Although courts are generally reluctant to equitably subordinate claims of non-insiders, the United States Bankruptcy Court for the District of Montana recently did just that to the claims of a non-insider lender based on overreaching and self-serving conduct in Credit Suisse v. Official Committee of Unsecured Creditors (In Re Yellowstone Mt. Club, LLC), Case No. 08-61570-11, Adv. No. 09-00014 (Bankr. D. Mont. May 13, 2009).

Equitable subordination is governed by section 510(c) of the Bankruptcy Code and permits the bankruptcy court to subordinate all or part of an allowed claim to all or part of another allowed claim. Subordination under section 510(c) generally requires three findings: (1) that the claimant engaged in some type of inequitable conduct; (2) that the misconduct injured creditors or conferred unfair advantage on the claimant; and (3) that subordination would not otherwise be inconsistent with the Bankruptcy Code. Moreover, when applying section 510(c) to a non-insider, the level of proof has been held to require “gross and egregious” conduct by the non-insider.

In Yellowstone, Credit Suisse, a non-insider lender, lent the debtor $375 million under a newly devised syndicated term loan product ostensibly for the development of the Yellowstone Club, a luxury home community. Credit Suisse had devised this new syndicated term loan product to “break new ground ... by doing real estate loans in the corporate bank loan market.” Credit Suisse would loan money to land-development companies, such as the Yellowstone Club, on a nonrecourse basis, earn a substantial fee and sell off most of the credit to syndicated loan participants. Particularly concerning to the court was that, under this new syndicated term loan, the equity owners of the land-development company could extract, in the form of a dividend, substantially all of the loan proceeds and, thereby, leave the land-development company thinly capitalized and subject to the entire risk of loss.

This is precisely what happened in Yellowstone. The debtor historically carried a debt load ranging from $4 million to $60 million and had approximately $20 million of debt on its books at the time of the Credit Suisse loan. Nevertheless, and despite the fact the debtor had negative cash flows for the prior several years, Credit Suisse provided a loan for $375 million to the debtor, representing at least a six-fold increase in debt. After the Credit Suisse loan was funded, the proceeds were then distributed to certain equity holders of the debtor with the express understanding that such proceeds would be used for purposes other than development of the Club. Following the Credit Suisse loan, the debtor was persistently behind in its accounts payable and was eventually forced into bankruptcy. Thereafter, the creditors’ committee sought to subordinate the Credit Suisse debt, alleging that Credit Suisse’s actions were “grossly and egregiously inequitable.”

The court held Credit Suisse’s actions warranted equitable subordination because Credit Suisse’s actions were “so far overreaching and self-serving that they shocked the conscience of the Court.” To that end, the court concluded that Credit Suisse’s financial “due diligence with respect to the $375 million loan was almost all but non-existent.” In particular, Credit Suisse never requested audited financial statements from the debtor, and it relied almost exclusively on the debtor’s future financial projections, even though they bore no relation to reality. Moreover, in order to justify the enormous increase in debt load for the debtor, Credit Suisse was forced to develop and justify an entirely new valuation methodology. Furthermore, the court was particularly troubled that Credit Suisse’s syndication of the loan’s credit risk left Credit Suisse solely motivated to increase the size of the loan as a basis for increasing the size of Credit Suisse’s underwriting fees. This left Credit Suisse with no regard for how the loan proceeds were used and thus at odds with members of the syndicate. The court also found that Credit Suisse was sophisticated enough to understand the impact the loan would have on the debtor, but Credit Suisse proceeded with the loan in order to earn its fee. Finally, the court concluded that Credit Suisse’s actions were overreaching and amounted to “predatory lending practices.”  

A Warning to Lenders

Courts analyze equitable subordination claims on a case-by-case basis. As such, it remains to be seen whether Yellowstone marks the beginning of a trend towards equitably subordinating non-insiders or will be confined to its unique facts. Nevertheless, Yellowstone is a clear warning to lenders that actions that demonstrate a disregard for risk and a motivation solely for fees will open the lender to the risk of equitable subordination. Moreover, the Yellowstone decision highlights the need for lenders to perform adequate due diligence before deciding if and how much to loan, including with respect to collateral value and the borrower’s ability to repay the loan. Furthermore, lenders should carefully consider any proposed use of loan proceeds that is unrelated to the borrower’s business.

Equitable subordination will typically have disastrous consequences for the subordinated creditor. When applied to a secured lender’s claim, equitable subordination will likely result in placing its claim below the claims of the debtor’s unsecured creditors, where it may well receive no recovery at all. It is critical, therefore, to identify loan structures and issues that may present equitable subordination risks if the borrower later encounters financial difficulty. Squire Sanders has considerable experience in assisting lenders in complex lending arrangements as well as in litigating equitable subordination claims.