Chapter 11 "Best Interests of Creditors Test" Not an Independent Basis for Subordination of a Claim
It is well recognized that a bankruptcy court has the power to subordinate claims in a bankruptcy case based on contractual, equitable, or statutory grounds. However, as illustrated in a ruling handed down by a Bankruptcy Appellate Panel for the Ninth Circuit (the "BAP"), there are limits to that power, particularly in cases where subordination is proposed under circumstances that are not expressly contemplated by the Bankruptcy Code.
In In re Matheson Flight Extenders, Inc., 679 B.R. 21 (B.A.P. 9th Cir. 2026), the BAP held that, after a reorganized debtor defaulted under a confirmed chapter 11 plan, the administrator of the plan could not seek to subordinate creditors' punitive damages claims under the "best interests of creditors test" in section 1129(a)(7) of the Bankruptcy Code. Compliance with the test is a condition to plan confirmation, rather than section 510, the provision of the Bankruptcy Code that specifically applies to subordination in bankruptcy cases.
According to the panel, section 1129(a)(7), which incorporates chapter 7's priority of distribution scheme giving a lower priority to punitive damages claims, applies only in connection with confirmation of a chapter 11 and cannot serve as an independent basis to subordinate a claim after the plan has been confirmed.
Subordination in Bankruptcy
The concept of claim, debt, or lien subordination is well recognized under federal bankruptcy law. A bankruptcy court's ability to reorder the relative priority of claims or debts under appropriate circumstances is part and parcel of its broad powers as a court of equity. The statutory vehicle for applying these powers in bankruptcy is section 510 of the Bankruptcy Code, which expressly contemplates three kinds of subordination.
First, Section 510(a) makes an otherwise valid contractual subordination agreement enforceable in a bankruptcy case to the same extent that it would be enforceable outside bankruptcy.
Next, section 510(b) generally subordinates claims arising from the purchase or sale of a security of the debtor or an affiliate of the debtor to all claims that are senior or equal to the claim or interest represented by the security. This is sometimes referred to as "mandatory," "statutory," or "categorical" subordination.
Finally, section 510(c) provides that misconduct that results in injury to creditors or shareholders can, "[n]otwithstanding subsections (a) and (b) of this [section 510]," result in the "equitable" subordination of a claim or interest or the issuance of an "order that any lien securing such a subordinated claim be transferred to the estate."
Equitable subordination is a remedy that was developed under common law prior to the enactment of the Bankruptcy Code to remedy misconduct by a creditor or equityholder of the debtor that results in injury to other creditors or shareholders. Where a creditor is shown to have engaged in such misconduct, the bankruptcy court has authority to subordinate the creditor's claim to the claim of a particular creditor injured by the misconduct, to the claims of an injured class of creditors, or to all other claims, depending on the circumstances.
In In re Mobile Steel Co., 563 F.2d 692 (5th Cir. 1977), the U.S. Court of Appeals for the Fifth Circuit articulated what has become the most commonly accepted standard for equitable subordination of a claim. Under this standard, a claim can be subordinated if the claimant engaged in inequitable conduct that resulted in injury to creditors (or conferred an unfair advantage on the claimant) and if equitable subordination of the claim is consistent with the provisions of the Bankruptcy Code. Id. at 700.
Courts have refined the test to account for special circumstances. For example, many courts make a distinction between insiders (e.g., corporate fiduciaries) and non-insiders in assessing the level of misconduct necessary to warrant subordination. See In re Alternate Fuels, Inc., 789 F.3d 1139, 1155 (10th Cir. 2015) ("If a claimant is an 'insider' or a 'fiduciary' of the debtor, our analysis is less stringent. '[T]he party seeking subordination need only show some unfair conduct, and a degree of culpability, on the part of the insider.'" (quoting In re Hedged–Investments Assocs., Inc., 380 F.3d 1292, 1301 (10th Cir. 2004)); In re Winstar Commc'ns, Inc., 554 F.3d 382, 412 (3d Cir. 2009).
For non-insiders, equitable subordination generally requires a finding of gross or egregious misconduct, whereas insider claims or interests may be subordinated upon demonstration of a lesser degree of unfair conduct. See In re AutoStyle Plastics, Inc., 269 F.3d 726, 744 (6th Cir. 2001); In re Mid-Am. Waste Sys., Inc., 284 B.R. 53, 70 (D. Del. 2002).
The Bankruptcy Code's Priority Scheme
The Bankruptcy Code sets forth certain priority rules governing distributions to creditors in both chapter 7 and chapter 11 cases. Secured claims enjoy the highest priority under the Bankruptcy Code. See generally 11 U.S.C. § 506. The Bankruptcy Code then recognizes certain priority unsecured claims, including claims for administrative expenses, wages, and certain taxes. See 11 U.S.C. § 507(a). General unsecured claims come next in the priority scheme, followed by any subordinated claims and the interests of equity holders.
In a chapter 7 case, the order of priority for distributions on unsecured claims is determined by section 726 of the Bankruptcy Code. The order of distribution ranges from payments on claims in the order of priority specified in section 507(a), which have the highest priority, to payment of any residual assets after satisfaction of all claims to the debtor, which has the sixth or lowest priority. Second and third priority is accorded to timely filed unsecured claims (section 726(a)(2)) and certain tardily filed unsecured claims (section 726(a)(3)).
Fourth priority in a chapter 7 liquidation is given to:
[A]ny allowed claim, whether secured or unsecured, for any fine, penalty, or forfeiture, or for multiple, exemplary, or punitive damages, arising before the earlier of the order for relief or the appointment of a trustee, to the extent that such fine, penalty, forfeiture, or damages are not compensation for actual pecuniary loss suffered by the holder of such claim.
See 11 U.S.C. § 726(a)(4).
Distributions are to be made pro rata to parties of equal priority within each of the six categories specified in section 726. If claimants in a higher category of distribution do not receive full payment of their claims, no distributions can be made to parties in lower categories.
In a chapter 11 case, the chapter 11 plan determines the treatment of secured and unsecured claims (as well as equity interests), subject to the requirements of the Bankruptcy Code.
The Best Interests of Creditors Test
If a creditor class does not agree to "impairment" of the claims in the class under the plan—generally less than payment in full according to its original terms—and votes to reject it, the plan can be confirmed only under certain specified conditions. Among these conditions is the requirement that each creditor in the impaired class receive at least as much under the plan as it would receive in a hypothetical chapter 7 liquidation. See 11 U.S.C. § 1129(a)(7). This is commonly referred to as the "best interests of creditors test" or the "best interests test." To determine whether the test has been satisfied as a condition to confirmation of a chapter 11 plan, the plan must include or incorporate a liquidation analysis. See generally Collier on Bankruptcy ¶ 1129.02[7][b][3] (16th ed. 2026).
Matheson
In 2012, seven former employees (the "Camara creditors") of U.S. mail logistics and transport company Matheson Flight Extenders, Inc. ("MFE") sued the debtor and its corporate parent Matheson Trucking, Inc. ("MTI") in Colorado federal district court (the "Colorado court") seeking damages for employment discrimination. In February 2015, a jury ruled in favor of the Camara creditors, and the Colorado court entered a judgment against MFE and MTI for a total of approximately $970,000 in compensatory damages and approximately $14 million in punitive damages.
Shortly after the Camara creditors sought an additional award of approximately $2.3 million in attorneys' fees, MFE filed for chapter 11 protection on April 19, 2015, in the District of Nevada (the "2015 bankruptcy"). The Camara creditors filed proofs of claim in the case for approximately $18 million, consisting of the approximately $15 million dollar compensatory and punitive damages judgment, attorneys' fees and costs, and pre- and post-judgment interest.
MFE, MTI, and the Camara creditors later entered into a settlement agreement (the "2015 settlement") whereby: (i) MTI would make an initial payment to each creditor in the amount of approximately $186,000; (ii) on the effective date of a chapter 11 plan, MFE would pay approximately $143,000 to each of the creditors; and (iii) thereafter, MFE and/or MTI would make 32 quarterly payments in the approximate amount of $714,000 (nearly $7.3 million in aggregate to each of the creditors). In the event of a default, the 2015 settlement provided that the Camara creditors could file a stipulated judgment in the amount of $10 million, less any payments received (the "judgment clause"), with the Colorado court, and the creditors could execute on the judgment against MTI as well as pursue their claim against MFE in its chapter 11 case.
MFE and (non-debtor) MTI proposed a chapter 11 plan (the "2015 plan") that incorporated the terms of the 2015 settlement. The Nevada bankruptcy court confirmed the plan in December 2015. During the next seven years, MFE and MTI paid the Camara creditors approximately $6.2 million of the $7.3 million obligation under the 2015 settlement and the 2015 plan.
In 2022, after the loss of several key contracts with the U.S. Postal Service, MFE, MTI, and another affiliate (collectively, the "debtors) filed another chapter 11 case (the "2022 case"), this time in the Eastern District of California (the "Cal. bankruptcy court"). The debtors proposed a joint liquidating plan (the "2024 plan") that classified the remaining amounts (approximately $1.1 million in aggregate) owed to the Camara creditors under the 2015 plan as a general unsecured claim classified together with the claims of general unsecured creditors, who were to receive pro rata distributions equal to approximately 26% of their claims. The 2024 plan also provided that post-confirmation, the plan administrator could seek to prosecute any objections to the allowance of any administrative claim and any general unsecured claim (among others) on any ground, including that any claim should be subordinated under section 510 of the Bankruptcy Code "or other applicable law."
In a liquidation analysis under section 1129(a)(7)'s best interests test, the disclosure statement accompanying the 2024 plan stated that projected recoveries to unsecured creditors (including the Camara creditors) if the case were converted to a chapter 7 liquidation would be less than the distributions to be made under the plan. The disclosure statement did not reference the impact on the liquidation analysis of the subordination of any unsecured claims to timely or tardily filed unsecured claims (see 11 U.S.C. § 726(a)(2)–(3)) under section 726(a)(4).
In October 2024, the California bankruptcy court confirmed the 2024 plan, finding, among other things, that it satisfied all of the requirements of section 1129(a).
In January 2025, the plan administrator objected to the Camara creditors' claim, arguing that the punitive damages should be "mandatorily" subordinated to other creditor claims under section 510(c). According to the administrator, the 2024 plan's liquidation analysis required by section 1129(a)(7) also required subordination of the punitive damage claim because the claim would be subordinated in a hypothetical chapter 7 case under section 726(a)(4), thus yielding a greater recovery for other unsecured creditors.
The administrator also sought disallowance of the judgment clause portion of the Camara creditors' claim ($2.7 million), arguing that the clause amounted to an unenforceable penalty because it bore no relation to the actual damages sustained by the creditors. The Camara creditors countered that: (i) the 2015 settlement and the 2015 plan converted their punitive damages claim to a contract claim, and the 2015 plan had res judicata effect on the allowability of the claim in the 2022 case; (ii) their claim could not be subordinated under section 510(c) in the absence of inequitable conduct; and (iii) the administrator was judicially estopped from arguing that the judgment clause was an unenforceable penalty.
The bankruptcy court issued a decision subordinating the Camara creditors' claim and disallowing the $2.7 million judgment clause claim as an unenforceable penalty. According to the court, under U.S. Supreme Court precedent in Archer v. Warner, 538 U.S. 314 (2003), and Brown v. Felsen, 442 U.S. 127 (1979), it had the power to re-examine the terms of the 2015 settlement to determine the true nature of the debt owed to the Camara creditors.
In doing so, the court ruled that the debt originated from a punitive damages award that must be subordinated under section 1129(a)(7) because, in accordance with the priority of distribution waterfall set forth in section 726(a), the punitive damages claim would be subordinated to the claims of other unsecured creditors pursuant to section 726(a)(4) in a hypothetical chapter 7 case. This meant that, absent subordination of the Camara creditors' punitive damages claim, other unsecured creditors would receive more in a hypothetical chapter 7 case than they would receive under the 2024 plan, thereby violating section 1129(a)(7).
Because the bankruptcy court relied on section 1129(a)(7) to subordinate the Camara creditors' claim, it did not address whether the claim should be equitably subordinated under section 510(c).
Finally, the bankruptcy court ruled that the $2.7 million claim based on the judgment clause must be disallowed on the basis that it was an unenforceable penalty under Nevada law because the amount of the claim was disproportionate to the actual damages sustained by the Camara creditors.
The Camara creditors appealed the ruling to the BAP.
The Bankruptcy Appellate Panel's Ruling
The BAP reversed the California bankruptcy court's ruling and remanded the case below.
Initially, U.S. Bankruptcy Judge William J. Lafferty III determined that the bankruptcy court did not abuse its discretion by characterizing the Camara creditors' claim as punitive damages. He did not fault the court's reliance on Brown and Archer as authority for examining the basis of the claim despite the creditors' allegation that it was transformed into a contract claim under the 2015 settlement and the 2015 plan. Matheson, 679 B.R. at 28–30.
Next, the BAP ruled that the bankruptcy court erred in subordinating the Camara creditors' claim under section 1129(a)(7). Judge Lafferty explained that section 510(c)—which authorizes equitable subordination—applies in cases under chapters 7, 11, 12, or 13 of the Bankruptcy Code by virtue of section 103(a), and a bankruptcy court has the power under section 510(c) to equitably subordinate a punitive damages claim under appropriate circumstances. However, he noted, the bankruptcy court premised its subordination ruling not on section 510(c), but on section 1129(a)(7), which, as noted, provides that, if an impaired class of unsecured creditors does not vote to accept a plan, each creditor in the class must receive at least as much under the plan as it would receive in a hypothetical chapter 7 liquidation. Id. at 30.
According to Judge Lafferty, in ruling that the Camara creditors' claim should be subordinated after confirmation of the 2024 plan, the bankruptcy court misplaced its reliance on section 726(a), which expressly does not apply in a chapter 11 case pursuant to section 103(b) (limiting the applicability of provisions in the first two subchapters of chapter 7 (including section 726) to chapter 7 cases). Id. He noted that it is appropriate for a bankruptcy court to "consult" section 726(a) to determine whether section 1129(a)(7) has been satisfied so that the court may confirm a chapter 11 plan, and that subordination of the Camara creditors' claim might have been appropriate at the time the court confirmed the 2024 plan. Id.
However, the BAP emphasized, reliance on section 1129(a) of the Bankruptcy Code, which expressly "applies only for the purpose of confirmation and must be satisfied at the time of confirmation," is inappropriate to subordinate a claim after confirmation of a chapter 11 plan. Id. According to Judge Lafferty, the only statutory exception lawmakers created to the pre-confirmation applicability of section 1129(a) is in section 1127, which provides that the proponent of a chapter 11 plan can modify the plan after confirmation prior to "substantial consummation" of the plan (as defined in section 1101(2)), but only if: (i) the plan as modified satisfies the requirements of sections 1122 and 1123 (governing classification of claims under a plan and the plan's mandatory contents); and (ii) the court, after notice and a hearing, confirms the modified plan "under section 1129." Id. at 31; see 11 U.S.C. § 1127(b). In addition, he explained, section 1127(c) mandates that a modified plan provide adequate disclosure and comply with the plan vote-solicitation procedures. See 11 U.S.C. § 1125.
In this case, neither the debtors nor the plan administrator sought modification of the 2024 plan, and the bankruptcy court made no factual findings or legal conclusions regarding the elements of section 1127 (which, as noted, incorporates section 1129(a)). Thus, the BAP concluded that the bankruptcy court lacked the authority to apply section 1129(a) to subordinate the Camara creditors' claim after confirmation of the 2024 plan. Matheson, 679 B.R. at 32. Moreover, Judge Lafferty emphasized, the order confirming the 2024 plan precluded re-litigation of the same issues that were or could have been raised at confirmation and were resolved in the order—specifically, whether the plan satisfied section 1129(a). Id.
The BAP rejected as "questionable" the plan administrator's argument that the 2024 plan reserved the right to seek subordination of the Camara creditors' claim, noting that "even if plan proponents may modify statutes through confirmation of a plan, the language in the [2024 plan] was much too vague to contemplate subordination of the Camara Creditors' claim under a theory that erroneously utilizes a confirmation statute for non-confirmation purposes." Id. Moreover, Judge Lafferty emphasized, nothing in the language of the 2024 plan fairly put the Camara creditors on notice that their claim, or any other creditor's claim, was subject to post-confirmation subordination under section 1129(a), "a statute that all parties would reasonably expect to be applied only at the time of confirmation." Id. at 33. In addition, he emphasized, the liquidation analysis in the 2024 plan did not mention the potential subordination of punitive damages claims.
Notably, Judge Lafferty emphasized that the BAP was not suggesting that a debtor can never seek subordination or reclassification of a claim after confirmation of a chapter 11 plan—merely that subordination or reclassification must comply with the Bankruptcy Code, including the requirement that affected creditors be given notice of the potential for post-confirmation subordination. Id. at 33 n.11.
Next, the BAP ruled that the bankruptcy court improperly disallowed the $2.7 million portion of the Camara creditors' claim based on the judgment clause. According to Judge Lafferty, the bankruptcy court did not articulate its rationale for holding that the judgment clause was a liquidated damages provision, but instead merely "jump[ed] directly to its analysis that the Judgment Clause was an unenforceable penalty." Because the purpose of the 2015 settlement "was to settle damages that were already liquidated or easily ascertainable," rather than "estimating unascertainable future damages," he explained, it is doubtful that the judgment clause was a liquidated damages provision. Id. at 34. Even if it were, Judge Lafferty emphasized, the bankruptcy court erred in ruling that the provision was an unenforceable penalty under Nevada law because the court relied on a flawed analysis to determine whether the liquidated damages were disproportionate to the actual damages suffered by the Camara creditors.
The BAP accordingly reversed the bankruptcy court's subordination order and remanded the case below so that the bankruptcy court could address equitable subordination of the Camara creditors' claim under section 510(c) of the Bankruptcy Code.
In a concurring opinion, Chief U.S. Bankruptcy Judge Spraker agreed with the result, but viewed the subordination issue as limited to an issue under section 726(a)(4)—which expressly does not apply in a chapter 11 case—rather than section 1129(a)(7). He explained that the only potential relevance of section 726(a) in a chapter 11 case is its bearing on the liquidation analysis required by section 1129(a)(7)'s best interest test as a condition for plan confirmation. According to Judge Spraker, nothing in section 1129(a)(7) or elsewhere in the Bankruptcy Code "permits chapter 11 debtors to utilize § 726(a)(4) to mandatorily and categorically subordinate all punitive damages to the full payment of unsecured claims." Id. at 37 (concurring opinion).
In addition, Judge Spraker noted, the order confirming the 2024 plan was never appealed and is final and "[a]ll confirmation issues are necessarily beyond the scope of this appeal," including whether the plan satisfied the best interests test in section 1129(a)(7). Moreover, no party either sought relief from the confirmation order or modification of the 2024 plan. Id. at 37–38
Outlook
Matheson is an interesting case for a number of reasons, not the least of which is its unusual posture—an attempt to subordinate a claim after confirmation of a chapter 11 plan based not on section 510 of the Bankruptcy Code or the bankruptcy court's broad equitable powers, but on the strictures governing confirmation of the plan itself.
Key takeaways from the decision include the following:
- A bankruptcy court has the power to contractually, categorically, or equitably subordinate claims, including punitive damages claims, under section 510 of the Bankruptcy Code.
- One of the conditions to confirmation of a chapter 11 plan—the best interests test requiring that dissenting creditors will receive at least as much under the plan as they would receive in a hypothetical chapter 7 liquidation—applies only to confirmation and is not an independent basis for subordination of a claim after confirmation.
- In applying the best interests test, bankruptcy courts examine what dissenting classes of creditors would receive in a hypothetical chapter 7 liquidation in accordance with chapter 7's priority of distribution scheme. If certain creditors would receive more in a chapter 7 liquidation because other creditor claims would be subordinated, the best interests test has not been satisfied.
If a plan contemplates that a creditor's rights might be impacted after confirmation by, for example, disallowance, reclassification, or subordination of its claims, or avoidance of transfers, affected creditors should be specifically notified.
