The Outer Boundaries of a Bankruptcy Court’s Equitable Powers:
Equitable Subordination and Equitable Disallowance
By virtue of loan agreements or a debtor’s acquiescence, a creditor often has varying degrees of influence and control over a debtor and its business. Sometimes, however, a creditor may utilize this control to benefit itself at the expense of other creditors. On the eve of bankruptcy (and even post-petition), such abuse of control is anathema to the delicate distributional scheme guaranteed in the Bankruptcy Code.
The doctrine of equitable subordination, codified in § 510(c)(1) of the Bankruptcy Code, seeks to redress these abuses and protect the integrity of the distributional regime. Additionally, in recent cases, courts have gone a step further, considering the remedy of equitable disallowance whereby a wrongdoer’s claim is not just subordinated, but is disallowed in its entirety.
The Doctrine of Equitable Subordination
Equitable subordination — a creature mostly confined to bankruptcy law — permits a bankruptcy court, in line with its inherent authority as a court of equity, to modify the proscribed bankruptcy distributional scheme by subordinating a claim within a senior class to or below the priority level of a junior class. Under the “principles of equitable subordination,” § 510(c)(1) of the Bankruptcy Code empowers a court to “subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all of part of an allowed interest to all or part of another allowed interest.” The doctrine of equitable subordination requires a court to view claims “through the eyes of equity and deal with them on the basis of equitable considerations to prevent injustice or unfairness in the bankruptcy situation.”
The doctrine of equitable subordination can be traced back to the Supreme Court’s landmark decision in Pepper v. Litton, wherein the court stated:
In the exercise of its equitable jurisdiction the bankruptcy court has the power to sift the circumstances surrounding any claim to see that injustice or unfairness is not done in administration of the bankrupt estate.
Despite some eight decades of equitable subordination jurisprudence since Pepper, the Bankruptcy Code fails to list the principles that warrant an invocation of the remedy. Instead, Congress left the development of such principles to be “defined by case law.”
Courts have since developed a three-part test to determine whether equitable subordination under § 510(c)(1) is appropriate: (1) the claimant must have engaged in some type of inequitable conduct; (2) the misconduct must have resulted in injury to the creditors of the bankrupt or conferred an unfair advantage onto the claimant; and (3) the equitable subordination of the claim must not be inconsistent with the provisions of the Bankruptcy Code. Of these three elements, the requirement of inequitable conduct has caused the most trepidation for courts in applying § 510(c)(1).
With respect to the challenges of identifying “inequitable conduct,” one commentator has noted that it is a “very slippery concept with little predictive value.” Most courts that have considered this issue have found that inequitable conduct generally encompasses “(1) fraud, illegality, or breach of fiduciary duties; (2) undercapitalization; and (3) the claimant’s use of the debtor corporation as a mere instrumentality or alter ego.”
Despite the broad conveyance to courts of power to relegate claims on equitable grounds, such power is not without limits. Most notably, the doctrine of equitable subordination by its terms is limited to reordering the priority of a claim and does not contemplate disallowance of the claim. In practice, this reordering often reaches the same result as disallowance if the assets of the estate are first consumed by other creditors.
Practical considerations aside, however, the remedy of equitable subordination is designed to ensure fairness in the bankruptcy process as a whole. Thus, equitable subordination requires the court to tailor the remedy to fit the harm. If the injury or unfair advantage only harms a specific creditor or segment of creditors, the court should subordinate the offending claimant only to the more limited class of claims rather than the claims of all creditors. In this regard, equitable subordination is remedial, not punitive, and a claim will be subordinated only to the extent necessary to offset the harm that resulted.
The Doctrine of Equitable Disallowance
Both case law and the Bankruptcy Code provide undisputable authority that the doctrine of equitable subordination is available to remedy inequities in a bankruptcy proceeding. But under principles of equity, may a court disallow a claim in its entirety because of a creditor’s misconduct? Two notable bankruptcy decisions have recently wrestled with this very issue, raising new questions relating to the outer boundaries of the court’s equitable powers given the absence of Bankruptcy Code authority.
In a twist of fate, equitable disallowance, like equitable subordination, traces its origins to Pepper v. Litton. The court in Pepper emphasized that by virtue of its equitable powers, a claim may be subordinated or disallowed as equity requires. Critics of the court’s reasoning point to the fact that equitable disallowance is inherently punitive while equitable subordination is remedial. Despite other criticisms of Pepper’s take on equitable disallowance, the doctrine has not only survived, but has recently been accepted in some of the largest bankruptcy cases in this nation’s history.
The first of the recent cases to accept equitable disallowance as a colorable claim was In re Adelphia. In Adelphia, the creditors’ committee brought a claim for equitable subordination and disallowance for claims held by certain banks that lent nearly $5.6 billion to the debtors. The loans were structured in a manner that allowed a third party to draw on the loans, yet relegated repayment responsibilities to the debtors. Citing rules of statutory construction and Pepper, the court found that the creditors’ committee had asserted a colorable claim for equitable disallowance, providing resuscitation for the long-dormant doctrine.
After Adelphia recognized equitable disallowance as being a colorable claim, the issue resurfaced again in In re Washington Mutual. In Washington Mutual, the equity committee argued that equitable disallowance of the claims held by certain hedge funds that held Washington Mutual notes was warranted because the note-holders had allegedly traded securities of the debtors while in possession of material, nonpublic information concerning plan-related settlement negotiations. The court, citing Adelphia, stated that despite the dearth of textual support from the Bankruptcy Code, “it does have the authority to disallow a claim on equitable grounds ‘in those extreme instances — perhaps very rare — where it is necessary as a remedy.’”
The question that remains unanswered by the courts is, What conduct on the part of a creditor constitutes an extreme instance where a “draconian” remedy such as equitable disallowance is warranted? In both Adelphia and Washington Mutual, the common denominator invoking equitable disallowance involved an abuse of position of trust or control by a creditor in the debtor’s affairs. This is not particularly helpful, however, as these factors mirror the elements of an equitable subordination claim. Perhaps more revealing was the fact that the equity committee in Washington Mutual was denied standing to pursue an equitable subordination claim and the court was eager to find relief in some other manner. The same could not be said in Adelphia, where the equitable subordination claim passed muster. Needless to say, the two decisions leave wary creditors wanting.
Given that the issue of equitable disallowance was not litigated to a substantive conclusion in either Adelphia or Washintgon Mutual, it is challenging to infer what conduct by a creditor warrants total claim disallowance, as opposed to subordination. Until more courts entertain the issue, the viability of equitable disallowance as a remedy will remain nebulous and controversial.
1. 11 U.S.C. § 510(c)(1).
3. Bostian v. Schapiro (In re Kansas City Journal-Post Co.), 144 F.2d 791, 800 (8th Cir. 1944).
4. Pepper v. Litton, 308 U.S. 295, 308, 60 S. Ct. 238, 246, 84 L. Ed. 281 (1939).
5. S. Rep. No. 989, 95th Cong., 2d Sess. 74, reprinted in 1978 U.S. Code Cong. & Admin. News, 5787, 5860.
6. Benjamin v. Diamond (In re Mobile Steel Co.), 563 F.2d 692, 701 (5th Cir. 1977).
7. 2 David G. Epstein et al., Bankruptcy, §§ 6-93, at 256 (1992).
8. Fabricators Inc. v. Technical Fabricators Inc. (In re Fabricators Inc.), 926 F.2d 1458, 1467 (5th Cir. 1991).
9. In re Mobile Steel Co., 563 F.2d at 699.
12. Pepper v. Linton, 308 U.S. 295 (1939).
14. Alan M. Ahart, Why the Equitable Disallowance of Claims in Bankruptcy Must Be Disallowed, 20 Am. Bankr. Inst. L. Rev. 445, 450 (2012).
15. In re Adelphia Commc'ns. Corp., 365 B.R. 24 (Bankr. S.D.N.Y. 2007).
19. In re Washington Mut. Inc., 461 B.R. 200, 257 (Bankr. D. Del. 2011).