United States: Equitable And Mandatory Subordination: The Disappearing Claim

Last Updated: July 22 2013
Article by Vicki Harding

Prior to bankruptcy, a claimant obtained a $4 million judgment, which supposedly represented one-third of the value of the debtor's business.  The debtor filed a bankruptcy complaint alleging that the creditor's interest was equity rather than debt, so that its claim should be recharacterized or subordinated under Section 510 of the Bankruptcy Code.  The creditor moved to dismiss the complaint; the bankruptcy court rejected the motion to dismiss, finding that the debtor's allegations provided sufficient grounds to proceed.

Purportedly the creditor (Tasos) was to receive 50% of the debtor's stock in exchange for making available his expertise and experience.  Apparently the arrangement was not documented.  In state court, although the debtor contended that Tasos did not have any equity interests in the company, the state court did not agree.  So, in the bankruptcy court the debtor asserted that Tasos made a capital contribution, not a loan, and claimed that the bankruptcy court should grant both mandatory and equitable subordination.

The elements of mandatory subordination under Section 510(b) of the Bankruptcy Code are: (1) the claim involves a security, (2) there is a purchase or sale of the security, and (3) the claim is for damages that arose out of the purchase or sale.

The bankruptcy court considered the debtor's recharacterization argument as equivalent to the first element of the mandatory subordination claim.  After noting a variety of multi-factor tests adopted by courts for recharacterization (for example, an inference based on what parties say and do and the economic reality of the circumstances), the court concluded that the debtor's allegations were sufficient to support recharacterizing Tasos' interest as equity.  The court also concluded that obtaining stock in exchange for expertise and experience was sufficient to establish a "purchase" transaction, since the term purchase is broadly defined.

As to the final element, it was clear that Tasos did not get what he bargained for, and the judgment was for profit that he would have been entitled to as an owner.  Consequently the claim was for damages that arose from a purchase.  Accordingly, the debtor's allegations were sufficient so that it could pursue an action for mandatory subordination under Section 510(b).

Alternatively the debtor sought to equitably subordinate the claim under Section 510(c)(1) of the Bankruptcy Code, which provides for subordination "under principles of equitable subordination."  Under 3rd Circuit law, elements of equitable subordination include:  (1) inequitable conduct by the claimant, (2) with the misconduct resulting in injury to other creditors or conferring an unfair advantage on the claimant, and (3) subordination is not inconsistent with the Bankruptcy Code.

As a threshold question, it is not clear that inequitable conduct is always required.  Most courts that have considered the issue will waive the misconduct requirement in only very limited circumstances (such as claims for tax penalties, stock redemption claims, and punitive damages claims).  The bankruptcy court concluded that both the U.S. Supreme Court and the 3rd Circuit have reserved ruling on the question of whether there can be "no-fault" equitable subordination.  However, the court concluded that it did not need to reach this issue:

The Complaint cites what constitutes colorable misconduct on Tasos' part.  Specifically, Tasos is alleged to have asserted as a debt claim what he previously asserted to constitute an equity claim.  The court finds it troubling that Tasos would take a position wholly at odds with the stance he took in the state court.  His motivation appears obvious:  the premise which served him so well in the state court will place him at the end of the line in the Bankruptcy Code's distribution scheme.  This calls into question Tasos' good faith so much so that judicial estoppel might be invoked.

Thus, the court found that the allegations of misconduct were sufficient to survive the motion to dismiss.

Based on the debtor's bankruptcy schedules: (1) Tasos' $4 million claim was almost 50% of the total unsecured claims, and (2) even without its claim, the debtor was insolvent so that the unsecured claims would not be paid in full.

With respect to the criterion that the misconduct result in injury, the court concluded that allowing the Tasos claim to remain in a class of unsecured creditors, as opposed to treating it like equity, would substantially dilute the payment to the unsecured creditors, and subordinating the Tasos claim would mitigate that injury.

As for the requirement that the subordination be consistent with the Bankruptcy Code, the absolute priority rule requires that creditors be paid in full before equity holders receive any distributions.  Although technically this rule applies only in the context of a cramdown,  the court noted that it was unlikely the unsecured claims would be paid in full, so subordinating the Tasos equity claim to claims classified as unsecured debt was consistent with the Bankruptcy Code.

Tasos' response included a contention that the debtor should be estopped from asserting its subordination arguments.  As noted above, the debtor's position in state court was that Tasos never had an equity interest.  However, the court did not see that the positions argued by the debtor as necessarily inconsistent.  The debtor lost in state court and its position was rejected.  Its arguments before the bankruptcy court were "simply a recognition that the issue is now settled as a matter of law."  The court also found no bad faith, nor did it view the debtor's arguments as opportunistic or untoward.

Consequently, the court found that the complaint was sufficient to support a claim for either mandatory or equitable subordination under Section 510 of the Bankruptcy Code.

The court's view that Tasos was arguably guilty of misconduct by taking inconsistent positions in state court and bankruptcy court is a reminder that there can be limits on advocacy.  (See also "Vacuous" Landlord Lien Claim: There Are Limits to Advocacy.)  This case also illustrates that, given the right facts and circumstances, the ability to subordinate a claim can be a powerful tool for a debtor.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Vicki Harding
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