'My Claim Is What?'

Line of Cases

A line of cases emerged in the pre-Code period wherein courts determined it appropriate to equitably subordinate stock redemption claims only if such claims constituted unlawful distributions under state law. See McConnell v. Estate of Butler, 402 F.2d 362, 365 (9th Cir. 1968). Although this line of state-law based no-fault equitable subordination survived to some degree in the Ninth Circuit and in isolated bankruptcy decisions post-Code, see e.g. La Grand Steel Products Co. v. Goldberg (In re Poole, McGonigle & Dick, Inc.), 796 F.2d 318 (9th Cir. 1986) and In re Charter Co., 63 B.R. 680 (Bankr. M.D. Fla. 1986), its reasoning is somewhat specious and largely rejected in the modern era on preemption grounds. “We find no precedent for the proposition that where state law deems a claimant a creditor, a Bankruptcy Court may not subordinate his claims to those of other creditors under '510(c).” Envirodyne Industries v. American Express (In re Envirodyne Industries, Inc.), 176 B.R. 825 (Bankr. N.D. Ill. 1995), aff'd 79 F.3d 579 (7th Cir. 1996).

Another form, called “no-fault subordination,” met with more widespread acclaim after the passage of the Bankruptcy Code in 1978. The Bankruptcy Courts have seized upon the broad discretion afforded under ' 510(c) to create, on their own initiative, two exceptions to the general rule that a claim or interest will not be equitably subordinated absent inequitable conduct by the claimant or interest holder.

First, several courts waived the requirement that an objecting party prove inequitable conduct where the claim stems from a non-pecuniary tax penalty. See Noland, 517 U.S. at 539; In re First Truck Lines, Inc., 48 F.3d 210,218 (6th Cir. 1995); Burden v. United States, 917 F.2d 115, 120 (3d Cir. 1990); Schultz Broadway Inn v. United States, 912 F.2d 230, 234 (8th Cir. 1990); In re Virtual Network Services Corp., 902 F.2d 1246, 1250 (7th Cir. 1990). These courts reasoned that a tax penalty claim should be per se subordinated because such claims provide no benefit to the debtor or to the debtor's bankruptcy estate. See First Truck, 48 F.3d at 218.

Second, many courts waived the requirement that a party seeking equitable subordination establish inequitable conduct by the claimant where the claim at issue stemmed from a stock redemption transaction. See SPC Plastics Corp. v. Griffith (In re Structurlite Plastics Corp.), 224 B.R. 27 (6th Cir. BAP 1998); In re Main Street Brewing Co., Ltd., 210 B.R. 662 (Bankr. D. Mass. 1997); Ferrari v. Family Mutual Savings Bank (In re New Era Packaging), 186 B.R. 329 (Bankr. D. Mass. 1995); Envirodyne, 79 F.3d at 583; In re SPM Manufacturing Corp., 163 B.R. 411 (Bankr. D. Mass. 1994); Liebowitz v. Columbia Packing Co., 56 B.R. 222 (D. Mass. 1985).

Robinson v. Wangemann

The no-fault subordination of stock redemption claims originated from the Fifth Circuit decision in Robinson v. Wangemann, 75 F.2d 756 (5th Cir. 1935). In Robinson, the court equitably subordinated a claim based on a stock redemption agreement based solely on the fact that the claim originated from such an agreement. See Id. at 757. The Robinson court explained the rationale for its brief holding:

“A transaction by which a corporation acquires its own stock from a stockholder for a sum of money is not really a sale. The corporation does not acquire anything of value equivalent to the depletion of its assets, if the stock is held in the treasury, as in this case. It is simply a method of distributing a proportion of the assets to the stockholder … and stockholders are not entitled to receive any part of [the assets] unless creditors are paid in full.” Id.

Noland

The United States Supreme Court rejected the premise of per se equitable subordination of claims in its decision in Noland, supra, 517 U.S. 535 (1996). In Noland, the Chapter 7 Trustee of a bankrupt trucking company objected to the classification of the IRS' claims for post-petition tax penalties as an administrative expense. See Id. at 537. The bankruptcy court, district court, and Court of Appeals for the Sixth Circuit all agreed that, although tax penalties qualify as administrative expenses, such penalties should be equitably subordinated under ' 510(c) because the penalty claims did not stem from actual pecuniary injury to the IRS, and thus allowance of such penalties as an administrative expense would be inequitable to other creditors. See Id.

The Supreme Court reversed. The Court held that a bankruptcy court may not equitably subordinate whole categories of claims under '510(c) because doing so usurps Congress' prerogative to legislate categorical priorities as it sees fit. See Noland, 517 U.S. at 536-537. “[I]f the provision also authorized a court to conclude on a general, categorical level that [a class of claims] should be [subordinated], it would empower a court to modify the operation of the priority statute at the same level at which Congress operated when it made its characteristically general judgment to establish the hierarchy of claims in the first place.” Id. at 540. The Court concluded that, under the Court of Appeals' rationale, all nonpecuniary tax penalty claims would necessarily be subordinated; thus, endorsement of that rationale would constitute a categorical priority determination by the judiciary in violation of the separation of powers. See Id. at 542. The Court nevertheless explicitly refused to impose a strict requirement of inequitable conduct, or “fault,” for subordination under '510(c). See Id. at 543. “Given our conclusion that the Sixth Circuit's rationale was inappropriately categorical in nature, we need not decide today whether a bankruptcy court must always find creditor misconduct before a claim may be equitably subordinated.” Id. This equivocation allows for the uncertainty and conflict necessary for continuing litigation on the question of no-fault subordination.

The Supreme Court reinforced the Noland doctrine in U.S. v. Reorganized CF&I Fabricators of Utah, Inc., 518 U.S. 213, 116 S.Ct. 2106, 135 L.Ed.2d 506 (1996) (“The principle is simply that categorical reordering of priorities that takes place at the legislative level of consideration is beyond the scope of judicial authority to order equitable subordination under ' 510(c)”). In the wake of Noland and CF&I, lower courts to address the issue of subordination of tax penalties have reverted to the fault standard of Mobile Steel, supra. See Freeland v. IRS, 264 B.R. 916, 922-23 (N.D. Ind. 2001); Rice v. IRS (In re Odom Antennas, Inc.), 258 B.R. 376, 387 (Bankr. E.D. Ark. 2001); Solow v. U.S. (In re Johnson Rehabilitation Nursing Home, Inc.), 239 B.R. 168, 180-81 (Bankr. N.D. Ill. 1999).

The Noland decision likewise supports the proposition that stock redemption claims, like tax penalty claims, may no longer be equitably subordinated per se merely because of their origin in a stock redemption transaction. See Moyer v. Official Creditors Committee of Paint and Assembly Corp., 2001 WL 290384, *4 (S.D. Ind. 2001) (“The power of equitable subordination can not be exercised in such a way that the 'inevitable result' would be the equitable subordination of every claim that falls within a certain category”); Montgomery Ward Holding Corp. v. McCaffrey (In re Montgomery Ward Holding Corp.), 2000 WL 33712303, *5 (Bankr. D. Del. 2000) (“Under Noland, I cannot subordinate McCaffrey's claim simply because it is a stock redemption claim … without first 'exploring the particular facts and circumstances' presented in this case to determine that subordination is warranted”). The courts accepting this logical interpretation of Noland have implicitly concluded that, to the extent that Robinson and its progeny provide for the automatic equitable subordination of a claim solely because of its origin in a stock redemption transaction, those decisions were overruled by Noland.

Not all courts, however, have unanimously accepted that Noland put an end to the no-fault subordination of stock redemption claims. Two courts have found it appropriate to apply no-fault equitable subordination to stock redemption claims notwithstanding the strictures of Noland. See Structurlite Plastics, 224 B.R. at 35; Main Street Brewing, 210 B.R. at 665. In both decisions, the courts justified no-fault equitable subordination of stock redemption claims on the grounds that stock redemption claims constitute de facto equity interests rather than loans or debt obligations. See Structurlite, 224 B.R. at 35; Main Street Brewing, 210 B.R. at 666.

Neither court, however, performed a proper factual analysis of whether or not the claims should be recharacterized before subordinating them to equity status. If a court may subordinate a stock redemption claim on the grounds that it is effectively “equity” without first conducting a proper recharacterization inquiry, then necessarily all stock redemption claims must be subordinated. Such categorical subordination violates Noland.

Conclusion

Thus, it appears that in these cases, the courts drew some sort of middle ground between the traditionally strict factual standard for recharacterization and the categorical subordination of stock redemption claims prevalent prior to Noland.

Whether or not such a middle ground actually exists as more than a convenient chimera will not be resolved until some court takes a proper accounting of the meaning of Noland. Until that time, these authors submit that no-fault subordination is dead.

(see below)

The Eleventh Circuit has established 13 factors relevant to the recharacterization of debt as equity:

• The name given to the obligation;
• The presence or absence of a fixed maturity date;
• The source of payments on the obligation;
• The purported creditor's right to demand payment;
• Whether or not the obligation entitled the purported creditor to increased participation in management;
• Whether or not the obligation is subordinated to other creditors;
• The intent of the parties as objectively manifested;
• The adequacy of the debtor's capitalization when the obligation was incurred;
• Any Identity of interest between an equity interest held by the creditor and the alleged debt obligation;
• The source of any interest payments;
• The debtor's ability to obtain financing from external lenders;
• The extent to which the funds advanced were used to acquire capital assets; and
• Any failure of the debtor to repay on the due date.

See Stinnett's Pontiac Service Inc. v. Commissioner of Internal Revenue Service, 730 F.2d 634, 638-40 (11th Cir. 1984); In re Biscayne Investment Group, Ltd., 264 B.R. 765, 771-73 (Bankr. S.D. Fla. 2001).

For many years, the holder of a stock redemption claim against a company in bankruptcy faced almost certain demotion to the class of interest holders. No matter how long ago the stock redemption occurred, no matter the solvency of the company, and no matter how innocent the holder appeared, any claim for unpaid installments due under a stock redemption agreement was sent to the back of the line. In 1996, the Supreme Court issued a decision that rekindled hope for stock redemption claimants; recent case law, unfortunately, has failed to maintain a uniform front on this issue.

Section 510(c) empowers a bankruptcy court to equitably subordinate a claim:

“(c) Notwithstanding subsections (a) and (b) of this section, after notice and a hearing, the court may – (1) 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 another allowed interest …” 11 U.S.C. '510(c) (2002). Generally, a court should not equitably subordinate a particular claim or interest under '510(c) absent a showing of some form of inequitable conduct by the claimant or interest holder. See United States v. Noland , 517 U.S. 535, 538, 116 S.Ct. 1524, 1526, 134 L.Ed.2d 748 (1996); Benjamin v. Diamond (In re Mobile Steel Co.), 563 F.2d 692, 700-02 (5th Cir. 1977). In the absence of inequitable conduct, a debt obligation claim may be “recharacterized” as equity upon a detailed factual showing of certain indicia of equity. For particular classes of claims, however, the courts have not strictly adhered to the general principals requiring inequitable conduct by the claimant or a demonstration of the recharacterization factors.

Line of Cases

A line of cases emerged in the pre-Code period wherein courts determined it appropriate to equitably subordinate stock redemption claims only if such claims constituted unlawful distributions under state law. See McConnell v. Estate of Butler , 402 F.2d 362, 365 (9th Cir. 1968). Although this line of state-law based no-fault equitable subordination survived to some degree in the Ninth Circuit and in isolated bankruptcy decisions post-Code, see e.g. La Grand Steel Products Co. v. Goldberg (In re Poole, McGonigle & Dick, Inc.), 796 F.2d 318 (9th Cir. 1986) and In re Charter Co., 63 B.R. 680 (Bankr. M.D. Fla. 1986), its reasoning is somewhat specious and largely rejected in the modern era on preemption grounds. “We find no precedent for the proposition that where state law deems a claimant a creditor, a Bankruptcy Court may not subordinate his claims to those of other creditors under '510(c).” Envirodyne Industries v. American Express (In re Envirodyne Industries, Inc.), 176 B.R. 825 (Bankr. N.D. Ill. 1995), aff'd 79 F.3d 579 (7th Cir. 1996).

Another form, called “no-fault subordination,” met with more widespread acclaim after the passage of the Bankruptcy Code in 1978. The Bankruptcy Courts have seized upon the broad discretion afforded under ' 510(c) to create, on their own initiative, two exceptions to the general rule that a claim or interest will not be equitably subordinated absent inequitable conduct by the claimant or interest holder.

First, several courts waived the requirement that an objecting party prove inequitable conduct where the claim stems from a non-pecuniary tax penalty. See Noland, 517 U.S. at 539; In re First Truck Lines, Inc., 48 F.3d 210,218 (6th Cir. 1995); Burden v. United States, 917 F.2d 115, 120 (3d Cir. 1990); Schultz Broadway Inn v. United States , 912 F.2d 230, 234 (8th Cir. 1990); In re Virtual Network Services Corp., 902 F.2d 1246, 1250 (7th Cir. 1990). These courts reasoned that a tax penalty claim should be per se subordinated because such claims provide no benefit to the debtor or to the debtor's bankruptcy estate. See First Truck, 48 F.3d at 218.

Second, many courts waived the requirement that a party seeking equitable subordination establish inequitable conduct by the claimant where the claim at issue stemmed from a stock redemption transaction. See SPC Plastics Corp. v. Griffith (In re Structurlite Plastics Corp.), 224 B.R. 27 (6th Cir. BAP 1998); In re Main Street Brewing Co., Ltd., 210 B.R. 662 (Bankr. D. Mass. 1997); Ferrari v. Family Mutual Savings Bank (In re New Era Packaging), 186 B.R. 329 (Bankr. D. Mass. 1995); Envirodyne, 79 F.3d at 583; In re SPM Manufacturing Corp., 163 B.R. 411 (Bankr. D. Mass. 1994); Liebowitz v. Columbia Packing Co. , 56 B.R. 222 (D. Mass. 1985).

Robinson v. Wangemann

The no-fault subordination of stock redemption claims originated from the Fifth Circuit decision in Robinson v. Wangemann , 75 F.2d 756 (5th Cir. 1935). In Robinson, the court equitably subordinated a claim based on a stock redemption agreement based solely on the fact that the claim originated from such an agreement. See Id. at 757. The Robinson court explained the rationale for its brief holding:

“A transaction by which a corporation acquires its own stock from a stockholder for a sum of money is not really a sale. The corporation does not acquire anything of value equivalent to the depletion of its assets, if the stock is held in the treasury, as in this case. It is simply a method of distributing a proportion of the assets to the stockholder … and stockholders are not entitled to receive any part of [the assets] unless creditors are paid in full.” Id.

Noland

The United States Supreme Court rejected the premise of per se equitable subordination of claims in its decision in Noland, supra, 517 U.S. 535 (1996). In Noland, the Chapter 7 Trustee of a bankrupt trucking company objected to the classification of the IRS' claims for post-petition tax penalties as an administrative expense. See Id. at 537. The bankruptcy court, district court, and Court of Appeals for the Sixth Circuit all agreed that, although tax penalties qualify as administrative expenses, such penalties should be equitably subordinated under ' 510(c) because the penalty claims did not stem from actual pecuniary injury to the IRS, and thus allowance of such penalties as an administrative expense would be inequitable to other creditors. See Id.

The Supreme Court reversed. The Court held that a bankruptcy court may not equitably subordinate whole categories of claims under '510(c) because doing so usurps Congress' prerogative to legislate categorical priorities as it sees fit. See Noland, 517 U.S. at 536-537. “[I]f the provision also authorized a court to conclude on a general, categorical level that [a class of claims] should be [subordinated], it would empower a court to modify the operation of the priority statute at the same level at which Congress operated when it made its characteristically general judgment to establish the hierarchy of claims in the first place.” Id. at 540. The Court concluded that, under the Court of Appeals' rationale, all nonpecuniary tax penalty claims would necessarily be subordinated; thus, endorsement of that rationale would constitute a categorical priority determination by the judiciary in violation of the separation of powers. See Id. at 542. The Court nevertheless explicitly refused to impose a strict requirement of inequitable conduct, or “fault,” for subordination under '510(c). See Id. at 543. “Given our conclusion that the Sixth Circuit's rationale was inappropriately categorical in nature, we need not decide today whether a bankruptcy court must always find creditor misconduct before a claim may be equitably subordinated.” Id. This equivocation allows for the uncertainty and conflict necessary for continuing litigation on the question of no-fault subordination.

The Supreme Court reinforced the Noland doctrine in U.S. v. Reorganized CF&I Fabricators of Utah, Inc. , 518 U.S. 213, 116 S.Ct. 2106, 135 L.Ed.2d 506 (1996) (“The principle is simply that categorical reordering of priorities that takes place at the legislative level of consideration is beyond the scope of judicial authority to order equitable subordination under ' 510(c)”). In the wake of Noland and CF&I, lower courts to address the issue of subordination of tax penalties have reverted to the fault standard of Mobile Steel, supra. See Freeland v. IRS , 264 B.R. 916, 922-23 (N.D. Ind. 2001); Rice v. IRS (In re Odom Antennas, Inc.), 258 B.R. 376, 387 (Bankr. E.D. Ark. 2001); Solow v. U.S. (In re Johnson Rehabilitation Nursing Home, Inc.), 239 B.R. 168, 180-81 (Bankr. N.D. Ill. 1999).

The Noland decision likewise supports the proposition that stock redemption claims, like tax penalty claims, may no longer be equitably subordinated per se merely because of their origin in a stock redemption transaction. See Moyer v. Official Creditors Committee of Paint and Assembly Corp., 2001 WL 290384, *4 (S.D. Ind. 2001) (“The power of equitable subordination can not be exercised in such a way that the 'inevitable result' would be the equitable subordination of every claim that falls within a certain category”); Montgomery Ward Holding Corp. v. McCaffrey (In re Montgomery Ward Holding Corp.), 2000 WL 33712303, *5 (Bankr. D. Del. 2000) (“Under Noland, I cannot subordinate McCaffrey's claim simply because it is a stock redemption claim … without first 'exploring the particular facts and circumstances' presented in this case to determine that subordination is warranted”). The courts accepting this logical interpretation of Noland have implicitly concluded that, to the extent that Robinson and its progeny provide for the automatic equitable subordination of a claim solely because of its origin in a stock redemption transaction, those decisions were overruled by Noland.

Not all courts, however, have unanimously accepted that Noland put an end to the no-fault subordination of stock redemption claims. Two courts have found it appropriate to apply no-fault equitable subordination to stock redemption claims notwithstanding the strictures of Noland. See Structurlite Plastics, 224 B.R. at 35; Main Street Brewing, 210 B.R. at 665. In both decisions, the courts justified no-fault equitable subordination of stock redemption claims on the grounds that stock redemption claims constitute de facto equity interests rather than loans or debt obligations. See Structurlite, 224 B.R. at 35; Main Street Brewing, 210 B.R. at 666.

Neither court, however, performed a proper factual analysis of whether or not the claims should be recharacterized before subordinating them to equity status. If a court may subordinate a stock redemption claim on the grounds that it is effectively “equity” without first conducting a proper recharacterization inquiry, then necessarily all stock redemption claims must be subordinated. Such categorical subordination violates Noland.

Conclusion

Thus, it appears that in these cases, the courts drew some sort of middle ground between the traditionally strict factual standard for recharacterization and the categorical subordination of stock redemption claims prevalent prior to Noland.

Whether or not such a middle ground actually exists as more than a convenient chimera will not be resolved until some court takes a proper accounting of the meaning of Noland. Until that time, these authors submit that no-fault subordination is dead.

(see below)

The Eleventh Circuit has established 13 factors relevant to the recharacterization of debt as equity:

• The name given to the obligation;
• The presence or absence of a fixed maturity date;
• The source of payments on the obligation;
• The purported creditor's right to demand payment;
• Whether or not the obligation entitled the purported creditor to increased participation in management;
• Whether or not the obligation is subordinated to other creditors;
• The intent of the parties as objectively manifested;
• The adequacy of the debtor's capitalization when the obligation was incurred;
• Any Identity of interest between an equity interest held by the creditor and the alleged debt obligation;
• The source of any interest payments;
• The debtor's ability to obtain financing from external lenders;
• The extent to which the funds advanced were used to acquire capital assets; and
• Any failure of the debtor to repay on the due date.

See Stinnett's Pontiac Service Inc. v. Commissioner of Internal Revenue Service , 730 F.2d 634, 638-40 (11th Cir. 1984); In re Biscayne Investment Group, Ltd., 264 B.R. 765, 771-73 (Bankr. S.D. Fla. 2001).