Delaware District Court: Using Contract Rights to Strategic Advantage Not Grounds for Equitable Subordination in Bankruptcy

When lenders use an aggressive strategy to deal with a financially troubled borrower that ultimately files for bankruptcy protection, stakeholders in the case, including chapter 11 debtors, trustees, committees, and even individual creditors or shareholders, frequently pursue causes of action against the lenders in an effort to augment or create recoveries. The incidence of lender liability-type claims in bankruptcy in the guise of litigation seeking, among other things, to equitably subordinate lender claims or to recharacterize such claims as equity has led some lenders to second-guess how aggressively they can enforce their rights under a loan agreement, including the extent to which they can take an active role in the affairs of a borrower.

The U.S. District Court for the District of Delaware recently handed down a ruling that should be welcome news to lenders facing equitable subordination claims in this context. In Tilton v. MBIA Inc. (In re Zohar III, Corp.), 2022 WL 3278836 (D. Del. Aug. 11, 2022), appeal dismissed, No. 22-2695 (3d Cir. Nov. 10, 2022), the district court affirmed a bankruptcy court's dismissal of an adversary proceeding (the "Adversary Proceeding") filed by entities affiliated with chapter 11 debtors seeking to equitably subordinate the claims of the debtors' senior secured creditor and certain other defendants. According to the plaintiffs, these creditors had seized control and, ultimately, ownership of the debtors' assets through deception and misinformation that caused the debtors to default on their obligations and file for bankruptcy. "There is nothing inequitable," the district court wrote, "about using contractual rights to a strategic advantage."

Equitable Subordination

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.

Equitable subordination is expressly recognized in section 510(c) of the Bankruptcy Code, which provides that the bankruptcy 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." However, the Bankruptcy Code does not elaborate on the "principles of equitable subordination" referred to in section 510(c) or set forth a particular standard for courts to apply when evaluating an equitable subordination claim. 

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).


Three investment vehicles—Zohar I, Corp. ("Zohar I"), Zohar II, Corp. ("Zohar II") and Zohar III, Corp. ("Zohar III" and, collectively, the "Funds")—created by Patriarch Partners, LLC (together with its affiliates, "Patriarch") founder Lynn G. Tilton used collateral from investors to make loans to distressed companies (the "Portfolio Companies") in exchange for repayment obligations and equity in the Portfolio Companies. The Funds issued collateralized interest-bearing notes to investors with various priorities and maturities. Through an affiliate, Tilton was the Funds' preferred shareholder, and as such, she was entitled to any excess value generated by them. She also allegedly indirectly owned and controlled the equity of the Portfolio Companies.

As a "credit enhancer," insurer MBIA Insurance Corp. ("MBIA") guaranteed senior notes issued by Zohar I and Zohar II. The insurance guarantee agreements provided that, upon the event of default by Zohar I or Zohar II, MBIA would, by way of subrogation, become those funds' senior secured creditor. MBIA also had the right to liquidate investor collateral held by Zohar I and Zohar II to recoup any insurance payouts.

With Zohar I at risk of defaulting on its notes, Tilton and MBIA engaged in discussions during the period from 2012 to 2014 regarding an extension of maturities and a global restructuring of the insured notes. Plaintiffs in the Adversary Proceeding—including Tilton and Patriarch (collectively, the "Plaintiffs")—alleged that, during this time, MBIA provided confidential, nonpublic information and misinformation regarding the Portfolio Companies to the U.S. Securities and Exchange Commission ("SEC") in connection with an SEC fraud investigation into the affairs of Tilton and Patriarch. The SEC investigation was eventually resolved in the favor of Tilton and Patriarch.

Restructuring talks for the Funds continued throughout 2015 without success. Zohar I defaulted on its senior insured notes in November 2015. In connection with the Zohar I default (and subsequent defaults by Zohar II and Zohar III), MBIA paid a total of approximately $919 million to the insured noteholders. According to the Plaintiffs, although MBIA supported an extension of the maturity date of the Zohar I notes and a global restructuring of the Funds' note obligations throughout the three years of discussions, MBIA later refused to agree to either option, ultimately "causing" the Zohar I default in an effort to take control of the Funds.

On November 22, 2015, Tilton filed an involuntary bankruptcy case against Zohar I. After discussions among the parties in this initial bankruptcy case, Tilton caused the collateral managers of the Funds to resign beginning in 2015, and the bankruptcy case was dismissed. Tilton alleged that, although she was assured by MBIA that she could then appoint new Fund collateral managers, MBIA and certain Zohar III noteholders unilaterally appointed a new collateral manager for the Funds.

In June 2016, MBIA instructed the trustee bank under the Funds' note indentures to conduct an auction of the investor collateral held by Zohar I. The Plaintiffs sued in state court to enjoin the auction, arguing that the sale was a commercially unreasonable "sham" auction because it included equity in more than 20 Portfolio Companies allegedly owned by the Plaintiffs.

After the action was removed to federal district court, the district court rejected the Plaintiffs' claims that the proposed sale was commercially unreasonable and ruled that the auction could proceed. At the auction, MBIA prevailed with an approximately $150 million credit bid. Although Tilton had the right to match that bid under the Funds' organizational documents, she elected not to do so.

The new collateral manager for the Funds commenced litigation on the Funds' behalf in Delaware Chancery Court alleging that the prior collateral managers violated their contractual obligation to turn over certain Fund books and records. It also filed a separate action on the Funds' behalf in the same court seeking a determination that the Funds, and not Tilton, who had been removed from the portfolio companies' boards of directors at MBIA's direction, owned the equity in the portfolio companies. The court ruled in favor of the Funds in both cases.

In addition, the new collateral manager sued the Plaintiffs in a New York federal district court alleging violations of the civil RICO statute and New York common law (together with the Delaware Chancery Court actions, the "Zohar Litigation"). The district court ultimately dismissed with prejudice the RICO complaint as well as a third-party complaint filed in the action by the Plaintiffs alleging that MBIA and the new collateral manager breached their contractual and fiduciary duties.

After Zohar II and Zohar III also defaulted on their obligations to pay the insured notes, the Funds filed for chapter 11 protection in March 2018 in the District of Delaware. In 2019, the Plaintiffs filed the Adversary Proceeding in the bankruptcy court, seeking to equitably subordinate the claims of MBIA, the trustee bank, the new collateral manager and various Fund investors (collectively, the "Defendants") to the Plaintiffs' claims against the Funds. According to the Plaintiffs, MBIA, with the assistance of the other Defendants, wrested control of the Funds from the Plaintiffs and perpetrated a decade-long scheme to deprive the Plaintiffs of more than one billion dollars of their equity holdings in the Portfolio Companies by means of "sham" litigation. The Plaintiffs also alleged that MBIA's behavior was motivated by the need to rescue itself from the brink of financial ruin caused by an overwhelming amount of insurance guaranty obligations that arose as a result of the 2008 financial crisis. 

The bankruptcy court dismissed the complaint, ruling that the Plaintiffs failed to allege facts sufficient to raise a plausible inference of inequitable conduct. It also held that the Plaintiffs were collaterally estopped from arguing that the Zohar Litigation and MBIA's inducement of the old collateral managers to resign was inequitable for purposes of equitable subordination, because the federal district court dismissed similar claims brought by the Plaintiffs against MBIA and the new collateral manager in the federal district court RICO litigation. 

The Plaintiffs appealed to the district court.

The District Court's Ruling

The district court affirmed the bankruptcy court's dismissal of the Adversary Proceeding complaint.

Initially, U.S. Circuit Judge Thomas L. Ambro (sitting by designation from the U.S. Court of Appeals for the Third Circuit) noted that the litigants did not challenge the bankruptcy court's designation of MBIA, the new collateral manager and certain Fund investors as insiders, and the trustee bank as a non-insider. Instead, he explained, the Plaintiffs argued that the bankruptcy court erred in concluding that: (i) MBIA's conduct in connection with the Zohar I restructuring negotiations, its alleged communications with the SEC, and its conduct (together with the trustee bank) in connection with the Zohar I auction sale were not plausibly inequitable; and (ii) the Plaintiffs were collaterally estopped from alleging that the Zohar Litigation and the inducement of the old collateral managers' resignations were inequitable.

First, Judge Ambro noted that the Plaintiffs' complaint contained no allegations suggesting that MBIA ever committed to an extension of maturity or a restructuring of Zohar I, nor did it contain factual allegations to support a claim that MBIA engaged in a protracted scheme "to string [the Plaintiffs] along because it had an interest in ensuring Tilton continued to manage the Funds during that period and increase their value." Zohar, 2022 WL 3278836, at *4. "There is nothing inequitable," he wrote, "about using contractual rights to a strategic advantage, nor does such a strategy support the inference that MBIA was deliberately misleading Plaintiffs for years about its willingness to negotiate a maturity extension." Id.

Second, Judge Ambro emphasized that the Plaintiffs' allegations regarding a secret misinformation scheme between MBIA and the SEC was not supported by any evidence of even a single piece of actual misinformation given to the SEC by MBIA, and the Plaintiffs acknowledged in the complaint that the information-sharing agreement between MBIA and the SEC was not secret, but in fact permitted the SEC to give Tilton notice of any disclosures.

Third, the district court found no error in the bankruptcy court's collateral estoppel ruling. According to Judge Ambro, the issues raised by the Plaintiffs (and dismissed by the court) in the RICO litigation regarding the Defendants' conduct in connection with the former collateral managers' resignation and the Zohar Litigation were sufficiently identical and necessarily decided, such that the bankruptcy court properly concluded that such claims could not be relitigated in the context of the Plaintiffs' equitable subordination complaint.

Finally, the district court rejected the Plaintiffs' argument that MBIA and the trustee bank acted inequitably in connection with the Zohar I auction. The record, Judge Ambro explained, reflected that the auction was regularly conducted under court supervision, and the Plaintiffs failed to provide any factual allegations to support an inference that MBIA's winning credit bid was a "windfall," particularly because Tilton had the right to match the offer yet chose not to do so.


The district court's decision in Zohar has been welcomed by lenders. It provides some level of comfort that they can enforce contractual rights negotiated at arm's length while minimizing exposure to equitable subordination claims (and potentially other lender liability claims) in a borrower's bankruptcy case. Lenders should still be wary of conduct that could be viewed as overreaching, but unless they qualify as insiders of the borrower-debtor, the bar for equitable subordination remains relatively high.

With the consent of the litigants, the Third Circuit dismissed the Plaintiffs' appeal of the district court's ruling on November 10, 2022.

In many respects, Zohar is reminiscent of another decision issued by a Delaware district court in 2016 addressing lender liability claims in bankruptcy, including equitable subordination, equitable disallowance, and breach of the covenant of good faith and fair dealing. In In re Hercules Offshore, Inc., 565 B.R. 732 (Bankr. D. Del. 2016), the court overruled the objections of a committee of equity security holders to a chapter 11 plan that included releases of prepetition lenders, including a hedge fund that acquired 40% of secured debt refinanced as part of a previous chapter 11 filing. The court rejected the committee's argument that the releases were inappropriate given the existence of colorable claims against the lenders for misconduct in enforcing their rights under a prepetition credit agreement.

The equity committee claimed that the first-lien lenders had breached the implied covenant of good faith and fair dealing by asserting "baseless" events of default under the first-lien credit agreement, declining to extend the deadline for compliance with certain covenants in the credit agreement, and forcing the debtor to enter into certain forbearance agreements.

U.S. Bankruptcy Judge Kevin J. Carey rejected those arguments. He explained that the debtors did not dispute that they had breached covenants under the first-lien credit agreement. Similarly, the court determined that withholding consent to an extension of time for the debtors to comply with covenants "was arguably unfortunate, but not inappropriate." According to Judge Carey, although the first-lien lenders "were strategic in their actions, lenders are free to enforce contract rights and negotiate hard against borrowers at [arm's length], particularly those that are in distress, as here." Id. at 762.

In Hercules Offshore, Judge Carey noted that the debtors characterized the first-lien lenders, "sardonically, as 'aggressive,' 'vocal,' 'persistent,' and at times 'annoying.'" However, he wrote, "there is no evidence that they acted unlawfully and no evidence that the Debtors were damaged by any alleged lender misconduct." Evidence was lacking, he explained, that the first-lien lenders had interfered with the debtors' business or had somehow been implicitly bound to grant extensions of time to satisfy covenants. Nor was any evidence introduced to establish that the lenders had caused or contributed to the debtors' inability to timely satisfy covenants. Instead, the record showed that the first-lien lenders "acted within the boundaries of their contractual rights." Id. at 763.


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