Equitable Subordination Still Requires Proof of Harm

The company continued to experience severe cash flow problems after the first loan. With the directors' “keen ' aware[ness] of [their] efforts,” the insiders tried to obtain other financing. Id. When a bank declined to make a loan to the company “but agreed to allow the [insiders] to borrow the funds directly from the bank so that the [insiders] could, in turn, lend the proceeds to” the company, the board quickly approved the loan. Id. As with the earlier loan, the insiders received a lien on the company's most valuable collateral. As part of the second “loan package,” however, the insiders also used the same collateral to secure their potential $4.3 million guarantee liability of the company's pre-existing obligations. Id.

The insiders were removed as officers of the debtor and resigned their director positions in mid-2004. The company then filed a Chapter 11 petition in August, 2004. Id. at *2. When the insiders filed secured claims based on their two loans, the creditors' committee (the litigation was apparently prosecuted later by a “plan administrator” with the powers of a trustee ) sued the insiders, “challenging their right to be treated as secured creditors.” Id.

Bankruptcy Court: Breach Of Fiduciary Duty

The bankruptcy court found that the insiders, “as fiduciaries, engaged in inequitable conduct ' and that their conduct conferred an unfair advantage upon them.” Id. According to the bankruptcy court, the insiders “breached their fiduciary duties in part by the manner in which they presented the [second] loan transaction to the board ['] as the only option available, at the eleventh hour, as a fait accompli ' [T]he board was given the option, 'approve the loan or the company collapses tomorrow.'” Id. Moreover, the bankruptcy court questioned why the loan had to be secured, finding that the insiders had “grabbed for as much as they could get[,] and they got it all.” Id. Finally, the bankruptcy court found that the insiders' release of themselves as guarantors, at the expense of the corporation and its unsecured creditors, constituted an “unfair advantage.” Id. As a result, the bankruptcy court equitably subordinated the insiders' claims “and thus converted [them] from secured to unsecured status.” Id. The insiders later appealed to the Fifth Circuit from the district court's affirmance of the bankruptcy court.

Court of Appeals: No Harm; No Subordination

The Court of Appeals stressed that the bankruptcy court had “made no specific findings that the [insiders'] actions in securing either of the 2003 loans or their pre-existing contingent liability on the guarantees resulted in harm to the corporation or to the unsecured creditors.” Id. Although the court “assume[d], without deciding ' inequitable conduct and unfair advantage” by the insiders, “the bankruptcy court made no finding of harm, and the record does not support a finding that either the debtor or the unsecured creditors were harmed by either loan transaction.” Id. at *4.

The trustee argued that securing the insiders' loan “reduced the assets available to the unsecured creditors and injured them.” Id. at *5. “[B]ecause neither the record nor the bankruptcy court's findings support a view that general unsecured creditors as a class were harmed,” the court rejected this claim. Id. In fact, the “proceeds of the loan were used to pay the unsecured creditors and keep the company in operation.” Id. Moreover, any “unsecured creditors who remain unpaid have advanced no theory supporting a view that they were entitled to payment over the creditors who were paid from the proceeds of the” two insider loans. Id.

The plaintiff trustee further argued that the insiders had gained “unfair advantage” because they had effectively been “released from liability for [their] guarantees.” Id. Because the insiders' “potential obligation on the guaranty agreements was never triggered,” and “because the company never defaulted on its principal obligations covered by the guarantees,” the Fifth Circuit held that “no harm resulted” to creditors. Id.

Deepening Insolvency Claim Rejected

The court also rejected the trustee's deepening insolvency claim, i.e., “that the unsecured creditors were harmed because the value of the company deteriorated as a result of the [second] loan transaction, thus decreasing the amount of funds available for the creditors.” Id. Not only did the deepening insolvency claim lack “legal support,” reasoned the court, but it was also “not supported by the record or the bankruptcy court's findings.” Id. at *7.

The trustee's expert testified at trial that the insiders had loaned money to the debtor “in the face of obvious evidence that the financial condition of the company was deteriorating and they had no reason to believe that the loan would allow the company to survive.” Id. at *6. The bankruptcy court, however, rejected this testimony, finding no evidence of insolvency or undercapitalization. Id. Agreeing with the Third Circuit's, Citx Corp. holding, 448 F.3d 672, 678 (3d Cir. 2006), the Fifth Circuit held that “deepening insolvency is not a valid theory of damages.” Id. Similarly, it noted the Delaware Court of Chancery's rejection of “the doctrine of deepening insolvency as an independent” claim or “as a theory of damages.” Id. Merely because creditors are unpaid “does not mean that the directors cannot choose to continue the firm's operations in the hope that they can expand the inadequate pie such that the firm's creditors get a greater recovery. By doing so, the directors do not become a guarantor of success.” Id., quoting Trenwick Am. Litig. Trust v. Ernst & Young, LLP, 906 A. 2nd 168, 174 (Del. Ch. 2006).

Harm Needed

In this author's view, the Fifth Circuit got it right. Failure to prove harm to creditors has always been fatal in equitable subordination litigation. 4 Collier on Bankruptcy ' 510.05[3][e], at 510-31 (15th rev. ed. 2008) (” ' the offending party's claim will be subordinated only to those who can show actual injury.”); In re SubMicron Systems Corp., 432 F.3d 448, 457-58, 462-63 (3d Cir. 2006) (held, recharacterization and equitable subordination claims against lender failed because documents were debt instruments and because creditors had not been harmed); In re Clark Pipe and Supply Co., Inc., 893 F.2d 693, 703 (5th Cir. 1990), reh'g denied, 899 F.2d 11 (5th Cir. 1990) (“record is devoid of any evidence that [lender] misled other ' creditors to their detriment”); In re Mobile Steel Co., 563 F.2d 692, 700 (5th Cir. 1977) (one of essential conditions for equitable subordination: resulting injury to creditors); In re Radnor Holdings Corp., 353 B.R. 820, 841 (Bankr. D. Del. 2006) (no misconduct or misleading of creditors; loans enhanced liquidity; allowed continued operations; reduced net debt); In re Bentley-Russell, Inc., 201 B.R. 354, 356 (Bankr. W.D.N.Y. 1996) (subordinating insider loans made to finance stock redemption but refusing to subordinate insider loans to provide working capital); In re 80 Nassau Associates v. Crossland Federal Savings Bank (In re 80 Nassau Associates), 169 B.R. 832, 843 (Bankr. S.D.N.Y. 1994) (complaint legally insufficient under the Mobile Steel test because it sought to subordinate entire claim without setting forth degree of resulting injury it caused or unfair advantage obtained, and because it failed to allege legally sufficient injury to creditor body as a whole).

Courts consistently require satisfaction of the Mobile Steel injury requirement before ordering equitable subordination. See, e.g., In re Racing Services, Inc., 340 B.R. 73, 76-77 (8th Cir. B.A.P. 2006) (relying on entry of forfeiture judgment in favor of the United States to find sufficient evidence of injury to creditors warranting equitable subordination of claimant's claim); In re KDI Holdings, Inc., 277 B.R. 493, 515-16 (Bankr. S.D.N.Y. 1999) (finding sufficient evidence of injury to creditors to satisfy pleading requirements).

An equitable subordination plaintiff must “plead and prove that the offending conduct caused injury to the debtor or its creditors, or resulted in an unfair advantage to the claimant.” In re Nassau Associates, 169 B.R. at 840 (citing In re Mobile Steel); Pepper v. Litton, 308 U.S. 295, 311-12 (1939) (claims equitably subordinated because dominant shareholder manipulated corporation's affairs so that unsecured creditor would receive nothing); Taylor v. Standard Gas & Electric Co., 306 U.S. 307, 323-24 (1939) (equitable subordination of insider ordered; to prevent stockholders from voting, insider caused corporation “to pay ' dividends in large amounts”; “inflicted serious detriment.”). “If the misconduct results in harm to the entire creditor body, the objecting party need not identify the injured creditors or quantify their injury, but need only show that the creditors were harmed in some general concrete manner ' Thus, it is sufficient to allege that the general creditors are less likely to collect their debts ' ” Id. (citations omitted).

Bankruptcy courts must also “tailor the remedy to fit the harm.” In re Nassau Associates, 169 B.R. at 840. “If the injury or unfair advantage affects only a specific creditor or segment of creditors, the court should subordinate the offending claimant only to the more limited class of claims rather than the claims of all creditors.” Id. (citations omitted). In other words, “a claim should be subordinated only to the extent necessary to offset the harm which the debtor or its creditors have suffered as a result of the inequitable conduct.” In re SI Restructuring, Inc., 2008 WL2469406 at *4 (citing In re Mobile Steel and In re 80 Nassau Associates); In re Fabricators, Inc., 926 F.2d 1458, 1464 (5th Cir. 1991) (“Moreover, the doctrine is remedial, not penal, and should be applied only to the extent necessary to offset the specific harm that the creditors suffered on account of the inequitable conduct.”) (citations omitted).

Further, an equitable subordination determination must be supported by “specific findings and conclusions with respect to each requirement.” In re SI Restructuring, Inc., 2008 WL2469406 at *4 (internal quotation marks and footnoted citations omitted). Accordingly, when the bankruptcy court in In re SI Restructuring, Inc. made no finding of harm to either the debtor or the unsecured creditors, and when the record failed to support such a finding, the court correctly reversed the equitable subordination order.

Deepening Insolvency Mostly Dead

The trustee's deepening insolvency claim was legally and factually defective. Appellate courts in the past three years have been regularly holding that deepening insolvency is not a valid claim or damage theory. See, e.g., In re Teleglobe Communications Corporation, 493 F.3d 345, 385 n. 36 (3d Cir. 2007) (noting that in Trenwick America Litigation Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 205 (Del.Ch. 2006), “the Vice Chancellor put to rest the notion that there is such a thing as a cause of action for so-called “deepening insolvency in Delaware law”); In re Citx Corp., 448 F.3d 672, 678 (3d Cir. 2006 (“[t]he deepening of a firm's insolvency is not an independent form of corporate damage. Where an independent cause of action gives a firm a remedy for the increase in its liabilities, the decrease in fair asset value, or its lost profits, then the firm may recover, without reference to the incidental impact upon the solvency calculation.”); Christians v. Grant Thornton, LLP, 733 N.W. 2d 803, 812 (Minn. Ct. App. 2007) (deepening insolvency not recognized form of corporate damage in Minnesota). Even if it were, however, the trustee failed here to prove the debtor's undercapitalization or insolvency.

Michael L. Cook, a member of this newslettter's Board of Editors, is a partner at Schulte Roth & Zabel LLP in New York.

The U.S. Court of Appeals for the Fifth Circuit reversed a bankruptcy court's equitable subordination order on June 20, 2008. Wooley v. Faulkner (In re SI Restructuring, Inc.), ____ F.3d __, 2008 WL2469406 (5th Cir. 2008). According to the court, subordination of the insiders' secured claims was “inappropriate” because the bankruptcy trustee had failed to show that the defendant insiders' “loans to the debtor harmed either the debtor or the general creditors.” Id. at *1. The court also rejected the trustee's “deepening insolvency” argument on the facts and as a matter of law. The defendants had been officers, directors and the largest shareholders of the corporate debtor. Id.

Facts

The insiders made two secured loans to the corporate debtor during the year preceding bankruptcy. The first loan for $1 million was made “after other financing options fell through.” Id. It was secured by the debtor's most valuable assets; approved by the debtors' audit committee and board of directors as a related party transaction; and disclosed in a SEC filing. Separate legal counsel represented all parties. Id.

The company continued to experience severe cash flow problems after the first loan. With the directors' “keen ' aware[ness] of [their] efforts,” the insiders tried to obtain other financing. Id. When a bank declined to make a loan to the company “but agreed to allow the [insiders] to borrow the funds directly from the bank so that the [insiders] could, in turn, lend the proceeds to” the company, the board quickly approved the loan. Id. As with the earlier loan, the insiders received a lien on the company's most valuable collateral. As part of the second “loan package,” however, the insiders also used the same collateral to secure their potential $4.3 million guarantee liability of the company's pre-existing obligations. Id.

The insiders were removed as officers of the debtor and resigned their director positions in mid-2004. The company then filed a Chapter 11 petition in August, 2004. Id. at *2. When the insiders filed secured claims based on their two loans, the creditors' committee (the litigation was apparently prosecuted later by a “plan administrator” with the powers of a trustee ) sued the insiders, “challenging their right to be treated as secured creditors.” Id.

Bankruptcy Court: Breach Of Fiduciary Duty

The bankruptcy court found that the insiders, “as fiduciaries, engaged in inequitable conduct ' and that their conduct conferred an unfair advantage upon them.” Id. According to the bankruptcy court, the insiders “breached their fiduciary duties in part by the manner in which they presented the [second] loan transaction to the board ['] as the only option available, at the eleventh hour, as a fait accompli ' [T]he board was given the option, 'approve the loan or the company collapses tomorrow.'” Id. Moreover, the bankruptcy court questioned why the loan had to be secured, finding that the insiders had “grabbed for as much as they could get[,] and they got it all.” Id. Finally, the bankruptcy court found that the insiders' release of themselves as guarantors, at the expense of the corporation and its unsecured creditors, constituted an “unfair advantage.” Id. As a result, the bankruptcy court equitably subordinated the insiders' claims “and thus converted [them] from secured to unsecured status.” Id. The insiders later appealed to the Fifth Circuit from the district court's affirmance of the bankruptcy court.

Court of Appeals: No Harm; No Subordination

The Court of Appeals stressed that the bankruptcy court had “made no specific findings that the [insiders'] actions in securing either of the 2003 loans or their pre-existing contingent liability on the guarantees resulted in harm to the corporation or to the unsecured creditors.” Id. Although the court “assume[d], without deciding ' inequitable conduct and unfair advantage” by the insiders, “the bankruptcy court made no finding of harm, and the record does not support a finding that either the debtor or the unsecured creditors were harmed by either loan transaction.” Id. at *4.

The trustee argued that securing the insiders' loan “reduced the assets available to the unsecured creditors and injured them.” Id. at *5. “[B]ecause neither the record nor the bankruptcy court's findings support a view that general unsecured creditors as a class were harmed,” the court rejected this claim. Id. In fact, the “proceeds of the loan were used to pay the unsecured creditors and keep the company in operation.” Id. Moreover, any “unsecured creditors who remain unpaid have advanced no theory supporting a view that they were entitled to payment over the creditors who were paid from the proceeds of the” two insider loans. Id.

The plaintiff trustee further argued that the insiders had gained “unfair advantage” because they had effectively been “released from liability for [their] guarantees.” Id. Because the insiders' “potential obligation on the guaranty agreements was never triggered,” and “because the company never defaulted on its principal obligations covered by the guarantees,” the Fifth Circuit held that “no harm resulted” to creditors. Id.

Deepening Insolvency Claim Rejected

The court also rejected the trustee's deepening insolvency claim, i.e., “that the unsecured creditors were harmed because the value of the company deteriorated as a result of the [second] loan transaction, thus decreasing the amount of funds available for the creditors.” Id. Not only did the deepening insolvency claim lack “legal support,” reasoned the court, but it was also “not supported by the record or the bankruptcy court's findings.” Id. at *7.

The trustee's expert testified at trial that the insiders had loaned money to the debtor “in the face of obvious evidence that the financial condition of the company was deteriorating and they had no reason to believe that the loan would allow the company to survive.” Id. at *6. The bankruptcy court, however, rejected this testimony, finding no evidence of insolvency or undercapitalization. Id. Agreeing with the Third Circuit's, Citx Corp. holding, 448 F.3d 672, 678 (3d Cir. 2006), the Fifth Circuit held that “deepening insolvency is not a valid theory of damages.” Id. Similarly, it noted the Delaware Court of Chancery's rejection of “the doctrine of deepening insolvency as an independent” claim or “as a theory of damages.” Id. Merely because creditors are unpaid “does not mean that the directors cannot choose to continue the firm's operations in the hope that they can expand the inadequate pie such that the firm's creditors get a greater recovery. By doing so, the directors do not become a guarantor of success.” Id., quoting Trenwick Am. Litig. Trust v. Ernst & Young, LLP, 906 A. 2nd 168, 174 (Del. Ch. 2006).

Harm Needed

In this author's view, the Fifth Circuit got it right. Failure to prove harm to creditors has always been fatal in equitable subordination litigation. 4 Collier on Bankruptcy ' 510.05[3][e], at 510-31 (15th rev. ed. 2008) (” ' the offending party's claim will be subordinated only to those who can show actual injury.”); In re SubMicron Systems Corp., 432 F.3d 448, 457-58, 462-63 (3d Cir. 2006) (held, recharacterization and equitable subordination claims against lender failed because documents were debt instruments and because creditors had not been harmed); In re Clark Pipe and Supply Co., Inc. , 893 F.2d 693, 703 (5th Cir. 1990), reh'g denied , 899 F.2d 11 (5th Cir. 1990) (“record is devoid of any evidence that [lender] misled other ' creditors to their detriment”); In re Mobile Steel Co., 563 F.2d 692, 700 (5th Cir. 1977) (one of essential conditions for equitable subordination: resulting injury to creditors); In re Radnor Holdings Corp., 353 B.R. 820, 841 (Bankr. D. Del. 2006) (no misconduct or misleading of creditors; loans enhanced liquidity; allowed continued operations; reduced net debt); In re Bentley-Russell, Inc., 201 B.R. 354, 356 (Bankr. W.D.N.Y. 1996) (subordinating insider loans made to finance stock redemption but refusing to subordinate insider loans to provide working capital); In re 80 Nassau Associates v. Crossland Federal Savings Bank (In re 80 Nassau Associates), 169 B.R. 832, 843 (Bankr. S.D.N.Y. 1994) (complaint legally insufficient under the Mobile Steel test because it sought to subordinate entire claim without setting forth degree of resulting injury it caused or unfair advantage obtained, and because it failed to allege legally sufficient injury to creditor body as a whole).

Courts consistently require satisfaction of the Mobile Steel injury requirement before ordering equitable subordination. See, e.g., In re Racing Services, Inc., 340 B.R. 73, 76-77 (8th Cir. B.A.P. 2006) (relying on entry of forfeiture judgment in favor of the United States to find sufficient evidence of injury to creditors warranting equitable subordination of claimant's claim); In re KDI Holdings, Inc., 277 B.R. 493, 515-16 (Bankr. S.D.N.Y. 1999) (finding sufficient evidence of injury to creditors to satisfy pleading requirements).

An equitable subordination plaintiff must “plead and prove that the offending conduct caused injury to the debtor or its creditors, or resulted in an unfair advantage to the claimant.” In re Nassau Associates, 169 B.R. at 840 (citing In re Mobile Steel); P epper v. Litton , 308 U.S. 295, 311-12 (1939) (claims equitably subordinated because dominant shareholder manipulated corporation's affairs so that unsecured creditor would receive nothing); Taylor v. Standard Gas & Electric Co. , 306 U.S. 307, 323-24 (1939) (equitable subordination of insider ordered; to prevent stockholders from voting, insider caused corporation “to pay ' dividends in large amounts”; “inflicted serious detriment.”). “If the misconduct results in harm to the entire creditor body, the objecting party need not identify the injured creditors or quantify their injury, but need only show that the creditors were harmed in some general concrete manner ' Thus, it is sufficient to allege that the general creditors are less likely to collect their debts ' ” Id . (citations omitted).

Bankruptcy courts must also “tailor the remedy to fit the harm.” In re Nassau Associates, 169 B.R. at 840. “If the injury or unfair advantage affects only a specific creditor or segment of creditors, the court should subordinate the offending claimant only to the more limited class of claims rather than the claims of all creditors.” Id. (citations omitted). In other words, “a claim should be subordinated only to the extent necessary to offset the harm which the debtor or its creditors have suffered as a result of the inequitable conduct.” In re SI Restructuring, Inc., 2008 WL2469406 at *4 (citing In re Mobile Steel and In re 80 Nassau Associates); In re Fabricators, Inc., 926 F.2d 1458, 1464 (5th Cir. 1991) (“Moreover, the doctrine is remedial, not penal, and should be applied only to the extent necessary to offset the specific harm that the creditors suffered on account of the inequitable conduct.”) (citations omitted).

Further, an equitable subordination determination must be supported by “specific findings and conclusions with respect to each requirement.” In re SI Restructuring, Inc., 2008 WL2469406 at *4 (internal quotation marks and footnoted citations omitted). Accordingly, when the bankruptcy court in In re SI Restructuring, Inc. made no finding of harm to either the debtor or the unsecured creditors, and when the record failed to support such a finding, the court correctly reversed the equitable subordination order.

Deepening Insolvency Mostly Dead

The trustee's deepening insolvency claim was legally and factually defective. Appellate courts in the past three years have been regularly holding that deepening insolvency is not a valid claim or damage theory. See, e.g., In re Teleglobe Communications Corporation , 493 F.3d 345, 385 n. 36 (3d Cir. 2007) (noting that in Trenwick America Litigation Trust v. Ernst & Young, L.L.P. , 906 A.2d 168, 205 (Del.Ch. 2006), “the Vice Chancellor put to rest the notion that there is such a thing as a cause of action for so-called “deepening insolvency in Delaware law”); In re Citx Corp., 448 F.3d 672, 678 (3d Cir. 2006 (“[t]he deepening of a firm's insolvency is not an independent form of corporate damage. Where an independent cause of action gives a firm a remedy for the increase in its liabilities, the decrease in fair asset value, or its lost profits, then the firm may recover, without reference to the incidental impact upon the solvency calculation.”); Christians v. Grant Thornton, LLP , 733 N.W. 2d 803, 812 (Minn. Ct. App. 2007) (deepening insolvency not recognized form of corporate damage in Minnesota). Even if it were, however, the trustee failed here to prove the debtor's undercapitalization or insolvency.

Michael L. Cook, a member of this newslettter's Board of Editors, is a partner at Schulte Roth & Zabel LLP in New York.