The Toolbox: Subordination of Claims or Interests

This month I want to talk about the subordination of claims or interests. Subordination is governed by Bankruptcy Code ¹11 U.S.C. §§101 et seq. (the “Code”). Section 510. ²Code Section 510 states as follows:

(a) A subordination agreement is enforceable in a case under this title to the same extent that such agreement is enforceable under applicable nonbankruptcy law.

(b) For the purpose of distribution under this title, a claim arising from rescission of a purchase or sale of a security of the debtor or of an affiliate of the debtor, for damages arising from the purchase or sale of such a security, or for reimbursement or contribution allowed under section 502 on account of such a claim, shall be subordinated to all claims or interests that are senior to or equal the claim or interest represented by such security, except that if such security is common stock, such claim has the same priority as common stock.

(c) Notwithstanding subsections (a) and (b) of this section, after notice and a hearing, the court may—

(1) 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

(2) order that any lien securing such a subordinated claim be transferred to the estate.

The section is broken down into three parts. First, Section 510(a) provides for contractual subordination. Second, Section 510(b) provides for subordination of certain claims based on their genesis in transactions involving securities fraud. Third, Section 510(c) permits subordination based on equitable considerations.

Contractual subordination is most often seen where an issue of publically held debt is subordinated to lender – typically bank – debt. Subordination works not by eliminating the subordinated claim, but rather through transferring its benefit to the senior creditors until they are paid in full. By way of example, suppose claims in a case include $4 million of senior debt, $4 million of subordinated debt, and $4 million of trade debt. Suppose further that the plan provides 25% return on each claim for three years ($3 million total distribution per year). Then the effect of the subordination of subordinated debt to senior debt is to reallocate recovery from the annual distributions as follows:

The effect is to allocate to senior creditors the subordinated creditors’ recovery until the senior debt has been paid in full and then to allocate the recovery due to both to junior debt. Trade creditors – i.e., the creditors not party to the subordination agreement - - are not affected by it and receive their full distributions each year.

Obviously the chart provided is an oversimplification. The terms of the subordination may be complex and may include provisions for senior debt to vote or otherwise control the claims of junior debt. ³See, e.g., In re Avondale Gateway Ctr. Entitlement, LLC, No. CV10–1772–PHX–DGC, BK No. 02–09–BK–12153–CGC, 2011 BL 97020, at *1-5 (D. Ariz. Apr. 12, 2011) (enforcing subrogation clause in subordination agreement authorizing senior creditor to vote on reorganization plan on behalf of junior creditor).Note that “[t]he enforceability of voting rights provisions in subordination agreements has addressed by several bankruptcy courts, with varying results, and has yet to be the subject of a Circuit Court decision.” In re Coastal Broad. Sys., Inc., No. 11–10596 (GMB), 2012 BL 169253, at *7-8 (Bankr. D.N.J. July 6, 2012) (citations omitted). Subordination is typically negotiated in such situations and may involve complex formulae. Such subordination agreements are by the terms of Section 510(a) enforceable in a bankruptcy case, although they may be waived or subsumed in a plan.

Section 510(b) was included in the Code to resolve the issue of whether an equity owner obtaining a judgment for rescission of a sale of stock due to the debtor’s fraud held a general unsecured claim on a level comparable with other debt or was entitled only to a junior claim on a parity with the security as to which rescission was granted. The plain language of the statute extends its coverage to claims arising indirectly from securities transactions – e.g., indemnity claims. Thus, if a claimant holds a judgment or makes a claim based on rescission of a securities transaction, that claim is not entitled to any distribution from the estate until claims senior to or equal to the priority of that security have been satisfied. Note that Section 510(b) applies only to some claims that might be asserted by the security holder. Others – e.g., for unpaid dividends – may not be affected.

Section 510(c) was intended to codify case law allowing for subordination of a claim on equitable grounds. ⁴See, e.g., HBE Leasing Corp. v. Frank, 48 F.3d 623, 634 (2d Cir. 1995) (citations omitted). Equitable subordination will only be ordered to the extent necessary to cure the wrong done by the claim holder; it does not necessarily apply to all other claims but only to those affected by the subordinated creditor’s conduct and will be ordered only as necessary to make up for that effect. ⁵E.g., In re Kreisler, 546 F.3d 863, 866 (7th Cir. 2008) (citing Benjamin v. Diamond (In re Mobile Steel Co.), 563 F.2d 692, 701 (5th Cir. 1977)). Equitable subordination requires a showing that (1) the targeted creditor has engaged in inequitable conduct; (2) that conduct harmed other creditors or benefited the targeted creditor; and (3) subordination is not otherwise inconsistent with the Code. ⁶E.g., id. Generally, too, subordinated claims are the claims of insiders or creditors that engaged in fraudulent conduct. ⁷See, e.g., Holt v. FDIC (In re CTS Truss, Inc.), 868 F.2d 146, 148-49 (5th Cir. 1989) (citations omitted).

One of the interesting things about Section 510(c) is that it allows not only affected creditors but also a trustee to assert a position common to less than all creditors. ⁸See, e.g., Sloan v. Zions First Nat’l Bank (In re Castletons, Inc.), 990 F.2d 551, 553 (10th Cir. 1993).See also Code §522(g) (contemplating the trustee’s ability to recovery property under Code §510(c)(2)). Unlike cases such as class suits, the trustee is not barred by Caplin v. Marine Midland Grace Trust Co. of New York
⁹406 U.S. 416 (1972). from claiming equitable subordination because fewer than all creditors will benefit from it. This is particularly significant because the elements that will support equitable subordination often are the same as would support a claim of fraud, including securities fraud. Thus the equitable subordination suit may be dispositive of a class suit for fraud by some but not all creditors or interest holders.

When Congress adopted Section 510(c), it left development of the concept of equitable subordination to the courts. ¹⁰United States v. Noland, 517 U.S. 535, 539 (1996) (“Congress intended that the term ’principles of equitable subordination’ follow existing case law and leave to the courts development of this principle” (quoting 124 Cong. Rec. 32398, 33998) (internal quotation marks omitted)) However, the most significant expansion of equitable subordination since passage of the Code was to extend the rule to penalties such as tax penalties. ¹¹See, e.g., id. at 536-43. Just as penalties are automatically subordinated in Chapter 7 under Code Section 726, courts held they should be subordinated in Chapter 11 cases to general unsecured claims. This idea was rejected by the Supreme Court which held that equitable subordination could not be based upon categorical restructuring of the priorities fixed in the code by Congress but rather required a creditor’s individual inequitable conduct. ¹²Id.

Before concluding I must address so-called structural subordination. In fact, structural subordination just involves recognition of the separateness of entities within a corporate family, not actual subordination of one claim or group of claims. Structural subordination occurs when a subsidiary has its own assets and debts – requiring that those assets be used to satisfy those debts before value may be up streamed for the parent’s creditors.

Structural subordination like contractual subordination is a useful tool for creditors planning ahead for possible insolvency of a debtor. The former allows for insulation of assets or part of a business from unrelated debt. The latter provides a means to increase recovery at the expense of other creditors.

Equitable subordination, on the other hand, is more often seen as a threat than actually effected. Though it requires an adversary proceeding, ¹³Fed. R. Bankr. P. 7001(8). it is often combined with a claim objection and used largely for leverage: it is not easy to prove and can be costly to litigate, but its consequences are sufficiently severe to encourage the targeted creditor to settle.

Regardless, Section 510 of the Code provides useful tools the practitioner can use both to protect creditor clients and to improve returns in an eventual bankruptcy. While equitable subordination in particular should be used cautiously, it also provides an additional tactic that offers practitioners an invitation to novel theories and poses a serious threat to the recalcitrant creditor.