Hon. Jack B. Schmetterer of the U.S. Bankruptcy Court for the Northern District of Illinois issued a memorandum opinion dismissing a debtor’s lawsuit to equitably subordinate a secured lender’s claim. In re American Consolidated Transportation Cos. Inc., Adv. No. 10-00154, slip op. (Bankr. N.D. Ill. July 13, 2010). In American Consolidated, the court set forth the pleading requirements for a species of lender liability claim that will effectively prevent future debtors from equitably subordinating a secured lender’s claim absent extreme circumstances. The case is noteworthy because, under the guise of the heightened pleading standards of Twombly[1]and Iqbal,[2] the bankruptcy court held that a lawsuit predicated on the facts of a fairly typical lender-borrower scenario is not a viable lawsuit.
Background
In September and October 2006, American Consolidated Transportation Companies and its related companies (collectively, the “debtors”) entered into a series of agreements with RBS Citizens NA, d/b/a Charter One (the “bank”), including a $4 million variable rate-term note, an interest-rate swap, a loan and security agreement, a $1 million term note and a $1 million revolving-demand note (collectively, the “loan documents”). The loan documents contained a number of financial covenants, including a combined tangible net-worth requirement (the “net-worth covenant”) and an earnings-to-payments ratio requirement (the “cash-flow covenant”). In connection with the loan documents, the debtors pledged substantial collateral to the bank as security for the loans.
At the time that the debtors and bank entered into the loan documents, the debtors were already encountering financial difficulties (these problems were known to the bank). Specifically, the debtors had lost a major account that represented 25 percent of its total revenue. Documentation provided by the debtors to the bank in connection with the loan documents evidenced the debtors faltering business and financial difficulties. Despite these and other red flags, the bank continued to enter into new agreements with, and provide additional funding to, the debtors. From 2006-08, the bank seemed to turn a blind eye to the fact that the debtors were likely in default of the financial covenants under the loan documents.
On June 10, 2008, notwithstanding the fact that the debtors remained current on their payments and were not in default under any other loan provision, the bank sent the debtors a default and acceleration letter due to the debtors’ failure to comply with the net-worth and cash-flow covenants. The debtors and bank thereafter entered into a forbearance agreement, wherein the bank agreed to forbear from exercising its remedies under the loan documents for a 120-day period. As consideration for the forbearance, the debtors agreed to: (1) provide the bank with additional collateral, (2) hire a chief restructuring consultant of the bank’s choosing and (3) pursue a strategy for the sale of the debtors’ business. The forbearance agreement required the debtors to give the CRO substantial managerial responsibility over the debtor’s businesses, including with respect to the marketing and sale of the company and its assets. Specifically, the bank required that the CRO have the following duties:
[D]irecting any sale process; providing financial analysis assistance to [the debtors] to identify cost saving and improvement of margins; assisting [the debtors’] Chief Executive Officer on any major business decisions; assisting the CEO in supervising all of [the debtors’] officers, employees, and consultants, including hiring and firing decisions and compensation; assisting [the debtors] in preparing a cash flow plan and management of cash activity, including control of disbursements as to timing, priority, and amount; reviewing all check requests and other payments made pursuant to American’s budget; assisting the CEO in supervising all professionals, including attorneys and accountants; and assisting [the debtors] in complying with the Forbearance Agreement and loan documents.
Opinion at 5-6.
In addition, the CRO was required to “communicate directly with the Bank regarding all aspects of American’s finances and any proposed refinancing or sale of American’s businesses” and provide the bank with regular financial reports. Id. at 5.
On July 18, 2009, the debtors filed for chapter 11 protection (Case No. 09-26062). The bank subsequently filed a proof of claim in the amount of $6,008,538.21, representing amounts owed to the bank by the debtors under the loan documents. On Jan. 31, 2010, the debtors filed a complaint seeking to equitably subordinate the bank’s claim. In response, the bank filed a motion to dismiss the debtors’ complaint for failure to state a claim pursuant to Rule 12(b)(6) of the Federal Rules of Civil Procedure, made applicable by Rule 7012(b) of the Federal Rules of Bankruptcy Procedure.
Equitable Subordination under § 510(c)
Under § 510(c) of the Bankruptcy Code, a claim “may be subordinated to other claims or interests, and any lien securing a subordinated claim may be transferred to the debtor’s bankruptcy estate.” Opinion at 8. Equitable subordination of a claim is a drastic remedy, and is only available to a debtor if: “(1) the claimant…engaged in inequitable conduct; (2) the misconduct…resulted in injury to the [debtor’s] creditors…or conferred an unfair advantage on the claimant; and (3) subordination [is] not… inconsistent with the provisions of the Bankruptcy [Code].” In re Kreisler, 546 F.3d 863, 866 (7th Cir. 2008) (citing United States v. Noland, 517 U.S. 535, 538-39 (1996)). Conduct is considered “inequitable” for the purposes of equitable subordination if a creditor breaches a fiduciary duty or engages in egregious conduct to the detriment of other creditors. See Opinion at 8.
Courts have generally held that “[t]he level of inequitable conduct required [to equitably subordinate a claim] depends on the legal relationship between the debtor and the claimant.” Id. Opinion at 9 (citing In re Kids Creek Partners L.P., 200 B.R. 996, 1015-16 (Bankr. N.D. Ill. 1996)). Claims by fiduciaries are subjected to stricter scrutiny than claims by other parties. A fiduciary’s claim will be equitably subordinated unless the fiduciary can prove that the claim arose as a result of an arm’s-length transaction. Conversely, if a claimant is not a fiduciary, a debtor has to pass a higher threshold in order to equitably subordinate. Specifically, to subordinate claims filed by non-fiduciaries, a debtor must prove that the claimant is “guilty of gross misconduct tantamount to fraud, overreaching or spoliation to the detriment of others.” Id. at 9 (citations omitted). The debtors in American Consolidated alleged that the Bank’s claims should be subordinated because the bank (1) was acting as a fiduciary and (2) was guilty of egregious conduct tantamount to fraud.
Bank Did Not Act as a Fiduciary of the Debtors
The debtors asserted that the bank exercised sufficient control over the debtors to become a fiduciary. Specifically, the debtors alleged that the bank had usurped the decision-making authority of the company and had taken over the business. According to the debtors, the mechanism for asserting this control was put into effect when the bank called a default based merely on noncompliance with the financial covenants and forced the debtors to enter into the forbearance agreement, appoint a CRO of the bank’s choosing and take steps to liquidate the business. Once a default was called, the debtors believed that they had no choice but to comply with the many and onerous demands of the bank.
The debtors contended that the bank-selected CRO was empowered to “assist”the debtors in all of their major business decisions, and considering the level of control and oversight given to the CRO, the line between “assisting” and “controlling” was blurred to the point of giving the bank de facto control through the CRO. The CRO was to be an integral part of the debtors’ everyday business, including reviewing all check requests and disbursements. Even though the CRO was retained to “assist” with these and other business decisions, the debtors argued that CRO (as an agent of the bank) was actually controlling all facets of the debtors’ business. As one example of that control, the debtors pointed to multiple occasions when the bank would not consent to the use of cash collateral to enable the debtors to retain post-petition experts and financial consultants, and where the bank would threaten to withhold use of cash collateral when extracting financial information from or making unreasonable requests of the debtors.
Despite the presence of these and other indicia of control, the court disagreed with the debtors, and found that the requisite control was missing in the relationship between the bank and debtors. The court held that, for a lender to be considered a fiduciary, it must actually “exercise…managerial discretion to such an extent that the lender usurps the power of the borrower’s directors and officers to make business decisions.” Id. at 10. According to the court, the level of control necessary to turn a lender into a fiduciary does not arise due to an “imbalance in bargaining power,” but rather, only when there is essentially a “merger of identity or a domination of the borrower’s will.” Id. Per the court, “control is not established when a lender insists on standard loan agreement restrictions, closely monitors the borrower’s finances, [or] makes business recommendations,” nor when a “borrower hires a management or restructuring consultant selected by the lender.” Id.
While the court acknowledged that the bank had significant leverage due to the debtors’ default and the bank’s ability to foreclose on its collateral, the court stressed that an imbalance in bargaining power does not create a fiduciary relationship. At all relevant times, the court noted, the debtors had the ability to choose another path. In other words, the debtors, and only the debtors, could decide their own fate. Rather than entering into the forbearance agreement with the bank and providing the bank with additional collateral, the debtors could have simply chosen to permit the bank to foreclose on the existing collateral and exercise its other contractual remedies. The debtors also could have filed their chapter 11 cases in lieu of entering into the forbearance agreement.
Moreover, the fact that the bank recommended the CRO and that the CRO was tasked with advising and assisting in business decisions—as distinct from making those decisions for the debtors—did not give rise to a fiduciary relationship between the parties. Unless the CRO was empowered to make unilateral business decisions, or “the Bank directed or controlled which creditors American paid, that it hired or fired employees, or that the Bank made any other similar intrusion into the day-to-day operations” of the debtors, the relationship would not rise to the level of fiduciary. Id. at 11. The court found that, on the facts, the CRO merely “assisted,” rather than “controlled,”the debtors in the operation of their business.
Bank Did Not Act Inequitably
Because the court found that the bank was not a fiduciary, the debtors were required to have adequately “plead facts showing particularly egregious conduct by the bank that is tantamount to fraud.” Id. at 12 (citations omitted). The debtors asserted that the bank engaged in egregious misconduct by, among other things, (1) representing to the debtors that they would not call a financial covenant default unless the debtors failed to stay current on their payments; (2) accelerating the loans despite having no reason to believe that the debtors would fail to timely pay amounts due; (3) accelerating the loans for the sole purpose of freeing-up cash for other endeavors; (4) forcing them to enter into the forbearance agreement, provide additional collateral and retain a CRO; and (5) forcing them to pursue a sale of their business. The court was not persuaded.
First, the court found that there was insufficient evidence that the bank represented that it would not call a default if the debtors stayed current on their loans. While the debtors made a number of conclusory statements to that effect, the debtors failed to “allege who made the purported representation…or when or how that person made it.” Id. at 12. The court found that the bank was well within its powers to call a default based on the debtors’ noncompliance with the financial covenants, and that it was merely exercising its bargained-for contractual rights.
The court also dispensed with the debtors’ arguments that the bank had no concerns about the loans being repaid and only called the default as to free-up capital to be used for other purposes. In dismissing these arguments, the court again cited to the debtors’ failure to proffer any evidence in support of their conclusory allegations. Moreover, the court did not believe that it was “inequitable for a creditor to seek payment of a debt to it for use of the money in other loans.” Id. at 13. Even if the court were to accept the debtors’ assertions as true, the actions taken by the bank were not out of line because “[c]reditors may make business judgments in their favor without those being treated per se as insidious conduct.” Id. at 13.
Finally, as discussed above, the court found that the debtors were not “controlled” by the bank and could have—at any time—chosen not to move forward with the forbearance, the retention of the CRO or the sale. Specifically, the court held that the debtors “could have refused the Bank’s demands and allowed it to pursue its contract remedies.” Id. at 13. Ultimately, the court determined that it was “not plausible to conclude that the…alleged acts of inequitable conduct, were anything other than hard bargaining from a superior negotiating position”—hardly rising to the level of wrongful conduct necessary for equitable subordination. Id. at 13-14.
The Impact of American Consolidated
The American Consolidated decision is interesting because the court used the developing case law on the heightened pleading requirements established under Twombly and Iqbal as a springboard to articulate substantive rules for what does and does not constitute lender misconduct or control. Viewed in this manner, American Consolidated is not so much a case where the court is saying that the specificity or plausibility of the pleading was inadequate as it is a determination by the court that “a lender liability case predicated on these facts will fail as a matter of law.” Indeed, the facts appear to have been so plainly and fully pleaded that the bank’s motion to dismiss could have been a motion for summary judgment. Put another way, the court did not tell the plaintiff to put more flesh on the bones, but rather, the court was telling the plaintiff that to succeed it had to plead a different case. In essence, no matter how strong the bargaining power of a secured lender or how much pressure the lender is able to exert on a distressed borrower, the lender’s claims will not be equitably subordinated unless the lender was actually in control.
The ruling in American Consolidated implies that there is no such thing as economic duress in the context of a commercial loan because, even in a situation where the bank has exerted a great deal of pressure on a borrower, including the appointment of a hand-picked CRO and wholesale influence over a borrower’s budget and disbursements, such influence does not rise to the level of control necessary to equitably subordinate the lender’s claim. After American Consolidated, debtors in the Northern District of Illinois and elsewhere will be hard pressed to seek to subordinate a secured lender’s claims in a similar fact pattern.