the bank’s secured claim for $16,500. The transaction was financed by a loan to Garlin from another corporation that the debtors controlled. In return for his efforts, the attorney debtor was to receive $35,000 from the funds that Garlin would receive from the bankruptcy estate on account of its newly acquired claim.  

Equitable Subordination

Following acquisition of the bank’s secured claim, Garlin’s effort to have the claim paid ran into serious opposition from the trustee and the bankruptcy court. The trustee sought to equitably subordinate the claim to all other claims because the debtors covertly dominated and controlled Garlin. The latter’s nominal shareholders and directors had neither contributed any capital nor participated in any of its operations. To make matters worse, Garlin had concealed its purchase of the bank’s claim by failing to file a notice of assignment of the claim, as specifically required by Rule 3001(e)(2) of the Federal Rules of Bankruptcy Procedure.  

The trustee contended that had she known of Garlin’s deal with the bank, she would have proposed an alternative that would have been more favorable to other creditors.  

The bankruptcy court agreed with the trustee that the claim should be equitably subordinated on the basis that Garlin had purchased the claim through “an elaborate scheme” to obtain the proceeds from the sale of the debtors’ property “to the exclusion of their unsecured creditors.” The debtors had improperly dominated Garlin by treating it as essentially their own, even though it was nominally owned by separate shareholders. The debtors also concealed the transaction by failing to cause Garlin to file a notice of assignment.  

The bankruptcy court’s opinion was affirmed on appeal to the district court, and an appeal to the Seventh Circuit followed.  

Seventh Circuit Review

The Seventh Circuit took a different view of the situation, based on the doctrine that equitable subordination generally is appropriate “only if a creditor is guilty of misconduct that causes injury to the interests of other creditors” (slip op. at p. 2). The debtors’ course of conduct in forming a corporation and causing it to purchase a secured claim against their own estates “may have amounted to misconduct, but it did not harm the other creditors, who were in the same position whether the original creditor or the debtors’ corporation owned the secured claim.”  

The court briefly reviewed the judicially developed doctrine of equitable subordination,1 which generally requires three conditions to be satisfied: (1) the claimant must have “engaged in some type of inequitable conduct”; (2) the misconduct must either have “resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant”; and (3) subordination must “not be inconsistent with the provisions of the Bankruptcy Act.” (Quoting United States v. Noland, 517 U.S. 535, 538-39 (1996), which in turn relied upon the seminal decision of the Fifth Circuit in In re Mobile Steel, 563 F.2d 692 (5th Cir. 1977)).  

Equitable subordination is remedial, not punitive, and is intended to minimize the effect of the misconduct on other creditors. As Mobile Steel held, a claim is equitably subordinated only to the extent necessary to undo the effect of the inequitable conduct on other creditors, 563 F.2d at 701 (slip op. at p. 5).  

The Seventh Circuit did not necessarily agree with the courts below that the debtors and Garlin had engaged in misconduct. Although in a footnote it pointed out that courts subject an insider’s dealings to “rigorous scrutiny” for inequitable conduct, citing its earlier decision in In re Lifschultz Fast Freight, 132 F.3d 339 (7th Cir. 1997) (that quoted Pepper v. Litton, 308 U.S. 295, 306 (1939)) (at p. 6). In Lifschultz, the court previously had noted that conduct considered inequitable in this context “generally falls within the following categories: (1) fraud, illegality, breach of fiduciary duties; (2) undercapitalization; and (3) [the] claimant’s use of the debtor as a mere instrumentality or alter ego.”  

Harm v. Wrongdoing

In the Kreisler case, the Seventh Circuit agreed with the bankruptcy court below that the conduct of the debtors through Garlin “does not fit neatly into any of these categories” (slip op. at p.6). Although the court acknowledged that the debtors’ conduct had “a certain underhanded quality” and their effort to conceal “their involvement suggests that they thought they were doing something wrong” (at p. 9), the court never squarely addressed the issue of whether the conduct was inequitable for purposes of Section 510(c). Instead, its holding was limited to whether the debtors’ actions had harmed other creditors.  

The appellate court examined each of the factors cited by the bankruptcy court but found no indication that the creditors suffered harm. Garlin’s deeply discounted purchase of the bank’s secured claim affected only the bank, which entered into the transaction voluntarily and did not object to it. The bank knew at the time with whom it was dealing since it had negotiated the transaction directly with one of the debtors. The purchase of the claim did not affect other creditors, which were in the same position whether the bank or Garlin asserted and received payment on the claim (slip op. at pp. 6-7).  

Further, the debtors’ improper domination of Garlin injured only Garlin’s independent shareholders, not other creditors. Garlin’s failure to file the required notice of assignment of the claim it acquired as required by Rule 3001(e)(2) did not appear to have harmed other creditors. The only creditor that potentially could have been affected by the failure to give notice of the claim transfer was the bank, and it was not objecting that the transfer was improper. The trustee was not affected by the failure to file the notice of assignment because the transaction already had been completed by the time the obligation to file the notice arose. At that time, it was too late for the trustee to negotiate a better deal with the bank (slip op. at pp. 8-9).  

No Fiduciary Duty

The court did slightly hedge its view regarding the potential harm to creditors if Garlin’s purchase of the claim had interfered with a settlement between the trustee and the bank. But there was no evidence that a deal between them was imminent or even likely, and the trustee acknowledged that there only had been discussions with the bank.  

Even had the trustee been close to reaching agreement with the bank, it was “far from clear that Garlin’s usurpation of that deal would amount to misconduct,” the court stated. “Debtors generally do not owe fiduciary duties to their creditors.” Hence, the debtors were not required to offer this deal to the trustee before they caused Garlin to accept it, the court noted (slip op. at p. 7).  

A significant factor in this case was that each debtor had filed an individual chapter 7 case, in which a trustee routinely is appointed to administer the estate. Had the debtors been debtors-in-possession in chapter 11 cases, no trustee would have been automatically appointed, and the debtors would have owed fiduciary duties to their estates and their creditors. In that hypothetical context, if the debtors-in-possession had not attempted to negotiate with the bank on behalf of their chapter 11 estates and instead had secretly purchased the claim for themselves, they may well have breached their fiduciary duties and subjected their conduct to more serious scrutiny. This may have resulted in a different outcome.  

Although not specifically addressed by the Seventh Circuit, the Mobile Steel standards for equitable subordination would be satisfied by conduct that “conferred an unfair advantage on the claimant,” even though other creditors were not harmed. An opportunistic claim purchase accomplished covertly and in breach of fiduciary duties arguably could constitute an unfair advantage sufficient to justify equitable subordination. Therefore, the Kreisler holding may not apply to similar actions by debtors or other insiders arising in a different context, such as in a chapter 11 proceeding.  

In its overview of the case, the Seventh Circuit viewed the situation before it as essentially an unusual form of claims trading, a practice that has become increasingly common in bankruptcy cases. The Kreisler decision should give enhanced comfort to claims purchasers that their actions would not ordinarily subject their acquired claims to equitable subordination. Unless there is sufficient evidence that a claimant’s actions either caused harm to other creditors or gained it an unfair advantage, even chapter 7 debtors may act opportunistically to acquire claims against their estates without being subject to equitable subordination, at least in the Seventh Circuit.