Equitable Subordination Good-Faith Transferees Beware

Journal Issue

Apr 2006

Column Name

Feature

Citation

ABI Journal, Vol. XXV, No. 3, p. 46, April 2006

Bankruptcy Code

510

Journal HTML Content

In a recent decision in the Enron chapter 11 case, Enron Corp. v. Avenue
Special Situations Fund II L.P. (the "Enron Opinion"), Judge Arthur
Gonzales of the U.S. Bankruptcy Court for the Southern District of New York
ruled that bank claims held by post-petition transferees may be equitably subordinated
pursuant to §510(c) of the Bankruptcy Code, 11 U.S.C. §§101,
et seq., on the basis that the transferors engaged in inequitable pre-petition
conduct. This is an unprecedented expansion of the doctrine of equitable subordination,
and the decision's significance extends beyond Enron and threatens serious
disruption to the distressed debt-trading markets.

Background 
Prior to filing for chapter 11 protection, Enron borrowed $3 billion under
short- and long-term credit agreements from a consortium of banks, including
Fleet National Bank. Subsequent to Enron's filing, Fleet transferred 100 percent
of its claims against Enron, pursuant to these credit agreements (the "claims"),
to various entities; some of these claims were subsequently transferred to other
purchasers.
Almost two years after Enron's chapter 11 filing, Enron commenced an adversary
proceeding against various banks, including Fleet. In that action, Enron alleged,
among other things, that Fleet and other named bank defendants (1) received
preferential and fraudulent transfers, and (2) participated in pre-petition
inequitable misconduct with respect to Enron, which injured Enron's creditors
and gave an unfair advantage to Fleet and the other named defendants. Fleet
and the other bank defendants have vigorously contested these allegations, which
have yet to be adjudicated by the bankruptcy court.
In early 2005, Enron commenced an adversary proceeding against the purchasers
of the claims (collectively, the "defendants") in which it sought,
among other things, equitable subordination of the claims based on the alleged
misconduct of Fleet. The defendants moved to dismiss the adversary proceeding
asserting that they, unlike Fleet, were not alleged to have engaged in any inequitable
conduct. The defendants argued that their claims cannot be equitably subordinated
because §510(c) of the Code requires inequitable conduct by the party holding
the subject claims. On Nov. 17, 2005, the bankruptcy court denied the defendants'
motion to dismiss.
Bankruptcy Court's Decision
 In its decision, the bankruptcy court first examined the language of §510(c)
and found that its purpose is to advance equitable distribution among creditors.1
The bankruptcy court then analyzed the controlling three-part test for determining
if a claim should be equitably subordinated, which was first articulated in
Benjamin v. Diamond (In re Mobile Steel Co.), 563 F.2d 692 (5th.
Cir. 1977).2 The bankruptcy court next considered whether §510(c)
grants a court authority to equitably subordinate claims unrelated to any misconduct,
but that are held by a creditor alleged to have engaged in inequitable conduct
regarding the debtor. The bankruptcy court ruled that it has such authority,
citing as support the pronouncement in Mobile Steel that "[i]mproper
acts unconnected with the acquisition or assertion of a particular claim have
frequently formed at least a part of the basis for the subordination of that
claim." Enron Opinion, p. 23.

Next, the bankruptcy court considered whether claims that could have been equitably
subordinated in the hands of the original transferor remain subject to subordination
in the hands of a transferee. Commenting that "[t]here is no basis to find
or infer that transferees should enjoy greater rights than the transferror,"
the bankruptcy court concluded that §510(c) permits a court to subordinate
a claim held by an innocent transferee based solely on the misconduct of a predecessor-in-interest.
Enron Opinion, p. 29. In reaching this conclusion, the bankruptcy court
relied on case law dealing with the law of assignments and addressing transferees
of priority wage claims. In particular, the bankruptcy court focused on a decision
in Shropshire, Woodlife & Co. v. Bush, 204 U.S. 186 (1907), a case
involving the priority of assigned wage claims.
In Shropshire, the U.S. Supreme Court found that an assignment of a
wage claim, voluntarily assigned pre-petition, does not affect the statutory
priority afforded to that claim. The Shropshire court reasoned that because
the statutory priority attached to the wage claim as the debt was incurred,
the right to such priority is not altered simply because it is asserted by an
assignee. The bankruptcy court analogized the circumstances in Shropshire
to those in the present case and found that a transferee steps into the shoes
of the transferor at the time of the transfer.
To support its decision, the bankruptcy court relied heavily on policy concerns.
Specifically, the court was concerned with the burden that a debtor might face
if it were not permitted to subordinate the claims of innocent transferees based
on the misconduct by their predecessors in interest. It found that the "necessity
of collecting damages in lawsuits against each of the original or previous holders
who engaged in inequitable conduct" would "delay the ultimate distribution
by the debtor, which delay is contrary to the goal of the Bankruptcy Code."
Enron Opinion, p. 36.

As for defenses, the bankruptcy court held that its construction of §510(c)
affords no protection to transferees that acquire claims in good faith and for
value. The bankruptcy court based its holding in part on the absence of any
explicit provision in the Code establishing a defense to equitable subordination
under §510(c) for good-faith transferees. The bankruptcy court further
reasoned that the good-faith defense is not applicable in the context of equitable
subordination because all claim transferees by definition know they are purchasing
a claim against a debtor and know that any defense, including equitable subordination,
may be asserted against the claim.
The Appeal
 The defendants immediately appealed the decision, asserting that the bankruptcy
court had erred in holding that (1) §510 of the Code permits subordination
of a claim in the hands of a transferee based solely on the fact that a predecessor
in interest—but not the transferee—engaged in misconduct; and (2)
the defense of good faith was not available to an innocent transferee who acquired
a claim in good faith and for value. The defendants also argued in the appeal
that in making its decision, the bankruptcy court failed to take into account
the profoundly disruptive effect its ruling will have on the distressed-debt
markets. In addition to the briefs filed by the defendants, an amici
brief was filed in support of the appeal by certain industry participants (the
"amici"), including the Loan Syndications and Trading Association.
Principles of Equitable Subordination
On appeal, the defendants argued that in deciding that §510(c) permits
a court to subordinate a claim held by an innocent transferee based solely on
the misconduct of a predecessor in interest, the bankruptcy court disregarded
the legislative history of §510(c), which in their view demonstrates Congress'
intent that misconduct by the holder of a claim be an essential element in equitably
subordinating a claim. The defendants further assert that the bankruptcy court's
holding contradicts the clear language of Mobile Steel's controlling
three-part test for determining if a claim can be equitably subordinated. The
first of the three essential elements is that there must be a finding of misconduct
on the part of the particular claimant holding the claim. The defendants contend
that the bankruptcy court's holding "contort[s] the definition of 'claimant'
to mean 'the claimant or any party that previously asserted the claim,'"
a construction that plainly contradicts the clear language of Mobile Steel
and its progeny. Appeal Brief, p. 13.

The Appeal Brief also highlights the bankruptcy court's failure to offer any
authority for the proposition that principles of equitable subordination permit
the subordination of claims held by an innocent, for-value transferee based
solely on the misconduct by a transferor. The bankruptcy court instead attempts
to justify its holding on "two inapposite areas of the law: the law of
assignments and case law addressing transferees of priority wage claims."
Appeal Brief, p. 14. The defendants were especially troubled by the bankruptcy
court's reliance on Shropshire as authority for its holding because,
in the defendants' view, Shropshire is inapplicable in the context of
the equitable subordination of transferred claims. The defendants contend that
the "statutory priority of wage claims derives from the 'character' of
the claim itself" and that "the character of the claim, i.e.,
a claim for wages, does not change upon its assignment." Appeal Brief,
p. 16. By invoking the holding in Shropshire, the defendants assert that
the bankruptcy court erroneously concluded that the priority adjustment of a
claim due to equitable subordination derives from the "character"
of the claim, when in fact, the priority adjustment of a claim derives from
a particular claimant's misconduct. The defendants insist that the principles
of equitable subordination offer no support for the bankruptcy court's finding
that "the adjustment of priority of a claim resulting from subordination
is attached to such claim and it travels with any subsequent transfer."
Appeal Brief, p. 16 (quoting Enron Opinion, p.33).

Protection for Good Faith, Value Transferees 
Both the amici and the defendants argue in their respective briefs that
the bankruptcy court failed to apply the well-established equitable principle
that affords protection to transferees that acquire claims in good faith and
for value. The defendants note that several sections of the Code provide protection
for innocent transferees. Specifically, the Code states that while §550(b)(1)
provides that a trustee may sue to recover transferred property or its value
from a subsequent transferee, it also provides a defense for "a transferee
that takes for value...and without knowledge of the viability of the transfer
avoided." The defendants contend that the inclusion of a good-faith defense
in §550(b)(1) demonstrates "(a) where Congress intended to impose
liability on subsequent transferees, it knew how to do so (and chose not to
do so in §510(c) by not referring to transferees); and (b) where Congress
did create a remedy against subsequent transferees, it provided protection to
good-faith purchasers for value." Appeal Brief, p.17.
The defendants and the amici continue their criticism by asserting that
the bankruptcy court's holding prevents a transferee from ever establishing
the prerequisite of a good-faith defense. According to the bankruptcy court's
opinion, because all claims transferees, by definition, know they are purchasing
a claim against a debtor and are on notice that a fiduciary is charged with
investigating each claim and asserting any defense, including equitable subordination,
all claims transferees are on notice of the risk of equitable subordination.
The defendants and the amici argue that this interpretation of "good faith"
is unprecedented and untenable. Notice of a debtor's bankruptcy at the time
a claim is purchased is not an element of an equitable subordination action;
by adopting such a test, the bankruptcy court is, in essence, defining away
the good-faith defense as "any purchaser of a bankruptcy claim must, by
definition, be on notice of the debtor's bankruptcy." Appeal Brief,
p. 20
Decision's Effect on Distressed Markets
The defendants and the amici further assert that although the bankruptcy
court devoted much of its opinion to a series of "policy arguments"
as justification for its decision, it ignored the crippling effect this decision
will have on the entire claims trading market.

The bankruptcy court's policy justifications for its decision focus on the
burden a debtor might bear if it was not permitted to subordinate the claims
of innocent transferees based on the misconduct of their predecessors in interest.
The potential burdens the bankruptcy court was concerned about include the administrative
burden of collecting damages in lawsuits against previous holders who engaged
in misconduct, and the uncertainty and delay attendant to litigation. The defendants
and amici argue, however, that the bankruptcy court's reasoning ignores
the fact that before a debtor can subordinate a claim, it must first establish
the misconduct of the claim's original holder. This requirement means that the
debtor must still engage in time-consuming and uncertain litigation, and thus
the burden or delay will not be appreciably different. In addition, the defendants
and amici contend that equitable subordination is merely a supplemental
remedy to the primary form of relief: the right to sue an alleged wrongdoer
for damages resulting from the alleged inequitable conduct. Accordingly, the
defendants and amici argue that facilitating the use of this supplemental
remedy, plus any purported incremental "administrative burden" on
a debtor unable to assert an equitable subordination claim against an innocent
transferee, cannot justify the disruptive effect the decision will have on the
claims-trading market and the unfair burden it imposes on innocent transferees.
The defendants and amici argue that the bankruptcy court downplayed
the effect its decision would have in that market and erred in citing secondary
sources to justify its holding, rather than relying on the views of actual market
participants (such as the amici).
It is the amici's position that this decision will have profound effects
on the market for bankruptcy claims and could decrease liquidity in what is
otherwise an efficient, healthy market. One such effect is that claim buyers,
in order to analyze their increased risk, will require more extensive due diligence
into the actions of all previous claim owners slowing the claims-trading process
and increasing costs.

Other effects may include the requirement of indemnities from sellers in order
to minimize the new risk of equitable subordination. As indemnities are only
as valuable as the financial condition of the indemnifying party, the claims
purchaser will require more extensive due diligence on the credit-worthiness
of the seller. In addition, there is a potential for a stream of litigation
up the chain of title when claims are bought and sold multiple times. For example,
if a debtor brings an equitable subordination suit against the ultimate buyer
of a claim, the buyer would bear the cost and expense of such litigation, plus
any litigation necessary to enforce any indemnification rights it may have against
the transferor of that claim. In turn, the transferor, if it is not the wrongdoer,
would most likely bring suit against its respective transferor and, where a
claim has been transferred multiple times, so on up the chain of title until
the litigation reaches the transferor who engaged in inequitable conduct. These
additional risks of litigation will have to be considered by any claims buyer,
who may discount their bids accordingly. The amici argue that the bankruptcy
court's analysis, with its myopic focus on the supposed benefits its decision
would provide to debtors, fails to account for the tremendous burdens its decision
places on market participants and the judicial system. The defendants and amici
contend that the decreased liquidity in the bankruptcy claims market, due to
higher risk premiums and fewer claims buyers, will result in higher credit costs
for borrowers. A primary mechanism for a lender to stem its losses if a borrower
defaults is its ability to sell its claims, and the viability of this exit strategy
is dependent on the availability of a liquid market for claims trading. If "exit-by-sale"
becomes a less-attractive option for lenders due to claim buyer's demand for
greater discounts, the result will be that lenders will demand more stringent
terms, which could price many distressed borrowers out of credit markets and
increase the number of bankruptcies.
Conclusion
The bankruptcy court's holding in Enron Corp. v. Avenue Special Situations
Fund II L.P. disregarded traditional principles of equitable subordination,
centuries of precedent with regard to good-faith purchasers and the serious
potential disruption to the distressed claims-trading market that will result
if the bankruptcy court's opinion remains law. It is bad law for distressed
companies, traders of distressed debt and the distressed-debt markets as a whole,
and should be overturned on appeal.
<blockquote> </blockquote>

<hr>
<h3>Footnotes</h3>

1 Section 510(c) of the Code provides, in relevant part: "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...." 11 U.S.C. §510(c).

2 The Mobile Steel test provides that a claim may be subordinated upon
three essential findings: 
<blockquote>
1. The claimant must have engaged in some type of inequitable conduct. 
2. The misconduct must have resulted in injury to the creditors...or conferred
an unfair advantage on the claimant. 
3. Equitable subordination of the claim must not be inconsistent with the
provisions of the Bankruptcy Act. In re Mobile Steel, 563 F.2d at 700
(citations omitted).

Journal Authors

Jeffrey D. Saferstein

Journal Date

Saturday, April 1, 2006 - 12:00

Bankruptcy Rule

2006

none