The Continuing Evolution of the Basis for Equitable Subordination

On June 10, 2014, the Bankruptcy Court for the Southern District of New York issued a 168-page post-trial opinion determining that it would equitably subordinate the claims of SP Special Opportunities LLC (SPSO) against LightSquared. LightSquared LP, et. al. v. SP Special Opportunities LLC, et. al., 511 B.R. 253 (Bankr. S.D. N.Y. 2014). The court reserved for later determination the amount to be equitably subordinated. Id. at 315, 361.

The court's opinion explained that SPSO, under the control of Charles Ergen, the founder, Board chair and controlling shareholder of Dish Network, had acquired $844 million of senior secured debt of LightSquared LP. 511 B.R. at 279, ”88, 89. Two hundred eighty seven million dollars of the face amount of the debt purchases occurred prior to the filing of the LightSquared bankruptcy cases on May 14, 2012, for a purchase price of $172 million. Id. at 274, '63. The purchases were made at a time when there were restrictions on the holders of LightSquared secured debt to preclude its competitors from holding that debt, and SPSO was aware of, and was created to, navigate those restrictions. Id. at 345-346.

There are a series of other decisions in the LightSquared case, including one issued on July 11, 2014, that denied confirmation of a plan, and addressed designation of votes under Section 1126(e); classification; unfair discrimination; fair and equitable standards; and indubitable equivalence. The discussion of the applicable law in these decisions is extensive and thorough. Because of their length and depth, dissecting these decisions in this article is not possible. For the same reasons, this article does not address subsequently reported developments such as resignations by certain members of the Board of LightSquared, filing of lawsuits, apparent settlements, and submission of competing plans.

Equitable Subordination

Equitable subordination is a basic theory of recovery in bankruptcy cases. Measuring the amount of subordination must be based on the degree of injury to the creditors of the bankruptcy estates under applicable law. As the Fifth Circuit recognized in In re Mobile Steel Co., 563 F.2d 692, 701 (5th Cir. 1977): “[A] claim or claims should be subordinated only to the extent necessary to offset the harm which the bankrupt and its creditors suffered on account of the inequitable conduct. ' The misconduct must have resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant.” Accord, Citicorp Venture Capital v. Comm. of Creditors Holding Unsecured Claims (In re Papercraft, Inc.), 160 F.3d 982, 990 (3d Cir. 1998) (a creditor “should not be permitted to profit by its” inequitable conduct); see also In re Westgate-California Corp., 642 F.2d 1174, 1178 (9th Cir. 1981) (“[T]he court ought not to subordinate where the value of the claim greatly exceeds the amount of damage that the claimant has inflicted by his inequitable conduct.”); In re Enron Corp., 333 B.R. 205, 222 (Bankr. S.D.N.Y. 2005) (“Subordinating any amount of claim in excess of the established injury sustained would be punitive, and not consistent with the principles of equitable subordination nor permissible.”).

In certain instances it may be difficult to quantify the exact amount of injury requiring subordination. As the Third Circuit explained in Papercraft, “[Q]uantification may not always be feasible. ' A bankruptcy court should, however, attempt to identify the nature and extent of the harm it intends to compensate. ' If that is not possible, the court should specifically so find.” 160 F.3d at 991. The Third Circuit explained further that any difficulty in quantifying a proven injury “should not redound to the benefit of the wrongdoer.” Id.

Pepper v. Litton, 308 U.S. 295 (1939) and Sampsell v. Bridgeford, 237 F.2d 182 (9th Cir. 1956) are two cases where equitable subordination was considered and ordered. In Pepper v. Litton, the seminal case on equitable subordination, the insider's judgment was disallowed in the bankruptcy and the oft-cited explanation of the equitable nature of the bankruptcy court's jurisdiction was set forth as follows: “They [the bankruptcy courts' equitable powers] have been invoked to the end that fraud will not prevail, that substance will not give way to form, that technical considerations will not prevent substantial justice from being done.” 308 U.S. at 304-305.

In Pepper v. Litton, the U.S. Supreme Court refused to allow a fiduciary to use his position to procure a benefit by obtaining a judgment and providing it priority over the claims of another creditor. At issue in Pepper v. Litton was a confession of judgment obtained by a corporate principal (Litton) on alleged wage claims in order to obtain priority over that of a bona fide lessor (Pepper) for royalties. Litton acquired property of the debtor in a sheriff's sale executing on the judgment. The assets so acquired were transferred to a new company, and the old company filed bankruptcy two days after the execution sale, with the Litton judgment and claims being disallowed. In Sampsell, a $30,000 claim against an insolvent corporation was given to a court-appointed company manager as a “gift” from the holder of the debt. The claim, which was worthless in the hands of the transferor, netted the court-appointed manager almost $26,000. The recovery was ordered to be disgorged.

The LightSquared Decision

In LightSquared, the bankruptcy court arguably expanded the application of the law on equitable subordination based on the facts it found in its extensive decision. It carefully determined that the conduct of a non-insider in acquiring claims in knowing violation of the spirit of an “eligible assignee” provision in a credit agreement did not violate the actual language in the credit agreement and did not provide a basis for disallowance of the acquired claims. 511 B.R. at 315-317, 336-340. Nonetheless, the court held that the challenged action, while not constituting a breach of the contract “not only violates the covenant of good faith and fair dealing implied in all contracts[,] but also constitutes an affront to the duty of good faith imposed on those who participate in [C]hapter 11 proceedings” Id. at 346.

The court reasoned that “[I]nequitable conduct is not limited to fraud or breach of contract, rather, it includes even lawful conduct that shocks one's good conscience.” Id . at 347. In reliance on Developmental Specialists, Inc. v. Hamilton Bank, N.A. (In re Model Imperial, Inc.), 250 B.R. 776, 804'05 (Bankr. S.D. Fla. 2000), the LightSquared court held that actions taken knowingly to circumvent limitations in a contract can support equitable subordination. 511 B.R. at 348. In Model Imperial, the court determined that actions taken to circumvent a negative covenant in a loan precluding other loans warranted equitable subordination of a claim in addition to finding that transfers made to the claimant were made with intent to hinder, delay, and defraud the existing lenders.

The key component to the analysis of the court in LightSquared is its determination that “[W]hile it is generally acceptable to obtain and deploy a blocking position to control the vote of a class with respect to a proposed plan of reorganization, it is not acceptable to deploy a blocking position to control the conduct of the case itself, to subvert the intended operation of a court-approved exclusivity termination arrangement, and to prevent the Court from directing and having visibility into events unfolding in the case.” 511 B.R. at 360.

The Court's Reasoning

The basis for equitable subordination is arguably more persuasively explained by the court in its decision denying confirmation in LightSquared. In re LightSquared Inc., 2014 WL 3535130 (Bankr. S.D.N.Y. July 11, 2014). In that decision, the LightSquared court discussed Sections 1126(e) and 510(c), and explained why the facts that the court held required equitable subordination in this case did not, as in In re DBSD N. Am., Inc., 634 F.3d 79 (2d Cir.2011), require designation of the vote of the subordinated creditor in its separate class to the extent that subordination was not ordered for the entire claim. It should be noted that the party in DBSD was Dish Network Corporation, which was also connected to, and a named party in, the LightSquared Adversary Proceeding. The LightSquared court's reasoning included the following discussion:

While the Debtors urge that DBSD compels designation of SPSO's vote to reject the Plan, to do so would materially extend the reach of DBSD in ways that section 1126(e) does not contemplate. The centerpiece of the Second Circuit's decision in DBSD was its observation that a competitor of DBSD (DISH) “bought claims with the intent of voting against any plan that did not give it a strategic interest in the reorganized company,” and it bought those claims above par and after a plan had been proposed by DBSD. DBSD , 634 F.3d at 104. So too in Allegheny, in which creditor Japonica purchased its claims after balloting on a plan had already begun. In re Allegheny Int'l, Inc. , 118 B.R. at 286. As Judge Gerber noted in DBSD, DISH intended “to use [its] status as a creditor to provide advantages over proposing a plan as an outsider or making a traditional bid for the company or its assets.” DBSD, 421 B.R. at 139-40. However, both Judge Gerber and the Second Circuit were particularly focused on the timing of DISH's debt purchases which were made after the plan in DBSD had been filed. Here, SPSO made no purchases of debt above par and acquired a significant portion (approximately $287 million) of its claim before the Chapter 11 Cases were commenced, when the LP Debt was trading at or below approximately 60 cents on the dollar; moreover, SPSO acquired all of its LP Debt below par and prior to the filing of any plan. SPSO is thus arguably, at least in part, a “pre-existing creditor,” albeit one who has allegedly voted with strategic intentions ' the type of creditor that the Second Circuit did not expressly include in the ambit of its prohibition on voting in connection with strategic claims acquisitions. DBSD, 634 F.3d at 106. The Court declines to extend the holding of DBSD to cover votes cast with respect to claims which were acquired before a plan had been proposed by any party and where, as discussed below, there are valid, economically self-interested creditor reasons for the holder of such claims to reject a proposed plan. (footnotes omitted).

* * *

The Debtors would have the Court conflate the provisions of section 1126(e) and section 510(c) and hold that a finding of inequitable conduct sufficient to support equitable subordination of a creditor's claim necessarily translates into the basis for designating the bad actor's vote. Moreover, the Debtors would seek to transform vote designation into a substantive treatment provision. The Court declines to read section 1126(e) so broadly; in the plain words of the statute, designation may be ordered with respect to “any entity whose acceptance or rejection of such plan was not in good faith.” It is vote-specific and plan-specific. It focuses on the voting conduct of the creditor holding the claim. Simply put, had SPSO voted to reject a plan that proposed to pay it in full in cash or a plan proposing that SPSO receive some other treatment that was accepted by the non-SPSO holders of LP Debt, SPSO's good faith in rejecting such a plan would be open to serious question. Indeed, as SPSO itself ironically points out in drawing a distinction between this case and DBSD, “[i]t is one thing to designate a creditor that votes against a [p]lan that manifestly compensates the designated stakeholder's economic expectations in full ” but quite another thing to designate SPSO's vote on this Plan. Here, while it is not subject to credible dispute that SPSO has non-creditor interests, its vote to reject this demonstrably unconfirmable plan cannot be designated, especially when to do so would arguably render the protections of section 1129(b) inapplicable.

LightSquared , 2014 WL 3535130, at *24-*25 (footnotes omitted, emphasis added).

The Court's Role

The LightSquared analysis weaves a path around decisions like Kham & Nate's Shoes No. 2, Inc. v. First Bank of Whiting, 908 F.2d 1351, 1356 (7th Cir. 1990) (“[W]e are not willing to embrace a rule that requires participants in commercial transactions not only to keep their contracts but also do 'more' ' just how much more resting in the discretion of a bankruptcy judge assessing the situation years later. ' Firms that have negotiated contracts are entitled to enforce them to the letter, even to the great discomfort of their trading partners, without being mulcted for lack of 'good faith.' Although courts often refer to the obligation of good faith that exists in every contractual relation, this is not an invitation to the court to decide whether one party ought to have exercised privileges expressly reserved in the document”) and Smith v. Assocs. Commercial Corp. ( In re Clark Pipe & Supply Co.), 893 F.2d 693 (5th Cir. 1990) (reversed equitable subordination because the actions taken were within the scope of the contract at issue), and arguably retrenches from the trial court determination in DBSD that designated the vote is the acquirer of the secured debt and deemed the class to have accepted. In re DBSD N. Am., Inc., 421 B.R. 133 (Bankr. SD NY 2009).

The issue in LightSquared is not contract enforcement. The issue is taking actions outside of the limitations of the contract by a stranger to the original contract that the bankruptcy court found objectionable based on the acquisition of debt in the context of wanting to use that debt to facilitate a potential acquisition of a debtor, and thereby to have a voice and be able to exert influence in the Chapter 11 case. Significantly in LightSquared , the bankruptcy court declined to invalidate or subordinate the position of the debt acquirer in the face of proposed plan treatment the court determined to be inadequate to allow confirmation. Arguably, a reason for this result is that the court had not quantified the amount of the debt that was required to be subordinated because quantification was so difficult in a situation where the basis for the ruling included the expansion of the standard for equitable subordination. These points are best reflected in the following excerpts from the court's ruling:

Taken as a whole, SPSO's conduct not only violates the covenant of good faith and fair dealing implied in all contracts but also constitutes an affront to the duty of good faith imposed on those who participate in [C]hapter 11 proceedings. 511 B.R. at 346.

* * *

Although many aspects of SPSO's conduct are, as has been suggested, “perfectly lawful” ' including making purchases anonymously, acquiring a blocking position, and making an unsolicited cash bid for distressed assets ' its purchase of LP Debt in order to preserve a strategic option for the benefit of DISH, a Disqualified Company, violated the spirit of the Credit Agreement's restrictions on competitors owning LP Debt. Such conduct, as described more fully above, constitutes inequitable conduct sufficient to warrant equitable subordination of the SPSO Claim. Id. at 352-353.

* * *

Even if SPSO's acquisition of LP Debt was faultless, its intentional delay in closing its trades of LP Debt alone is sufficient to constitute the type of inequitable conduct necessary for the imposition of equitable subordination by the Court. Id. at 353.

* * *

While a creditor who is not an insider is not a fiduciary, a creditor nevertheless does not have the unfettered right to engage in such purposeful obstruction of the process. SPSO failed to act in a way that is consistent with the most basic concepts of good faith that are fairly to be expected of [C]hapter 11 creditors, especially those who voluntarily join the capital structure of a debtor well after distress has set in. '

As SPSO vehemently maintains, many aspects of SPSO's conduct are entirely acceptable (albeit aggressive) and do not provide grounds for equitable subordination. Such lawful and acceptable conduct includes: buying distressed debt; buying distressed debt anonymously; buying distressed debt anonymously at prices close to par; acquiring a blocking position in a class of debt; and making an unsolicited bid for assets of a debtor. Nothing in the Court's decision should in any way alter such conduct in the distressed debt marketplace. The Bankruptcy Code and the [C]hapter 11 process tolerate and even contemplate self-interested and aggressive creditor behavior. Nevertheless, SPSO's conduct in acquiring the LP Debt and in controlling the conduct of the [C]hapter 11 case through purposeful delays in closing hundreds of millions of dollars of LP Debt trades during a critical timeframe in these cases breaches the outer limits of what can be tolerated.

Id . at. 360 (footnotes omitted).

Conclusion

Whether, as is postulated above, the foregoing analysis reflects an evolution of the law of equitable subordination to affect the “inequitable conduct” standard required by Mobile Steel is a question for the reader. Further, whether LightSquared is a retrenchment from the analysis in DBSD in any way, or is just a conservative view based on the different facts presented, is also a fair topic for discussion and disagreement. Either way on either issue, the doctrine is alive and well, and bankruptcy courts are still following the admonition to elevate substance over form and evaluate conduct and actions accordingly based on receipt of a full evidentiary record.

Grant T. Stein, a member of this newsletter's Board of Editors, is a senior partner in Alston & Bird's Bankruptcy, Reorganization and Workouts Group, resident in the firm's Atlanta office. He is a Fellow in the American College of Bankruptcy and serves on its board of directors, is a past president of the Association of Insolvency and Reorganization Advisors, and former president and current director chair of the Southeastern Bankruptcy Law Institute. He can be reached at [email protected].

On June 10, 2014, the Bankruptcy Court for the Southern District of New York issued a 168-page post-trial opinion determining that it would equitably subordinate the claims of SP Special Opportunities LLC (SPSO) against LightSquared. LightSquared LP, et. al. v. SP Special Opportunities LLC, et. al., 511 B.R. 253 (Bankr. S.D. N.Y. 2014). The court reserved for later determination the amount to be equitably subordinated. Id. at 315, 361.

The court's opinion explained that SPSO, under the control of Charles Ergen, the founder, Board chair and controlling shareholder of Dish Network, had acquired $844 million of senior secured debt of LightSquared LP. 511 B.R. at 279, ”88, 89. Two hundred eighty seven million dollars of the face amount of the debt purchases occurred prior to the filing of the LightSquared bankruptcy cases on May 14, 2012, for a purchase price of $172 million. Id. at 274, '63. The purchases were made at a time when there were restrictions on the holders of LightSquared secured debt to preclude its competitors from holding that debt, and SPSO was aware of, and was created to, navigate those restrictions. Id. at 345-346.

There are a series of other decisions in the LightSquared case, including one issued on July 11, 2014, that denied confirmation of a plan, and addressed designation of votes under Section 1126(e); classification; unfair discrimination; fair and equitable standards; and indubitable equivalence. The discussion of the applicable law in these decisions is extensive and thorough. Because of their length and depth, dissecting these decisions in this article is not possible. For the same reasons, this article does not address subsequently reported developments such as resignations by certain members of the Board of LightSquared, filing of lawsuits, apparent settlements, and submission of competing plans.

Equitable Subordination

Equitable subordination is a basic theory of recovery in bankruptcy cases. Measuring the amount of subordination must be based on the degree of injury to the creditors of the bankruptcy estates under applicable law. As the Fifth Circuit recognized in In re Mobile Steel Co., 563 F.2d 692, 701 (5th Cir. 1977): “[A] claim or claims should be subordinated only to the extent necessary to offset the harm which the bankrupt and its creditors suffered on account of the inequitable conduct. ' The misconduct must have resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant.” Accord, Citicorp Venture Capital v. Comm. of Creditors Holding Unsecured Claims (In re Papercraft, Inc.), 160 F.3d 982, 990 (3d Cir. 1998) (a creditor “should not be permitted to profit by its” inequitable conduct); see also In re Westgate-California Corp., 642 F.2d 1174, 1178 (9th Cir. 1981) (“[T]he court ought not to subordinate where the value of the claim greatly exceeds the amount of damage that the claimant has inflicted by his inequitable conduct.”); In re Enron Corp., 333 B.R. 205, 222 (Bankr. S.D.N.Y. 2005) (“Subordinating any amount of claim in excess of the established injury sustained would be punitive, and not consistent with the principles of equitable subordination nor permissible.”).

In certain instances it may be difficult to quantify the exact amount of injury requiring subordination. As the Third Circuit explained in Papercraft, “[Q]uantification may not always be feasible. ' A bankruptcy court should, however, attempt to identify the nature and extent of the harm it intends to compensate. ' If that is not possible, the court should specifically so find.” 160 F.3d at 991. The Third Circuit explained further that any difficulty in quantifying a proven injury “should not redound to the benefit of the wrongdoer.” Id.

Pepper v. Litton , 308 U.S. 295 (1939) and Sampsell v. Bridgeford , 237 F.2d 182 (9th Cir. 1956) are two cases where equitable subordination was considered and ordered. In Pepper v. Litton, the seminal case on equitable subordination, the insider's judgment was disallowed in the bankruptcy and the oft-cited explanation of the equitable nature of the bankruptcy court's jurisdiction was set forth as follows: “They [the bankruptcy courts' equitable powers] have been invoked to the end that fraud will not prevail, that substance will not give way to form, that technical considerations will not prevent substantial justice from being done.” 308 U.S. at 304-305.

In Pepper v. Litton, the U.S. Supreme Court refused to allow a fiduciary to use his position to procure a benefit by obtaining a judgment and providing it priority over the claims of another creditor. At issue in Pepper v. Litton was a confession of judgment obtained by a corporate principal (Litton) on alleged wage claims in order to obtain priority over that of a bona fide lessor (Pepper) for royalties. Litton acquired property of the debtor in a sheriff's sale executing on the judgment. The assets so acquired were transferred to a new company, and the old company filed bankruptcy two days after the execution sale, with the Litton judgment and claims being disallowed. In Sampsell, a $30,000 claim against an insolvent corporation was given to a court-appointed company manager as a “gift” from the holder of the debt. The claim, which was worthless in the hands of the transferor, netted the court-appointed manager almost $26,000. The recovery was ordered to be disgorged.

The LightSquared Decision

In LightSquared, the bankruptcy court arguably expanded the application of the law on equitable subordination based on the facts it found in its extensive decision. It carefully determined that the conduct of a non-insider in acquiring claims in knowing violation of the spirit of an “eligible assignee” provision in a credit agreement did not violate the actual language in the credit agreement and did not provide a basis for disallowance of the acquired claims. 511 B.R. at 315-317, 336-340. Nonetheless, the court held that the challenged action, while not constituting a breach of the contract “not only violates the covenant of good faith and fair dealing implied in all contracts[,] but also constitutes an affront to the duty of good faith imposed on those who participate in [C]hapter 11 proceedings” Id. at 346.

The court reasoned that “[I]nequitable conduct is not limited to fraud or breach of contract, rather, it includes even lawful conduct that shocks one's good conscience.” Id . at 347. In reliance on Developmental Specialists, Inc. v. Hamilton Bank, N.A. (In re Model Imperial, Inc.), 250 B.R. 776, 804'05 (Bankr. S.D. Fla. 2000), the LightSquared court held that actions taken knowingly to circumvent limitations in a contract can support equitable subordination. 511 B.R. at 348. In Model Imperial, the court determined that actions taken to circumvent a negative covenant in a loan precluding other loans warranted equitable subordination of a claim in addition to finding that transfers made to the claimant were made with intent to hinder, delay, and defraud the existing lenders.

The key component to the analysis of the court in LightSquared is its determination that “[W]hile it is generally acceptable to obtain and deploy a blocking position to control the vote of a class with respect to a proposed plan of reorganization, it is not acceptable to deploy a blocking position to control the conduct of the case itself, to subvert the intended operation of a court-approved exclusivity termination arrangement, and to prevent the Court from directing and having visibility into events unfolding in the case.” 511 B.R. at 360.

The Court's Reasoning

The basis for equitable subordination is arguably more persuasively explained by the court in its decision denying confirmation in LightSquared. In re LightSquared Inc., 2014 WL 3535130 (Bankr. S.D.N.Y. July 11, 2014). In that decision, the LightSquared court discussed Sections 1126(e) and 510(c), and explained why the facts that the court held required equitable subordination in this case did not, as in In re DBSD N. Am., Inc., 634 F.3d 79 (2d Cir.2011), require designation of the vote of the subordinated creditor in its separate class to the extent that subordination was not ordered for the entire claim. It should be noted that the party in DBSD was Dish Network Corporation, which was also connected to, and a named party in, the LightSquared Adversary Proceeding. The LightSquared court's reasoning included the following discussion:

While the Debtors urge that DBSD compels designation of SPSO's vote to reject the Plan, to do so would materially extend the reach of DBSD in ways that section 1126(e) does not contemplate. The centerpiece of the Second Circuit's decision in DBSD was its observation that a competitor of DBSD (DISH) “bought claims with the intent of voting against any plan that did not give it a strategic interest in the reorganized company,” and it bought those claims above par and after a plan had been proposed by DBSD. DBSD , 634 F.3d at 104. So too in Allegheny, in which creditor Japonica purchased its claims after balloting on a plan had already begun. In re Allegheny Int'l, Inc. , 118 B.R. at 286. As Judge Gerber noted in DBSD, DISH intended “to use [its] status as a creditor to provide advantages over proposing a plan as an outsider or making a traditional bid for the company or its assets.” DBSD, 421 B.R. at 139-40. However, both Judge Gerber and the Second Circuit were particularly focused on the timing of DISH's debt purchases which were made after the plan in DBSD had been filed. Here, SPSO made no purchases of debt above par and acquired a significant portion (approximately $287 million) of its claim before the Chapter 11 Cases were commenced, when the LP Debt was trading at or below approximately 60 cents on the dollar; moreover, SPSO acquired all of its LP Debt below par and prior to the filing of any plan. SPSO is thus arguably, at least in part, a “pre-existing creditor,” albeit one who has allegedly voted with strategic intentions ' the type of creditor that the Second Circuit did not expressly include in the ambit of its prohibition on voting in connection with strategic claims acquisitions. DBSD, 634 F.3d at 106. The Court declines to extend the holding of DBSD to cover votes cast with respect to claims which were acquired before a plan had been proposed by any party and where, as discussed below, there are valid, economically self-interested creditor reasons for the holder of such claims to reject a proposed plan. (footnotes omitted).

* * *

The Debtors would have the Court conflate the provisions of section 1126(e) and section 510(c) and hold that a finding of inequitable conduct sufficient to support equitable subordination of a creditor's claim necessarily translates into the basis for designating the bad actor's vote. Moreover, the Debtors would seek to transform vote designation into a substantive treatment provision. The Court declines to read section 1126(e) so broadly; in the plain words of the statute, designation may be ordered with respect to “any entity whose acceptance or rejection of such plan was not in good faith.” It is vote-specific and plan-specific. It focuses on the voting conduct of the creditor holding the claim. Simply put, had SPSO voted to reject a plan that proposed to pay it in full in cash or a plan proposing that SPSO receive some other treatment that was accepted by the non-SPSO holders of LP Debt, SPSO's good faith in rejecting such a plan would be open to serious question. Indeed, as SPSO itself ironically points out in drawing a distinction between this case and DBSD, “[i]t is one thing to designate a creditor that votes against a [p]lan that manifestly compensates the designated stakeholder's economic expectations in full ” but quite another thing to designate SPSO's vote on this Plan. Here, while it is not subject to credible dispute that SPSO has non-creditor interests, its vote to reject this demonstrably unconfirmable plan cannot be designated, especially when to do so would arguably render the protections of section 1129(b) inapplicable.

LightSquared , 2014 WL 3535130, at *24-*25 (footnotes omitted, emphasis added).

The Court's Role

The LightSquared analysis weaves a path around decisions like Kham & Nate's Shoes No. 2, Inc. v. First Bank of Whiting , 908 F.2d 1351, 1356 (7th Cir. 1990) (“[W]e are not willing to embrace a rule that requires participants in commercial transactions not only to keep their contracts but also do 'more' ' just how much more resting in the discretion of a bankruptcy judge assessing the situation years later. ' Firms that have negotiated contracts are entitled to enforce them to the letter, even to the great discomfort of their trading partners, without being mulcted for lack of 'good faith.' Although courts often refer to the obligation of good faith that exists in every contractual relation, this is not an invitation to the court to decide whether one party ought to have exercised privileges expressly reserved in the document”) and Smith v. Assocs. Commercial Corp. ( In re Clark Pipe & Supply Co.), 893 F.2d 693 (5th Cir. 1990) (reversed equitable subordination because the actions taken were within the scope of the contract at issue), and arguably retrenches from the trial court determination in DBSD that designated the vote is the acquirer of the secured debt and deemed the class to have accepted. In re DBSD N. Am., Inc., 421 B.R. 133 (Bankr. SD NY 2009).

The issue in LightSquared is not contract enforcement. The issue is taking actions outside of the limitations of the contract by a stranger to the original contract that the bankruptcy court found objectionable based on the acquisition of debt in the context of wanting to use that debt to facilitate a potential acquisition of a debtor, and thereby to have a voice and be able to exert influence in the Chapter 11 case. Significantly in LightSquared , the bankruptcy court declined to invalidate or subordinate the position of the debt acquirer in the face of proposed plan treatment the court determined to be inadequate to allow confirmation. Arguably, a reason for this result is that the court had not quantified the amount of the debt that was required to be subordinated because quantification was so difficult in a situation where the basis for the ruling included the expansion of the standard for equitable subordination. These points are best reflected in the following excerpts from the court's ruling:

Taken as a whole, SPSO's conduct not only violates the covenant of good faith and fair dealing implied in all contracts but also constitutes an affront to the duty of good faith imposed on those who participate in [C]hapter 11 proceedings. 511 B.R. at 346.

* * *

Although many aspects of SPSO's conduct are, as has been suggested, “perfectly lawful” ' including making purchases anonymously, acquiring a blocking position, and making an unsolicited cash bid for distressed assets ' its purchase of LP Debt in order to preserve a strategic option for the benefit of DISH, a Disqualified Company, violated the spirit of the Credit Agreement's restrictions on competitors owning LP Debt. Such conduct, as described more fully above, constitutes inequitable conduct sufficient to warrant equitable subordination of the SPSO Claim. Id. at 352-353.

* * *

Even if SPSO's acquisition of LP Debt was faultless, its intentional delay in closing its trades of LP Debt alone is sufficient to constitute the type of inequitable conduct necessary for the imposition of equitable subordination by the Court. Id. at 353.

* * *

While a creditor who is not an insider is not a fiduciary, a creditor nevertheless does not have the unfettered right to engage in such purposeful obstruction of the process. SPSO failed to act in a way that is consistent with the most basic concepts of good faith that are fairly to be expected of [C]hapter 11 creditors, especially those who voluntarily join the capital structure of a debtor well after distress has set in. '

As SPSO vehemently maintains, many aspects of SPSO's conduct are entirely acceptable (albeit aggressive) and do not provide grounds for equitable subordination. Such lawful and acceptable conduct includes: buying distressed debt; buying distressed debt anonymously; buying distressed debt anonymously at prices close to par; acquiring a blocking position in a class of debt; and making an unsolicited bid for assets of a debtor. Nothing in the Court's decision should in any way alter such conduct in the distressed debt marketplace. The Bankruptcy Code and the [C]hapter 11 process tolerate and even contemplate self-interested and aggressive creditor behavior. Nevertheless, SPSO's conduct in acquiring the LP Debt and in controlling the conduct of the [C]hapter 11 case through purposeful delays in closing hundreds of millions of dollars of LP Debt trades during a critical timeframe in these cases breaches the outer limits of what can be tolerated.

Id . at. 360 (footnotes omitted).

Conclusion

Whether, as is postulated above, the foregoing analysis reflects an evolution of the law of equitable subordination to affect the “inequitable conduct” standard required by Mobile Steel is a question for the reader. Further, whether LightSquared is a retrenchment from the analysis in DBSD in any way, or is just a conservative view based on the different facts presented, is also a fair topic for discussion and disagreement. Either way on either issue, the doctrine is alive and well, and bankruptcy courts are still following the admonition to elevate substance over form and evaluate conduct and actions accordingly based on receipt of a full evidentiary record.

Grant T. Stein, a member of this newsletter's Board of Editors, is a senior partner in Alston & Bird's Bankruptcy, Reorganization and Workouts Group, resident in the firm's Atlanta office. He is a Fellow in the American College of Bankruptcy and serves on its board of directors, is a past president of the Association of Insolvency and Reorganization Advisors, and former president and current director chair of the Southeastern Bankruptcy Law Institute. He can be reached at [email protected].