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Absence of Actual Harm to Creditors Defeats Equitable Subordination Bid

The power to alter the relative priority of claims due to the misconduct of one creditor that causes injury to others is an important tool in the array of remedies available to a bankruptcy court in exercising its broad equitable powers. By subordinating the claim of an unscrupulous creditor to the claims of blameless creditors who have been harmed by the bad actor’s misconduct, the court has the discretion to implement a remedy that is commensurate with the severity of the misdeeds but falls short of the more drastic remedies of disallowance or recharacterization of a claim as equity. As illustrated by a ruling recently handed down by the Fifth Circuit Court of Appeals, however, purported creditor misconduct in and of itself does not warrant subordination of a claim. In In re SI Restructuring, Inc., the Fifth Circuit reversed an order equitably subordinating secured claims for the repayment of “eleventh hour” insider financing provided to the debtors to stave off bankruptcy, holding that subordination was inappropriate, given the lack of evidence that other creditors were injured in any way as a consequence of the insider creditors’ alleged misconduct.

Equitable Subordination

Equitable subordination is a common-law doctrine predating the enactment of the Bankruptcy Code, designed to remedy misconduct that causes injury to creditors (or shareholders) or confers an unfair advantage on a single creditor at the expense of others. The remedy is now codified in section 510(c) of the Bankruptcy Code, which provides that “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.” The statute, however, does not define the circumstances under which subordination is warranted, leaving the development of such criteria to the courts.

In 1977, the Fifth Circuit Court of Appeals in In re Mobile Steel Co. articulated what has become the most commonly accepted standard for equitably subordinating a claim. Under the Mobile Steel test, a claim can be subordinated if the claimant engaged in some type of 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. Courts have since refined the test to account for special circumstances. For example, many make a distinction between insiders (e.g., corporate fiduciaries) and noninsiders in assessing the level of misconduct necessary to warrant subordination. For insiders, inequitable conduct is generally found if the claimant has: (i) committed fraud or illegality or breached its fiduciary duties; (ii) left the debtor undercapitalized; or (iii) used the debtor as a mere instrumentality or alter ego. By contrast, as expressed by many courts, subordination of the claim of a noninsider creditor requires a showing of “gross misconduct tantamount to fraud, misrepresentation, overreaching or spoliation.” As demonstrated by SI Restructuring, however, misconduct or procuring an unfair advantage can properly be a basis for equitable subordination only if other creditors are actually injured because of it.

SI Restructuring

Schlotzsky’s, Inc., and its affiliates (“Schlotzsky’s”), an international franchise restaurant chain with locations in 35 states and six foreign countries, experienced a severe cash shortage throughout 2003. Two of its directors at the time, John and Jeffrey Wooley (the “Wooleys”), loaned Schlotzsky’s $1 million in April 2003 on a secured basis with collateral consisting of the company’s royalty streams from franchisees, its intellectual property rights, and other intangibles. They agreed to make the loans only after other financing options fell through. The Wooleys and Schlotzsky’s were separately represented in connection with the financing, the terms of which were approved by the audit committee of the company’s board as a related-party transaction. The loans were fully disclosed in the company’s SEC filings.

Schlotzsky’s cash shortage persisted through the fall of 2003, when the company’s general counsel contacted the International Bank of Commerce (“IBC”) about the possibility of additional financing. IBC declined to lend directly to Schlotzsky’s but indicated in October that it would be willing to loan $2.5 million to the Wooleys, with the expectation that the funds would then be loaned by them to the company. The need for additional financing was discussed at an October 31, 2003, meeting of the company’s board of directors. IBC approved the loan on November 10, after which a special meeting of the Scholtzsky’s board was called for November 13 and directors were provided with copies of the loan documentation. The second loan from the Wooleys was also to be secured by the company’s franchisee royalty income, intellectual property rights, and other intangibles.

At the time, the Wooleys had personally guaranteed $4.3 million of the company’s debt. As part of the second financing transaction, the Wooleys agreed to collateralize their personal guarantee obligations with the same collateral that secured both loans. The board, having been informed that payroll could not be met and that the company would default on another secured debt obligation without the cash infusion, formally approved the second loan transaction on November 13 during a telephone conference. All of the noninterested directors in attendance voted in favor of the loan, which was also approved by an independent audit committee and disclosed in SEC filings.

Scholtzsky’s filed for chapter 11 protection in August 2004 in Texas. The company’s unsecured creditors’ committee (later succeeded by the administrator of the debtors’ chapter 11 plans) sued to subordinate the Wooleys’ secured claims under section 510(c). During the ensuing trial, the bankruptcy court found that the Wooleys had engaged in inequitable conduct in connection with the November 2003 loan by breaching their fiduciary duties as officers and directors in presenting the loan transaction to the company’s board as a fait accompli with no options at the eleventh hour. The court also questioned the propriety of the loan’s secured status if it was truly intended to be a temporary bridge loan pending procurement of permanent financing. Finally, the bankruptcy court determined that the Wooleys’ insistence that their contingent guarantee obligation be secured in connection with the transaction, which effectively released them as guarantors at the expense of the corporation and its unsecured creditors, was a clear instance of “unfair advantage.”

The bankruptcy court made no specific findings that the Wooleys’ actions in connection with either of the 2003 loans resulted in any harm to Schlotzsky’s or its unsecured creditors. Even so, the court equitably subordinated their secured claims based upon both loans to the claims of other secured creditors. After the district court upheld that determination on appeal, the Wooleys appealed to the Fifth Circuit.

The Fifth Circuit’s Ruling

The Fifth Circuit reversed. Mobile Steel, the court emphasized, mandates that 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.” Observing that “equitable subordination is remedial, not penal,” the Fifth Circuit concluded that equitable subordination is therefore inappropriate “in the absence of actual harm.” The bankruptcy court made no specific findings that anyone was harmed due to the Wooleys’ alleged misconduct. The Fifth Circuit’s independent review of the record did not lead it to conclude otherwise.

According to the Fifth Circuit: (i) unsecured creditors were not harmed when the 2003 loans were secured by the company’s assets because the loan proceeds were used to pay unsecured creditors and keep the company operating; (ii) although securing the Wooleys’ personal guarantees with company assets arguably amounted to unfair advantage, no harm resulted because the guarantee obligations were never triggered; and (iii) the complaint’s asserted basis for harm to unsecured creditors amounted to a “deepening insolvency” theory of damages (i.e., unsecured creditors were harmed because the value of the company deteriorated as a result of the November 2003 loan transaction, thus diminishing the funds available to distribute in respect of unsecured claims), which the Fifth Circuit characterized as invalid. Even if the deepening-insolvency theory were valid, the court of appeals explained, the evidence clearly showed that, at the time of the second loan, the company was generally paying its debts as they matured and was neither undercapitalized nor insolvent. Based on these determinations, the Fifth Circuit reversed the rulings below and entered judgment in favor of the Wooleys.

Analysis

The Fifth Circuit’s ruling in SI Restructuring underscores the remedial, rather than penal, nature of equitable subordination under section 510(c) of the Bankruptcy Code. Under the Fifth Circuit’s holding, in the absence of any harm to other creditors or the debtor, equitable subordination of a claim is not the appropriate remedy. The decision also demonstrates the importance of developing a meticulous evidentiary record in litigating causes of action that hinge upon the bankruptcy court’s discretion in exercising equitable remedies. Finally, SI Restructuring indicates that courts are generally loath to second-guess corporate fiduciaries exercising their business judgment at a time when the corporation is struggling to stay afloat, particularly when their actions are the product of informed decisions that are subject to full disclosure.

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Wooley v. Faulkner (In re SI Restructuring, Inc.), 532 F.3d 355 (5th Cir. 2008).

Benjamin v. Diamond (In re Mobile Steel Co.), 563 F.2d 692 (5th Cir. 1977).
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