In recent opinions, the United States Courts of Appeals for the Fifth and Seventh Circuits have revisited the doctrine of equitable subordination and have underscored the requirement that, before a court can equitably subordinate a creditor’s claim, the court must find that other creditors have been harmed by the actions of the creditor. Importantly, both decisions stress that equitable subordination is meant to be remedial and not punitive, and may not be imposed merely because a creditor has engaged in misconduct. Even the claim of an egregiously misbehaving creditor cannot be subordinated if that misbehavior has not resulted in demonstrable damage to other creditors or to the debtor’s estate.

The Doctrine of Equitable Subordination

Section 510(c)(1) of the Bankruptcy Code provides that the bankruptcy court may “under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of an allowed claim or all or part of an allowed interest to all or part of another allowed interest.”1 The distinction between claims and interests corresponds to the distinction between creditors and equity holders, such that an equitably subordinated claim is junior to other claims, and an equitably subordinated equity interest receives payment only after other interest holders are paid in full.2

Although codified in the Bankruptcy Code, equitable subordination is a court-developed doctrine that permits a bankruptcy judge to reorder claims and interests in certain limited circumstances. The standard test, established by the United States Court of Appeals for the Fifth Circuit (the “Fifth Circuit”) in In re Mobile Steel, requires that (1) the holder of the claim being subordinated have engaged in inequitable conduct; (2) the inequitable conduct must have resulted in injury to creditors or conferred an unfair advantage on the claimant; and (3) equitable subordination not be inconsistent with the provisions of the Bankruptcy Code.3 A determination of equitable subordination must be supported by “specific findings and conclusions with respect to each requirement.”4 Even when these requirements are met, equitable subordination may be applied only to the extent necessary to offset the effect of the misconduct on other creditors. “Inequitable conduct” generally consists of fraud, illegality, breach of fiduciary duty, undercapitalization, or the claimant’s use of the debtor as a mere instrumentality or alter ego.

In re SI Restructuring

In Wooley v. Faulkner (In re SI Restructuring),5 the Fifth Circuit refused to subordinate secured claims of insiders of the debtor. The Court concluded that insider status alone did not justify subordination unless there was also proof of harm to the unsecured creditors.

SI Restructuring centers on loans made by John and Jeffrey Wooley to Schlotzky’s Inc. in the year before Schlotzky’s commenced bankruptcy proceedings. The Wooleys were the largest shareholders of Schlotzky’s and served as officers and directors of the company. In 2003, Schlotzky’s experienced a cash flow crisis, and the Wooleys extended two loans to the company, one in April for $1 million and another in November for $2.5 million. Both loans were secured by rights to certain royalty streams, intellectual property rights, and general intangibles. They were made only after other financing options fell through, were approved by the company’s audit committee and board of directors, and were disclosed in filings with the Securities & Exchange Commission. Although the November loan was made on only three days’ notice to the board of directors, the board was told that unless the funds were received the company would not be able to make payroll. The Wooleys’ loan enabled the company to meet these financial demands while they continued to seek permanent financing. As part of the November loan, the Wooleys also secured with the same collateral their potential liability as guarantors of $4.3 million of preexisting Schlotzky’s debt.

The Wooleys were removed as officers and resigned as directors in mid-2004. After the financial condition of the company further deteriorated, it filed for chapter 11 protection in August, 2004. When the Wooleys filed secured claims for the amount of the loans, the unsecured creditor’s committee challenged the secured status of the claims. The bankruptcy court equitably subordinated the claims, determining that the Wooleys had breached their fiduciary duties to the company by presenting the November loan to the board at the eleventh hour; the bankruptcy court also questioned whether the November loan genuinely needed to be secured if it was truly meant as temporary financing. The bankruptcy court found that securing the Wooleys’ preexisting contingent liability constituted an “unfair advantage” because it effectively released them as guarantors at the expense of the corporation.6 The district court affirmed, and the Wooleys appealed to the Fifth Circuit.

In reversing the lower courts, the Fifth Circuit revisited Mobile Steel, which also involved an attempt to equitably subordinate insider claims for loans made to the debtor. In that case, the court refused to allow subordination where the trustee “made no factual showing that any of these purported improprieties injured either [the debtor] or its creditors.”7

According to the Fifth Circuit, Mobile Steel “teaches that equitable subordination is remedial, not penal, and in the absence of actual harm, equitable subordination is inappropriate.”8

The Fifth Circuit looked closely at the record and focused on the harm requirement. Although the bankruptcy court found that the November loan involved inequitable conduct and unfair advantage, it made no finding of harm with regard to either of the Wooleys’ loans. In fact, proceeds of the loans were used to pay current unsecured creditors and keep the company in operation. Even though the Wooleys took security for existing personal guarantees, the guarantees were never triggered and, therefore, no harm resulted. Finally, the unsecured creditors’ committee sought to demonstrate harm to the debtor and its creditors by arguing that the Wooleys’ loan enabled the company to continue operations and incur further losses, with the result that fewer funds were available to creditors when the company filed for bankruptcy. The Fifth Circuit rejected this “deepening insolvency” argument, agreeing with the Third Circuit’s recent conclusion that deepening insolvency is “not a valid theory of damages.”9

In re Kreisler & Erenberg

In an entirely different context, the Seventh Circuit recently ruled that debtors may purchase discounted secured claims against their own estates without having those claims equitably subordinated to other creditors’ claims, even if such behavior amounts to misconduct, as long as no creditors were harmed by the debtors’ purchase.

The facts of In re Kreisler & Erenberg10 involve two individual chapter 7 debtors, Barry Kreisler and Marsha Erenberg, who owned several parcels of real estate. The real estate was overencumbered, securing claims that exceeded the value of the property. According to the district court, after filing his bankruptcy petition, Kreisler created a scheme to recoup some of the money that would be generated when the real estate was liquidated. Kreisler formed a corporation called Garlin Mortgage Corporation (“Garlin”) to purchase a junior mortgagee’s claims against the property. Garlin’s principals were Kriesler’s sister and a friend of Erenberg’s, neither of whom furnished capital to the company or provided any services as officers or directors. Garlin acquired a $900,000 secured claim against Kreisler and Erenberg’s estates for $16,500, using money borrowed from another company controlled by Kreisler and Erenberg. Kriesler served as legal counsel to Garlin and charged fees for his services. The debtors failed to disclose the transaction to the bankruptcy court or the chapter 7 trustee, in violation of Federal Rule of Bankruptcy Procedure 3001(e)(2).11

When the transactions were discovered, the bankruptcy court subordinated the claims that Garlin had acquired, and the district court affirmed. Reversing the lower courts, the Seventh Circuit focused on the fact that, while there was “a certain underhanded quality”12 to the debtors’ conduct, equitable subordination is not appropriate unless a claimant’s misconduct has resulted in specific harm. In this case, the only creditor affected by the debtors’ purchase of the claim was the junior mortgagee who had sold the claim – who voiced no complaint, and in fact negotiated the sale of its claim directly with the individual debtors. Other creditors remained in the same position regardless of who was asserting the junior mortgagee’s claim. As the Seventh Circuit stated, “[t]he debtors’ formation of a corporation 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.”13

In permitting the chapter 7 debtors’ “underhanded” behavior, the Seventh Circuit wrote that “[d]ebtors generally do not owe fiduciary duties to creditors.”14 Significantly, the same is not true for debtors-in-possession in a corporate chapter 11 case. Debtors-in-possession owe fiduciary duties to creditors, and pursuant to American United Mutual Life Insurance Co. v. Avon Park,15 a fiduciary cannot engage in claims trading without, at a minimum, full and complete disclosure of the fiduciary’s interests. Even with such disclosure a court may not accept, for example, a fiduciary’s vote in favor of a debtor’s plan as having been made in “good faith.”16 As a result, most businesses in bankruptcy will not be able to trade in claims against their own estates, notwithstanding the Seventh Circuit’s decision in Kreisler.

Discussion

Both Kreisler and SI Restructuring firmly set down a “no harm, no foul” rule for insiders asserting claims against a debtor’s estate, stating that, for purposes of equitable subordination, it is not enough that the party asserting the claim have engaged in inequitable conduct. Although the facts of Kriesler are inapplicable to most corporate chapter 11 cases, the decision is notable for the fact that it followed closely on the heels of SI Restructuring and, like SI Restructuring, emphasizes the requirement that there must be proof of resulting harm before a claim can be equitably subordinated.

The fact that these courts refused to equitably subordinate a creditor’s claim without proof of damages hardly constitutes a sea change in bankruptcy law. The harm requirement has been the second prong of the Mobile Steel test for over thirty years, and courts have regularly cited to its necessity. Rather, and more subtly, Kreisler and SI Restructuring may suggest that courts are reprioritizing the prongs of the Mobile Steel test. Previous courts have focused on the first requirement, casting equitable subordination as a tool that “allows a bankruptcy court to root out . . . mischief.”17 Equitable subordination cases have typically involved the claims of insiders, and the doctrine has been applied to ensure that the insiders abide by the “‘rules of fair play and good conscience.’” 18 Courts have generally begun their analysis by questioning whether the party seeking subordination has met its burden of proof of inequitable conduct.19 In contrast, the courts in Kreisler and SI Restructuring begin their discussion with the damages requirement. The Seventh Circuit “put to the side whether the court’s finding of inequitable conduct was correct” because that analysis did not affect the court’s conclusion and “misconduct alone does not justify subordination of [a] claim.”20 The Fifth Circuit does not even discuss whether the Wooleys’ actions were inequitable (although it suggests they were not), focusing solely on the harm requirement that it determined the lower courts had entirely disregarded.

This shift in the equitable subordination analysis is consistent with the bankruptcy policy that underlies the doctrine. Equitable subordination is intended to be an “extraordinary remedy” to redress actual harms to creditors. If the key issue is insider misbehavior or inequitable conduct, punitive remedies are available, including direct actions brought by the harmed parties. Equitable subordination, on the other hand, is meant to be a compensatory remedy that corrects the harm caused by the subordinated creditor’s misconduct. It is applied rarely because the practical effect is often to wipe out the subordinated claim altogether (because the now-senior claims are unlikely to be paid in full), without any consideration of whether the amount of the damage is equal to the value of the subordinated creditor’s claim. By focusing on harm rather than punishment, courts ensure that equitable subordination does not result in a windfall to other creditors or unfair treatment of the subordinated creditor’s claim.

These decisions, however, do more than iron out kinks in bankruptcy theory. As the Seventh Circuit has noted, most equitable subordination challenges involve claims by insiders for loans made to the debtor.21 In the current economic climate, troubled companies may have difficulty obtaining credit from third parties, and their best chance of avoiding bankruptcy may be to seek funding from insiders. Insiders may be more willing to extend this financing, or to do so on better terms, if there is a lower chance that their claims will be subordinated in the event the recipient company files for bankruptcy. In such cases, courts may be inclined to follow the lead set in SI Restructuring and Kreisler and focus on whether the debtor or its creditors were harmed, rather than needlessly scrutinizing the claimant’s motives.