Categorical Subordination Still Kicking

Journal Issue

Dec/Jan 2005

Column Name

Citation

ABI Journal, Vol. XXIV, No. 10, p. 8, December/January 2006

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Sometimes when the Supreme Court decides an
issue in the bankruptcy arena, it causes immediate changes in the way
that cases are resolved. Other times, the Court's decisions barely cause
a ripple in the flow of the way plans are drafted. The Court's two 1996
decisions on subordination of claims are, perhaps, an example of the
latter. Despite their apparent rejection of a shotgun approach to
subordinating certain types of claims (such as penalty claims that
governmental entities often have cause to impose), plan drafters seem to
go on routinely including such subordination provisions. Do those
decisions really still leave the issue open? Or is this just another
example of "let's put it in and see if anyone objects?" The United
States believes the latter is more likely—and that plan drafters
should think carefully before trying to subordinate penalties if they
are interested in avoiding objections from the government.

Section 510 of the Bankruptcy Code allows involuntary subordination
of claims in two circumstances—where the claim arises from
rescission of a contract for purchase or sale of a security, and under
principles of "equitable subordination." The subordination of claims
arising from the purchase and sale of securities is based on the notion
that such claims are more akin to equity interests than a true creditor.
Creditors have the right to be repaid the amount of their
debt—nothing more and nothing less. A person holding an equity
interest, on the other hand, has the hope of receiving much more than
the original investment and, conversely, the possibility of losing that
same amount. The risk and benefits are two sides of the same coin. The
absolute-priority rule reflects that reality and bars equity interests
from taking until true creditors have been satisfied. A claim relating
to the purchase or sale of stock does not necessarily involve the same
possibility of unlimited loss or gain, but still comes out of a
situation where the party had or will have those possibilities. The
Code, accordingly, gives those claims a position essentially equal to
the underlying rights of equity interests that merely held their shares.
In re Telegroup Inc., 281 F.3d 133, 138 (3rd Cir. 2002)
(subordination not limited to claims involving fraud in purchase or sale
but to any claims arising out of a transfer, where there is causal role
between sale and damages).

Equitable subordination, on the other hand, is based on the notion
that some claims are unworthy of being paid along with other, more
virtuous claims. Classically, such subordination involves a creditor
that engaged in some sort of unlawful or inequitable conduct in
obtaining the claim, or in situations where an insider demands the right
to be treated equally with outside creditors. See In re Mobile Steel
Co., 563 F.2d 692, 700 (5th Cir.1977) (claimant must be found to
have engaged in inequitable conduct; the misconduct must have either
resulted in injury to creditors or given the claimant an unfair
advantage, and subordination must not be in conflict with other
bankruptcy provisions). The issues as to insiders, who have greater
knowledge and greater abilities to benefit from the debtor's business
prospects, are, in many ways, akin to the issues relating to stock
interests. An alternative analysis may focus on whether the "claim"
should be recharacterized as an equity interest (which has the same
effect of subordinating the demand for payment). In addition to these
scenarios, however, there are other types of claims that have frequently
been subject to equitable subordination, including penalty claims and
debts under stock redemption agreements where the claim does not meet
the literal terms of §510(b). It is those issues that trigger the
questions about categorical subordination that the Supreme Court might
have thought it had resolved in 1996.

In chapter 7 cases, penalty claims that would otherwise be general
unsecured claims are subordinated pursuant to §726(a)(4), without
reliance on §510(c). Prior to 1996, courts routinely subordinated
penalty claims in chapter 11 and 13 cases as well, using two basic
rationales. The first was that it was inequitable to pay punitive claims
before compensatory claims were paid in full (i.e., "punitive
damages don't punish the debtor, only the creditors"). See In re
First Truck Lines (United States v. Noland), 48 F.3d 210,
214-18 (6th Cir. 1995), and discussion therein; In re Apex Oil Co.,
118 B.R. 683, 697-98 (Bankr. E.D. Mo. 1990); In re Johns-Manville
Corp., 68 B.R. 618 (Bankr. S.D.N.Y. 1986). The second was that such
subordination was required by the "best-interest-of-creditors" test.
Since such claims were subordinated in chapter 7, and since creditors
must receive at least as much as in a chapter 7 case, then—so goes
the argument—such claims must also, ipso facto, be
subordinated in chapter 11. See discussion in In re New York
Medical Group PC, 265 B.R. 408, 416, n. 5 (S.D.N.Y. 2001).

The first line of argument in particular reached its apogee in
Noland. In that chapter 7 case, the Sixth Circuit concluded that
post-petition tax penalties, which were given administrative
expense status under §503(b)(1)(C), could still be equitably
subordinated to other general unsecured claims because they were
penalties. It assumed that penalty claims were generally disfavored and
relied on ambiguous statements in the legislative history to justify
denying the claims the priority status prescribed by Congress. When the
case arrived at the Supreme Court, it quickly reversed in U.S. v.
Noland, 517 U.S. 535 (1996).

The Court held that while subordination could apply to any claim,
even including one given administrative status, the decision to do so
must be based on some characteristic of the specific claim that
justified denying it the presumptive status given by Congress. If an
issue was one that would result in a "categorical" restructuring of the
status of specific types of claims, that decision was one that must be
made by Congress, not the courts. Since in Noland nothing in the
lower court's decision turned on any facts unique to the case, or any
misconduct of the claimant, the result would apply to any penalty
claim. In other words, the Sixth Circuit was assuming, categorically,
that it would be inequitable to allow penalties to be paid pari
passu with other unsecured claims and that all such claims
would be subordinated. But such a decision, the Supreme Court held, was
one for Congress, not the courts.

The Court followed up with U.S. v. Reorganized CF & I
Fabricators of Utah Inc., 518 U.S. 213 (1996). The Tenth Circuit had
upheld a plan that placed pre-petition tax penalties into a subordinated
class, again based on the equitable subordination principles in
§510(c), without any showing of misconduct by the government, based
solely on the nature of the claim. The Court again firmly rejected the
notion that some types of claim could be subordinated based on a
"categorical" view of their merits, without regard to any specific
reason, for treating those claims differently than any others. If
Congress meant to subordinate all claims of a particular type, it
was quite capable, the Court held, of doing that; when it chose not to
do so, courts could not create their own automatic downgrades. While not
explicitly ruling that creditor misconduct must always be shown in all
cases, the Court did not cite any other bases for such subordination.
The most likely such reason might, as noted above, be the claims of
insiders, which may be subject to greater scrutiny. The Court also did
not decide two other issues: whether the claims could be separately
classified and the effect of the best-interest-of-creditors test.

After these two cases, it would seem that the treatment of penalty
claims in particular should change markedly in chapter 11 cases. The
holders of such claims have likely not engaged in misconduct; to the
contrary, they are more likely to be among the most sinned
against. As a result, equitable subordination would appear
to be inappropriate, leaving only the application of the "best
interests" as a basis for denying penalty claims equal treatment. At
first glance, the syllogism above—if penalties are subordinated in
chapter 7, they must also be subordinated in chapter 11 to give
creditors the same recovery—may seem logical, but it often falls
apart if one actually does the math.

The reason is simple—the "bigger pie" that chapter 11 is assumed
to create for creditors can readily make it possible to accommodate
penalty claims while still satisfying the best-interests test. Thus, to
be confirmed, a chapter 11 plan must show that it will produce at least
as much as the liquidation alternative and debtors usually manage to
"prove" that it will produce much more for unsecured creditors.
One may be cynical about those depressing liquidation analyses, but the
debtor cannot just disclaim them when it comes time for the penalty
analysis. In short, reorganizations always promise to create a
larger estate, and it is from that added recovery that penalties can be
paid. The best-interest test requires only that other creditors receive
more "absolute" dollars, not that they receive the same percent of the
overall estate as in chapter 7. With a larger estate, even if more
claims share in the pie, it is easily possible that the nonpenalty
claims will still receive as much or more in absolute dollars. For
instance, if $5 million in claims divide up a $1 million estate in a
"fire sale" liquidation, a $10,000 claim will receive $2,000. If a $1
million penalty claim is added in chapter 11 increasing the claims pool
to $6 million, but if the asset pool increases even
more—i.e., to $2.4 million—then that same claimant will
receive $4,000. Thus, it is quite possible to add penalty claims and
still not violate the best-interest test.

So with those principles, have plans stopped proposing to
automatically subordinate penalty claims? Hardly. It is a rare plan that
does not include a provision subordinating penalty claims, at
least for creditors other than tax claimants. Interestingly, though,
there have been few reported decisions in this area, suggesting either
that the plans have not been objected to, or conversely, that the
debtors have retreated from the position when challenged. Some decisions
suggest, generally without much real analysis, that the
best-interest-of-creditors test can decide the issue. See Owens
Corning v. Credit Suisse First Boston, 322 B.R. 719 (D. Del. 2005)
(large value of punitive damage claims in asbestos case indicates that
they should be subordinated under best-interest test, but no actual
calculations done). Cf. In re Cassis Bistro Inc., 188 B.R. 472
(Bankr. S.D. Fla. 1995) (pre-Noland case that used equitable
subordination, but at least made some attempt to actually apply
best-interest test to support the subordination decision).

In both the Enron and Worldcom cases—two bad
actors on a colossal scale—the plans initially provided for such
automatic subordination of penalty claims and for claims relating to the
securities fraud issues arising out of the debtors' misconduct. The
treatment of those latter claims has been much affected by the
provisions of the Sarbanes-Oxley Act (see the discussion in the
"A Collision of Fairness: Sarbanes-Oxley and §510(b) of the
Bankruptcy Code," ABI Journal, October 2005, p. 8.) Governmental
entities challenged the proposed treatment of penalty provisions and, in
both cases, forced the debtor to back off the attempt to decide the
issue in the plan by fiat. The debtors agreed that if they sought to
subordinate such claims they would have to do so by way of a specific
action brought against those claims with the government able to
challenge whether the debtor had shown both inequitable conduct and a
best-interest issue.

Other courts suggest that they can simply disallow punitive claims
even if such claims could plainly be found to have merit outside the
bankruptcy arena. This typically occurs in mass tort cases where the
plans routinely disallow all punitive damage claims, even where a
judgment has already been entered. See, e.g., the plan language
in In re Asbestos Claims Management Corp., 294 B.R. 663, 685
(N.D. Tex. 2003) and In re G-I Holdings Inc., 323 B.R. 583, 594
(Bankr. D. N.J. 2005). The Seventh Circuit rejected that notion in In
re A.G. Financial Services Inc., 395 F.3d 410, 413-15 (7th Cir.
2005), although on the merits it found that the creditors had not
asserted a credible claim for such damages. It noted that there was
nothing in the Code that allows for disqualification simply because of
the punitive nature of the claims; if courts do not have the power to
categorically subordinate claims, it can hardly be thought that they
have the power to categorically disallow them.

Other courts have taken a very broad view of the disqualification for
securities claims. Starting with the provision actually contained in the
Code, those courts have used the policy justifications about the profit
and loss potential for equity claims to extend to any matters that
relate in any way to a stock holding. In particular, a number of cases
had broadly made any claims arising out of stock-redemption candidates
for equitable subordination by extending the same principles used in
§510(b) into the §510(c) context.

The most recent case on this issue is In re Merrimac Paper,
420 F.3d 53 (1st Cir. 2005). It comes down squarely against automatic
subordination of such claims. That case involved an ERISA plan
participant who had received a stock distribution from his plan on
retirement, exercised an option to have the stock repurchased and was
being paid overtime on a simple promissory note. When the debtor filed
bankruptcy, the debtor argued that the payments on the note should be
subordinated because they were related to a stock transfer. The lower
courts concluded that the claim did not arise under §510(b) but
nevertheless considered it under §510(c) and equitably subordinated
it, essentially relying on reasoning in older cases that had held that
any sort of matter related to a stock transfer warranted subordination
for the same reasons as in §510(b). The First Circuit reversed. It
noted that after Noland and CF & I, general principles
about the types of claims that deserved to be subordinated were no
longer valid. "Taken together, the principles enunciated in
Noland and Reorganized CF & I vividly demonstrate why
the bankruptcy court erred in equitably subordinating the appellant's
claim based on nothing more than its classification as a stock
redemption claim." Merrimac, 420 F.3d at 62. Perhaps the ringing
reaffirmation of the principles in Noland and Merrimac may
signal a renewed devotion in the courts to the principle that
"categorical subordination" is not a power that courts may exercise.

That leaves, of course, the question of whether the Code
should allow such subordination, particularly for penalties.
There is certainly an intuitive sympathy to the notion—after all,
if those who have been truly "harmed" by the debtor are not being paid
in full, should someone else have their compensatory claim and a
punitive claim as well? Or should the government be able to extract at
least a partial pound of flesh when trade creditors may go unsatisfied?
Perhaps so, and perhaps Congress should do something to create an
unequivocal rule to that effect.

But before it does, at least a couple of countervailing
considerations should be included in the analysis. First, the notion
that only the creditors are being punished ignores completely the rather
large category of chapter 11 cases filed for closely held corporations.
In such cases, with an often-rather-modest "new value" infusion, it may
be quite possible for the owners to launder their stock holdings through
bankruptcy, pay a limited portion of their debts and, if penalties are
subordinated, rid themselves of those costs altogether without paying
anything for their misconduct. Barring such a maneuver surely
results in some punishment for the owners. At a minimum, the amount of
money necessary to constitute adequate "new value" will surely be larger
if penalties are included in the mix of claims that must be accounted
for.

Second, governmental penalties in particular are imposed on a
business for a reason—because it has been operating in a fashion
that victimizes the state's citizens. Such operations often tend to make
a business more prosperous or to allow it to operate a scheme that
otherwise could not continue for nearly as long. The trade creditors
dealing with such bad actor businesses typically are paid until nearly
the end, and have reaped the benefits of doing business for an extended
period. While a trade creditor might miss payment of the last invoice or
two, victims may have lost everything they paid to the debtor. In the
overall context of their relative dealings, is it really clear that
trade creditors should be paid everything and that the state should be
barred from collecting anything for the victims or for its own use in
enforcing the statute?

Third, penalties are meant to serve a deterrent factor—perhaps
not only as to the entity engaging in the misconduct, but those choosing
to do business with it—and facilitate its actions. Let's return to
the example of Enron, for instance—it did not engage in all of its
hidden ventures, its off-the-books financing and its manipulation of the
energy markets without business partners who have their own sins to
answer for. Where many of the largest creditors in the case—those
sitting on the creditors' committee—had their own potential
liabilities to answer for in terms of aiding, abetting, and facilitating
Enron's bad act (whether or not the actions of those third parties rose
to the level of specific civil or criminal culpability), is there not
some justice in forcing those parties to suffer in some part along with
Enron itself? In short, the question of what the rule should be
for treatment of penalties in chapter 11 cases is one that can engender
lively debate. The question of what the Code actually provides is far
simpler: Penalties may not be automatically subordinated, and the
government will challenge plans that propose to do so.

Journal Authors

Karen Cordry

Journal Date

Thursday, December 1, 2005 - 12:00

Bankruptcy Rule

2005