In part one of our series on recharacterization, we discussed the elements of judicial recharacterization of loans as equity interests.[i] In part two of the series, we considered how debtors can “claw back” putative “loans” that they may have repaid years earlier because the “loans” were in fact equity investments and their repayment was invalid.[ii] In this finale of the series, we contrast recharacterization with equitable subordination, which is another means by which some creditors can seek to push ahead of others.
Equitable subordination resembles recharacterization in that it permits a court to reorder stakeholder distributions made by a debtor. But recharacterization actually knocks claims lower than does equitable subordination. By recharacterization, a court transforms (or “properly characterizes”) a claim into an equity interest – and nothing can be distributed to an equity interest holder until all claims are paid in full. By equitable subordination, a court may subordinate a claim only to another claim, or an equity interest to another equity interest.[iii] If a court equitably subordinates a claim as deeply as possible, that is, beneath all other claims, the subordinated claim must be satisfied in full before any distribution can be made to equityholders.[iv]
Once on the attack, trustees and debtors often seek both to equitably subordinate and to recharacterize a claim, sometimes conflating the elements of these remedies. Unlike recharacterization, which is predicated on divining the true nature of the transaction at issue, equitable subordination generally requires proof that the defendant committed a bad act, such as fraud, which caused harm to others.[v] Because equitable subordination leaves a claim with a priority above that of a claim recharacterized as equity, it can be better to be the bad guy than to have one’s claim recharacterized.
The concept of equitable subordination pre-dates the current Bankruptcy Code. It is intended to be remedial, not penal, and to be used sparingly by courts. All or part of any claim (secured or unsecured) or interest may be subordinated in order to remedy the injury caused to the debtor or other creditors.[vi] In its famous Mobile Steel decision (famous to bankruptcy lawyers anyway), the Fifth Circuit laid out a three-part test for when courts could exercise the power of equitable subordination:
Congress codified the equitable subordination remedy in the 1978 Bankruptcy Code.[viii] The statute affords a measure of wiggle room to courts, however, by subsuming the remedy under (prior judicially-developed) “principles of equitable subordination.”[ix] The Supreme Court has since endorsed the Mobile Steel test and courts apply it when considering whether to equitable subordinate a claim.
Just how much “inequitable conduct” a court will require to be proven depends on the transgressor’s relationship to the debtor. If the offending claimant has a close relationship with the debtor (e.g., an officer, director, or shareholder), then the court will review very carefully the claimant’s transactions with the debtor. The rationale for this heightened scrutiny is that an “insider” is perceived to have greater opportunity than an unaffiliated party for shenanigans.[x] In very few cases have courts found a non-insider’s bad conduct to rise to the level required to equitably subordinate its claim.[xi]
“Inequitable conduct” is not defined in the Bankruptcy Code, but courts have found it where the transgressing creditor has (a) engaged in fraud, (b) improperly substituted debt funding for capital, or (c) controlled or used the debtor as an alter ego for the benefit of the transgressing creditor. In one notorious example of fraud, which also concerned use of a debtor as an alter ego, an “insider” director who controlled a company permitted a judgment in his favor to be entered against the company. In the company’s later-commenced bankruptcy case, the judgment enabled the insider to obtain a claim with a priority superior to that of another creditor.[xii] The bankruptcy court subordinated the insider’s claim to the claim of the second creditor.[xiii]
Courts also have equitably subordinated the claims of insiders who have used their control to fund a debtor with a very high level of debt (to such insiders) rather than equity capital, injuring creditors and the company. Subordination of the insider’s loan claim is justified because the insider, by inserting debt (to him) rather than equity, attempted to improve his recovery at the expense of other creditors.[xiv] In this scenario, subordination is more likely to be applied where the debt to the insider is incurred by a clearly undercapitalized company. Note, however, that courts have held that undercapitalization alone does not justify equitable subordination.[xv]
Trustees, always on the prowl to improve distributions to unsecured creditors, focus on loan claims of insiders. More cash will be available to distribute to other creditors if it can be shown that the insider’s loan was not a loan (recharacterization) or that it was a loan crafted to get the insider a higher priority at the expense of other creditors in a pre-ordained bankruptcy.
Okay, so the acts were bad, but were they harmful? To find the latter, courts require evidence that the creditor caused an actual, identifiable harm to the debtor or its other creditors, or gave itself an unfair advantage.
As noted above, equitable subordination is remedial in nature. Thus, a bad actor’s claim can be subordinated only to the extent required to offset the harm actually caused to the debtor or other creditors. If the culprit has a $200 claim and through bad acts causes $100 of damage to the debtor or creditors, then only $100 of his $200 claim can be subordinated. By contrast, as discussed in parts I and II in this series, every time debt is recharacterized to equity, that creditor’s entire claim is removed from the claim pool and dropped into the equity bucket. As a result, to lose by being bad can hurt less than to lose by mislabeling (even honestly) the substance of one’s claim.[xvi]
The third and final element for equitable subordination is that “subordination cannot be inconsistent with the Bankruptcy Code.” This element is a check on the bankruptcy judge’s equitable power. It means that, no matter how bad the creditor’s conduct, the judge cannot alter the Bankruptcy Code’s priority scheme to achieve a result the judge finds more equitable than the relief that can be afforded by equitable subordination.
In sum, equitable subordination requires a court to consider the harmful behavior of the parties involved, unlike recharacterization, which is concerned only with the proper understanding of the substance of the transaction.[xvii]
Consider the following two scenarios. In Scenario One, a vendor makes a “loan” to a troubled borrower and agrees to accept repayment only when the borrower begins making money again. Here, the entire amount of the “loan” would be ripe for recharacterization (from an unsecured debt claim to an equity interest) because the parties in fact treated the transfer as an equity investment (recovery dependent on company’s performance) rather than a loan (payment due at stated maturity).
In Scenario Two, a major equityholder sitting on a debtor’s board of directors obtained confidential information that claims will be paid at a higher rate under the debtor’s plan of reorganization than the market generally perceives. He then surreptitiously purchases claims against the debtor in order to enhance his or her own recovery. His claims will remain what they were – claims – but they may be equitably subordinated to other claims if his acts are found to have been both inequitable and harmful to debtor or creditors.
Fairness would seem to dictate that the accommodating vendor of Scenario One should recover at least something on his “loan,” while the devious board member of Scenario Two should be left with nothing to show for his duplicity. Yet the likely result is just the opposite. While the entire claim of the vendor will be recharacterized as equity (and likely become worthless), the scheming board member’s recovery generally will only be reduced to the price that he paid for the claims from the unsuspecting sellers (which would make the portion of his claim that was profit available for other creditors).[xviii]
Even if a court subordinated the board member’s entire claim, he or she would still do better than the vendor. Even equitably subordinated claims outrank any equityholder’s interest under the Bankruptcy Codes priority scheme. As noted above, Section 510(c) provides that a court may equitably subordinate a claim for purposes of distribution “to all or part of another allowed claim.” Thus, a bankruptcy court may subordinate a bad-acting creditor’s claim only to the claims of other creditors, but cannot subordinate a bad-acting creditor’s claims to the level equal to or below the interests of equityholders. In most cases, this is a distinction without a difference, as it is rare that general unsecured creditors get paid in full, leaving cash to be distributed to subordinated claims and then to interest holders. In those cases where general unsecured claims are paid in full, the distinction between subordinated claim and equity interest can make all the difference, for the interest holder gets nothing until the subordinated claimant is paid in full.
Though it may seem perverse to penalize a bad actor less severely than a mistaken lender, from another angle recharacterization makes intuitive sense. To return to a metaphor from part I of the series, if it walks, swims, and quacks like a duck (i.e., an equity interest), it’s a duck, regardless of whether the holder chooses to call it a swan (i.e., a loan claim). As we have discussed in this series, however, loans and equity investments may defy easy categorization. Given that recharacterization is an all or nothing remedy (or catastrophe) that does not require a showing of any inequitable conduct, lenders and their attorneys should consider at the time of transaction what their loan will look like to a trustee or creditors’ committee in a later bankruptcy case. Lenders who appear elsewhere in a borrower’s capital structure, such as by owning equity or warrants, should be even more careful when extending funds to the borrower, or they might be sent to (or toward) the back of the line…to share the fate of the ducks.
[iii] Section 510 and equitable subordination are applied to “interest holders” as well as claims holders, but this article will focus on claims holders for ease of presentation. Interest holders are those who own shares in the debtor, also called “equity interests.” Interest holders rank below claim holders in the distribution priority scheme in a bankruptcy case. To be an equitably subordinated interest holder, then, would rank one dead last.
[iv] See the helpful champagne glass pyramid analogy in Michael D. Schwarzmann and David Gottlieb, “File Early and Often: Filing and Amending Claims in a Bankruptcy Case,” at www.commercialbankruptcyinvestor.com:
Think of bankruptcy claims priority as one of those fancy pyramids of champagne glasses. The top levels of glasses (secured claims and administrative claims) are filled before the next levels of glasses (priority unsecured claims and then general unsecured claims) receive any champagne at all. No champagne is poured into the bottom-level glasses until after all of the higher levels are filled.
[v] The Supreme Court has expressly reserved decision on the issue of whether bad acts are required for a court to equitably subordinate a claim. See United States v. Noland, 517 U.S. 535, 543 (1996). In fact, some courts have permitted subordination in cases where no bad acts was demonstrated. See, e.g., SPC Plastics v. Griffith (In re Structurlite Plastics Corp.), 224 B.R. 27 (B.A.P. 1998) (equitable subordination not restricted to cases of creditor misconduct); but see In re Moll Indust., Inc., 454 B.R. 564 (Bankr. D. Del. 2011)(recognizing that Third Circuit has adopted inequitable conduct as a formal requirement for equitable subordination). As a practical matter, bad acts typically are an essential element of an equitable subordination claim.
[vi] When a secured claim is subordinated, the lien securing the claim is deemed to be transferred to the debtor’s bankruptcy estate. Essentially, the secured claim becomes unsecured and the property securing the claim becomes property of the debtor’s estate.
[vii] Benjamin v. Diamond (In re Mobile Steel Corp.), 563 F.2d 692 (5th Cir. 1977).
[viii] 11 U.S.C. § 501(c).
[ix] 11 U.S.C. § 501(c).
[x] In bankruptcy, an “insider” of a corporate debtor includes a director or officer of the debtor, a person who controls the debtor, a partnership in which the debtor is a general partner, a general partner of the debtor, or a relative of a general partner, director, officer or person in control of the debtor . 11 U.S.C. § 101(31).
[xi] See, e.g., Adelphia Commc’n, et al., v. Bank of America, et al., 365 B.R. 24, 74 (Bankr. S.D.N.Y. 2007).
[xii] See Pepper v. Litton, 308 U.S. 295 (1939)
[xiv] See, e,g, Machinery Rental Inc. v. Herpel (In re Multiponics, Inc.), 622 F.2d. 709 (5th Cir. 1980).[xv] Mobile Steel, 563 F.2d at 703.
[xvi] Interestingly, courts disagree over which parties have standing to bring an equitable subordination claim. In most cases only a debtor can bring a claim for equitable subordination unless the court grants a creditors’ committee standing or a creditor can show some particularized injury that resulted to it from the offending creditor’s actions.
[xvii] The Sixth Circuit succinctly captured the essence of these two similar, but distinct, concepts:
recharacterization and equitable subordination serve different functions…Recharacterization cases turn on whether a debt actually exists, not on whether the claim should be equitably subordinated. In a recharacterization analysis, if the court determines that the advance of money is equity and not debt, the claim is recharacterized and the effect is subordination of the claim as a proprietary interest because the corporation repays capital contributions only after satisfying all other obligations of the corporation. In an equitable subordination analysis, the court is reviewing whether a legitimate creditor engaged in inequitable conduct, in which case the remedy is subordination of the creditor’s claim to that of another creditor only to the extent necessary to offset injury or damage suffered by the creditor in whose favor the equitable doctrine may be effective.
Beyer Corp. v. MasoTech, Inc. (In re AutoStyle Plastics, Inc.), 269 F.3d 726, 748-49 (6th Cir. 2001) (emphasis in original) (internal quotations and citations omitted).
[xviii] This example does not consider violations of securities laws and is intended only to discuss how equitable subordination may work in such a scenario.
Lawrence V. Gelber is a partner in the Business Reorganization group of Schulte Roth & Zabel LLP, practicing in the areas of distressed M&A and financing, corporate restructuring, creditors’ rights, debt and claims trading, and prime brokerage insolvency/counterparty risk, with a focus on representation of investment funds and other financial institutions in distressed situations. His…
James is special counsel Schulte Roth and Zabel's Business Reorganization practice. He has significant experience in bankruptcy and out-of-court restructurings. James assists clients with acquisitions and divestitures of distressed companies and their assets, financing and use of cash collateral, and identifying exit strategies. He also litigates various disputes including labor issues, preference and fraudulent claim…
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