Equitable Subordination Risk Follows Claims

Buyers of claims in bankruptcy have long feared that their claims (including syndicated bank loan claims) may be tarnished by the conduct of a previous owner. Standard legal documentation used to purchase claims strives to protect buyers from "bad actors" in the upstream chain of title.

Introduction

Recently, U.S. Bankruptcy Judge Arthur J. Gonzalez ruled in the Enron bankruptcy proceeding that bankruptcy claims in the hands of innocent buyers may be equitably subordinated based on the conduct of upstream sellers, where conduct need not be related to the transferred claim. Opinion Denying First Cause of Action of Motion to Dismiss Field by Springfield Associates, L.L.C. Regarding Equitable Subordination dated Nov. 28, 2005, In re Enron Corp., Case No. 01-16034 (Bankr. S.D.N.Y.) (AJG); Enron Corp. v. Springfield Associates, L.L.C. and Westpac Banking Corp., Adv. Pro. No. 05-01025 (Opinion). We discuss the court’s decision below.  The decision increases the burden on buyers to conduct due diligence regarding a seller's overall conduct toward the debtor in order to negotiate appropriate representations, warranties and indemnities and, in some cases, ultimately to litigate to enforce those indemnification and warranty rights.  Notably, the court's holding may extend to the bond market, where buyers and sellers routinely trade without the benefit of such warranties and indemnification rights.¹

The court’s opinion was entered in a number of related adversary proceedings brought by Enron in which Enron sought to equitably subordinate claims in the hands of buyers based on the inequitable conduct of the seller banks. The sellers' alleged inequitable conduct was unrelated to the bank loan transactions that were the subject of the transferred claims. In the adversary proceedings, Enron argued that the buyers’ claims should be subject to equitable subordination under §510(c) of the Bankruptcy Code to the same extent that they would be subject to equitable subordination if they had not been transferred. 

A Claim May Be Subject to Equitable Subordination Due to Inequitable Conduct Not Connected to the Claim, and Transfer of Such a Claim Does Not “Wash” the Claim of Inequitable Conduct

As an initial matter, the Enron court concluded that equitable subordination can apply to any claim held by an accused bad actor, whether or not the claim is related to the alleged inequitable conduct. Opinion at p. 21, citing Benjamin v. Diamond (In re Mobile Steel Co.), 563 F.2d 692, 706 (5th Cir. 1977). 

Having concluded that it had authority to subordinate claims still in the hands of the seller for the inequitable conduct of the seller unconnected to the claim, the court next turned to the question of whether transfer of a claim subject to equitable subordination to an innocent buyer freed the claim from subordination in the hands of such buyer. The court rejected that argument, holding that “a claim in the hands of a [buyer], either as an initial [buyer] or a subsequent [buyer], who received that claim from a [seller] found to have engaged in inequitable conduct, is subject to the same equitable relief as if such claim was still held by the [seller].”  Opinion at p. 5.  The court's conclusion was informed by authority establishing that the general priority of a claim is not altered by its transfer and that an assignee succeeds to all the rights of the assignors. Based on such authority, the court concluded that:

Once it is established that a claim in the hands of the [seller] would be subject to subordination, such claim in the hands of a [buyer] should fare no differently. Rather, it should be subordinated to the same extent that such claim would be subject to equitable subordination in the hands of the [seller]. The purchase of a claim in a bankruptcy proceeding should not grant a [buyer] any greater rights than the [seller] had. The risks inherent in bankruptcy proceedings are merely shifted to another who stands in the shoes of the original or previous claimant. Opinion at p. 29.

The court rejected the buyers' argument that Enron already has a remedy available against the sellers accused of inequitable conduct in that it is free to sue for cash damages.  The court concluded that the burden of seeking such a recovery ought not to be placed on the debtor’s estate, holding that “burdening…the estate with the necessity of collecting damages to effectuate the remedy of equitable subordination would undermine the remedy itself.” Opinion at p. 33.  Ultimately, the court found that “when one balances the harm to the other members of the injured creditor class as against the risks to a claim-purchaser, the interests of the other members of the injured creditor class prevail.” Opinion at p. 39. 

Court Rejected the Buyers' "Good-Faith" Defense to Subordination

In subordinating the buyers' claims, the Enron court rejected the buyers’ arguments that they were nonetheless entitled to a “good-faith” defense because they had no knowledge of any allegations against the original sellers when they purchased the claims. The buyers argued that §550 of the Bankruptcy Code prevented the trustee from recovering the transferred property from a buyer, or any intermediate buyers, who paid value in good faith and without knowledge of the voidability of the transfer at issue. Opinion at p. 41.  The court rejected the application of §550 to the claims-transfer context, holding that "the policy considerations of the 'good-faith' defense under various provisions of the Code are not implicated in the claims-transfer process." Opinion at p. 44. 

In determining that the buyers could not demonstrate “good faith” under the Code, the Enron court focused on the buyers’ knowledge of the debtor’s unfavorable financial condition, rather than on the buyers' knowledge of the original sellers’ misconduct. Narrowing the issue in this manner, the court followed a line of cases holding that “a subsequent [buyer] is not a good-faith [buyer] if the [buyer] knew of the debtor’s financial difficulties at the time of the transfer."  Opinion at p. 45-46. Because the buyers in the Enron adversary proceeding purchased their claims post-petition, they were held to be on notice of the debtor's financial condition and were denied the good-faith defense. 

While the court's holding was limited to post-petition purchasers of debt, the court went on to indicate that a pre-petition buyer might also be denied the benefit of the good-faith defense if they "knew or should have known" of the debtor's "unfavorable financial condition at the time of the transfer" (even if that financial condition fell short of insolvency). Opinion at p. 45-46.  Presumably then, only a narrow class of buyers who conduct due diligence regarding the debtor’s financial condition and purchase debt at par should have the benefit of the good-faith defense.

Court's Holding Was Based in Part on a Misperception that the Claims Market and Buyers Discount Claims Based on the Risk that Full Recovery May Not Be Available, Whether as a Result of Debtor Insolvency or Seller Misconduct

In holding that equitable subordination applies to transferred claims and in denying buyers the benefit of the good-faith defense, the court was guided, in part, by its understanding that the market discounts claims precisely because of concerns about the likelihood of recovery on such claims. “In the claims-transfer market, the possibility of equitable subordination of a claim is not purely speculative or hypothetical. The value of a claim is set by the marketplace’s view of the attendant risks, including equitable subordination, in the bankruptcy process.” Opinion at p. 37-38, Id. at p. 49.

This element of the court’s analysis, however, may misperceive the basis for the discounted price paid for claims in the claims market. With respect to post‑petition claims, the discounted price likely reflects the parties’ analysis of the likelihood of recovery from the debtor, rather than the likelihood that recovery may be denied as a result of inequitable conduct by the seller. With respect to pre‑petition claims, such claims may not be discounted at all and may be traded at par.  Indeed, pre-petition, nondistressed claims where the buyer has no reason to believe that the debtor was, or might shortly become, financially distressed or that the seller engaged in inequitable conduct will often not trade at the discount cited by the court.

Following the court's decision, such buyers are well advised to conduct due diligence regarding both the debtor's finances and the seller's conduct. Further discounting may be appropriate to the extent that the seller’s conduct cannot be probed.

In the Syndicated Bank Loan Trading Market, Indemnification and Warranty Provisions in the LSTA Forms May Protect Buyers from the Risk of Equitable Subordination

The court noted that “[p]articipants in the claims-transfer market are aware, or should be aware, of the risks and uncertainties inherent in the purchase of claims associated with post-petition debtors, including the possibility of claims being subordinated, and they assume the liabilities arising from the post-petition transfer of claims.” Opinion at p. 37. The onus is therefore on buyers in the claims market to protect themselves from the risk that the seller has engaged in inequitable conduct by engaging in due diligence to try to uncover such conduct or by including strong indemnification and warranty provisions in claims-trading documentation.  Acknowledging this issue, the court bolstered the concept of “buyer beware” by noting that the Loan Syndication and Trading Association, Inc. (LSTA) has promulgated standardized provisions relating to transferred rights, assumed obligations, and buyer’s rights and remedies, and that one of the buyers in the Enron bankruptcy proceeding had in fact extracted an indemnification obligation from the seller, indicating that at least some buyers were mindful of the potential danger of future subordination of their claims. Opinion at p. 38, n. 14. The standard LSTA documentation includes an “acts and omissions” representation, the breach of which would give rise to a right to indemnity in favor of the buyer if, based on a seller’s inequitable conduct, the claim receives proportionately less in payments than the same type of claim held by other parties. ²

Buyers in the Bond-Trading Market May Also Be Subject to Equitable Subordination

Although the court's holding was limited to the facts before it, which involved the transfer of syndicated bank loan claims, the court was clear in pointing out that nothing prevented its extension to the bond-trading market. In rejecting the argument that the equitable-subordination risk should not travel with all categories of debt, such as bonds, because such debt is not "traded in the claims-transfer marketplace where the trading parties are free to negotiate representations, warranties, indemnities and other protection devices," the court concluded that the bond-trading market likely addresses the risk of equitable subordination in pricing. Opinion at p. 39, n. 15.³

According to the court's view, such purchasers

• either know or should know that the issuer of these securities is a debtor, so the prices for these transfers would reflect the attendant risks that the claims might be subordinated. Under those circumstances, the purchaser may well not have any available indemnity remedy against the seller, as is the case with the claims trading. But it is the marketplace that should address such risks in its pricing.  Apprehending higher risk associated with these securities, the purchaser may demand further discounts on the prices. And based on the court's previous policy analysis, no legal and policy basis supports the premise that the transferees of bonds or notes should be treated differently than those holding the transferred loan claims. All the post-petition transferees assume the risk that their claims may be subject to subordination....

Opinion p. 29, n. 15. While this portion of the court's holding is dicta and therefore not binding on subsequent courts, future courts will look to the Enron court's reasoning for guidance. Accordingly, buyers of bonds also run the risk that the taint of equitable subordination will pass with the claims traded.

Conclusion

Following the Enron court's decision, a buyer who buys its claim from a seller that engaged in inequitable conduct may have to recover from the seller, rather than a debtor in bankruptcy, and may have to engage in litigation to do so. This increases the burden on buyers to conduct due diligence about the seller’s conduct to obtain appropriate indemnification and warranty provisions and, possibly, to engage in litigation in order to enforce those indemnification and warranty rights. Unfortunately, it increases the risk of diminished recovery due to factors that are (1) extraneous to the debtor's ability to pay and (2) extraordinarily difficult to diligence.