United States: Claim Traders Beware: When Equitable Subordination Applies

Recently, in In re Enron Corp., U.S. Bankruptcy Judge Arthur J. Gonzalez of the U.S. Bankruptcy Court for the Southern District of New York was faced with the novel question of whether proofs of claim, which were transferred by the original claim holder (who is alleged to have engaged in inequitable conduct unrelated to the transaction that gave rise to the claims) would be subject to subordination in the hands of a transferee under Section 510(c) of the U.S. Bankruptcy Code.

In what has become a controversial opinion due to the potential ramifications the holding will have on purchasers of distressed credits (including loans, publicly traded debt and trade claims), the court held that: the doctrine of equitable subordination applies broadly to potentially reach any claims held by a claimant, limited by the amount of damages stemming from the inequitable conduct that is not otherwise fully compensated to the injured creditor class; the transfer of a claim subject to equitable subordination does not free such claim from subordination in the hands of a transferee; and the "good-faith" defense is not available to a purchaser of claims so as to protect it from equitable subordination that stems from the acts of the original claim holder.

Factual Background

On Dec. 2, 2001 (the petition date), Enron Corp. and certain of its affiliated entities filed voluntary petitions for relief under Chapter 11 of the Bankruptcy Code. Prior to the petition date, on May 14, 2001, Enron borrowed approximately $1.7 billion pursuant to a short-term credit agreement from a group of banks, including Fleet National Bank. On Oct. 15, 2002, two proofs of claim were filed against Enron's estate representing amounts due and owing to Fleet under the credit agreement. The claims were subsequently transferred to five separate entities (the claim purchasers).

Following the transfer of the claims, and nearly two years after the commencement of the case, Enron commenced an adversary proceeding against several banks, including Fleet. Enron alleged that Fleet, as well as other banks, received certain preferential payments and fraudulent transfers in connection with two series of prepaid forward transactions to which Fleet was a party. These transactions were unrelated to the loans made by fleet pursuant to the credit agreement.

In addition, Enron alleged that "Fleet benefited from its inequitable conduct, including its aiding and abetting Enron in engaging in accounting fraud, that resulted in injury to Enron's creditors and conferred an unfair advantage on Fleet." Enron did not allege that there was fraudulent or inequitable conduct under the credit agreement or that payments made pursuant to the credit agreement were voidable as preferences or fraudulent conveyances.

After the filing of the adversary proceeding, on Jan. 12, 2005, Enron commenced an adversary proceeding against the claim purchasers (now the defendants) seeking to subordinate and disallow the claims held by the claim purchasers as a result of Fleet's alleged inequitable conduct in the prepaid forward transactions. Enron asserted that under Section 510(c) of the Bankruptcy Code, had the claims not been transferred from Fleet to the defendants, the claims would have been subordinated for purposes of distribution, and any liens securing the claims would have been transferred to Enron's estate.

Enron argued that the claims should be subordinated, regardless of the fact that Fleet no longer held the claims, and any liens securing the claims should be transferred to Enron's estate. Enron also asserted that the "good-faith" of a transferee is irrelevant because the focus of Section 510(c) is on the conduct of the original holder of the claims.

The defendants responded by filing a motion to dismiss for failure to state a claim. They argued that the sole basis of Enron's cause of action was that Fleet - and not the defendants - allegedly received preferential payments of fraudulent transfers from Enron or engaged in inequitable acts in regard to the two prepaid financial transactions, which transactions were wholly unrelated to the claims that arose from the credit agreement.

The defendants asserted that under the plain language of Section 510(c), subordination does not follow the claim, but serves to punish claimants who are found to have acted inequitably. The defendants further alleged that even were equitable subordination to apply to the claims, they were entitled to assert a "good-faith" defense.

The court denied the defendants' motion to dismiss.

The Court's Analysis

In addressing this issue of first impression, the court focused on three distinct but related inquiries. The first was whether Section 510(c) grants a court authority to subordinate claims that are not related to any misconduct, but are merely held by a creditor who is found to have engaged in unrelated inequitable conduct.

The second was to what extent, if any, a claim subject to equitable subordination in the hands of a transferor remains subject to equitable subordination in the hands of a transferee.

The third was whether the "good-faith" defense should cover the transfer of claims subject to equitable subordination under Section 510(c). Before its substantive discussion of the three inquiries, the court examined Section 510(c) and the case law that interpreted it.

Section 510(c) and the Doctrine of Equitable Subordination.

Section 510(c) of the Bankruptcy Code provides that after notice and hearing, the court may: 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 an allowed interest to all or part of another allowed interest; or order that any lien securing such a subordinated claim be transferred to the estate.

Courts have discretion in determining whether equitable subordination is warranted. The doctrine of equitable subordination is generally applied where it is alleged that a creditor participated in some conduct that injured other claimants and resulted in the creditor obtaining an unfair advantage over those claimants.

In discussing the doctrine of equitable subordination, the court focused its attention on and adopted the three-prong Mobile Steel test, a test that was first enunciated by the 5th U.S. Court of Appeals in Benjamin v. Diamond (In re Mobile Steel Co.). Under the test, a bankruptcy court can exercise its power to equitably subordinate a claim if the following three elements are satisfied: the claimant engaged in some type of inequitable conduct; the inequitable conduct resulted in injury to creditors or conferred an unfair advantage on the claimant; and equitable subordination of the claim is not inconsistent with the provisions of the Bankruptcy Code.

The court also noted that when applying the doctrine of equitable subordination, courts are required to consider administrative convenience and the fundamental principles of equity.

Equitable subordination of claims unrelated to inequitable conduct is permitted.

In regard to its first inquiry, the court held that the doctrine of equitable subordination is not limited only to those claims related to the creditor's inequitable conduct. To the contrary, the court determined that the doctrine of equitable subordination may cover any claim necessary to effectuate the remedy set forth in Section 510(c), limited only by the extent of otherwise uncompensated injury to the related creditor class.

The court relied on the Mobile Steel case to support its conclusion: "[T]he Mobile Steel court found that when a court considers equitable subordination of a claim, the inequitable conduct does not have to be related to such claim to justify the subordination."

In further support of its conclusion, the court noted that there is currently no case law so limiting a court's exercise of the doctrine of equitable subordination. In addition, the court found its conclusion to be consistent with one of the policies of the Bankruptcy Code - to allow a court to exercise its authority in order to rectify harm to the estate or to creditors, and to achieve a fair distribution for all creditors.

Lastly, looking at the plain language of the Bankruptcy Code, the court concluded that had Congress intended to limit the doctrine of equitable subordination in any way, Congress would have manifested such an intent.

Equitable subordination is applicable to claims in the hands of a transferee.

In regard to the second inquiry, the court held that the transfer of a claim does not shield such claim from equitable subordination in the hands of the transferee.

In support of its conclusion, the court found that transferees should not enjoy greater rights than do the transferors. The court cited case law from several circuits supporting the proposition that in bankruptcy proceedings, an assignee stands in the shoes of its assignor and is therefore subject to all defenses which may be asserted against the assignor.

The court further supported its position by examining the plain language of Section 510(c). It pointed out that the statutory provision focuses on the word "claim" rather than "claimant." According to the court, had Congress intended for the application of the doctrine of equitable subordination to be limited to an original claimant rather than to the claim itself, Congress could have provided for such a limitation. In addition, the court determined that its conclusion was necessary in order to ensure that a creditor who engaged in inequitable conduct would not be permitted to frustrate, hinder, dilute or in any way delay a distribution to other members of the injured creditor class by transferring its claims.

Lastly, the court found that participants in the claims-transfer market know - or should be aware - of the risks and uncertainties inherent in purchasing claims, including the possibility that claims can be subordinated; as such, these participants assume the liabilities associated with such risks. The court also emphasized that by permitting a debtor to refrain from making a distribution on account of a transferred claim, the debtor avoids having to litigate or pursue the initial transferee for any distributions made on account of the transferred claim.

The "good-faith" defense will not protect transferees.

In regard to the third inquiry, the court held that purchasers of claims are not protected from equitable subordination as a result of their "good-faith" status. While acknowledging that the express language of Section 510(c) does not explicitly provide for such a defense, the defendants urged the court to extend the "good-faith" defense found in Section 550(b) of the Bankruptcy Code to purchasers of claims.

In support of their position, the defendants set forth the following facts: they acted in good faith and paid fair value for the claims they purchased; they did not engage in any misconduct in the postpetition purchase of the claims; and they had no knowledge of Fleet's alleged inequitable conduct when they purchased the claims since they did so more than one year before the adversary proceeding was initiated.

Despite the facts surrounding the defendants' purchase of the claims, the court held that the 550(b) "good-faith" defense did not extend to Section 510(c). The court noted several provisions of the Bankruptcy Code are explicitly covered by Section 550, but Section 510 is not one of them. The court found that had Congress intended the Section 550(b) "good-faith" defense to apply to 510(c), it could have included Section 510(c) among the sections referenced in 550(a). It also found that a claims purchaser knows it is purchasing a claim against a debtor, and is therefore on notice that any defense or right of the debtor may be asserted against the claim.

Furthermore, the court pointed out to the defendants that they should have been aware of the risks associated with the purchase of Enron's distressed debt, and that Enron had a fiduciary duty to ensure a just and fair distribution to creditors. Such a duty, the court concluded, undoubtedly requires an investigation into each proof of claim to determine whether the claim is subject to any defenses, including equitable subordination.

The Decision's Impact

The defendants and other permitted intervenors are currently preparing motions for leave to appeal the court's decision. It remains to be seen whether this decision will stand on appeal, and whether other courts will follow Gonzalez's ruling. For now, at least, purchasers of distressed debt and claim traders need to ensure that they obtain adequate indemnification from their transferors, they conduct thorough due diligence of their transferor's prior conduct, and they confirm their transferor's financial ability to honor any indemnification which the transferor agrees to provide.

Rudolph J. Di Massa Jr., a partner at Duane Morris, concentrates his practice in the areas of commercial litigation and creditors' rights. He is a member of the American Bankruptcy Institute, the American Bar Association and its business law section, the Commercial Law League of America, the Pennsylvania Bar Association and the business law section of the Philadelphia Bar Association.

Sommer L. Ross practices in the area of business reorganization and financial restructuring. Admitted to practice in Delaware, Pennsylvania and New Jersey, Ross is a 2004 graduate of Rutgers University School of Law, where she was a member of the Rutgers Law Journal, and a graduate of the University of Delaware.

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