Better Late Than Never: Claims Filed Years Late Did Not Waive Subordination Agreement Priorities Or Warrant Equitable Subordination

The Bankruptcy Code dictates the priority of distributions to the holders of allowed secured and unsecured claims in accordance with various statutory priority schemes. However, the Bankruptcy Code also provides that consensual pre-bankruptcy agreements between or among creditors that prioritize the right to receive payments from an obligor will generally be enforced in a bankruptcy case subsequently filed by the obligor.

In In re Franklin Bank Corp., 2014 BL 200948 (D. Del. July 21, 2014), a Delaware district court confronted the apparent conflict between the priorities established by the Bankruptcy Code for late-filed claims and a prepetition subordination agreement. The court vacated and remanded a bankruptcy court ruling that: (i) by filing its claims years after expiration of the claims "bar date," a creditor waived its right to enforce the terms of prepetition subordination agreements; or, in the alternative, (ii) the late filings justified equitable subordination of the tardy creditor's claims. According to the district court, the creditor's failure to act in a timely manner did not rise to the level of a "clear manifestation of intent to relinquish a contractual protection" and there was evidence of neither inequitable conduct nor harm to other creditors that would warrant equitable subordination of the late-filed claims.

Bankruptcy Code Priorities

Various provisions of the Bankruptcy Code establish priorities for claims against the debtor or the bankruptcy estate. For example, section 507 specifies 10 categories of unsecured claims (e.g., administrative expense claims, certain employee wage and benefit claims, certain tax claims, and certain personal injury claims) that have priority over the claims of general unsecured creditors.

Section 726(a) of the Bankruptcy Code establishes the priority scheme for the distribution of estate assets in a chapter 7 liquidation. It provides that, "[e]xcept as provided in section 510," first priority is given to timely filed claims of the kind (and in the order) specified in section 507. Timely filed unsecured claims without priority under section 507 as well as tardily filed unsecured claims submitted by creditors without notice or actual knowledge of the bankruptcy case (if filed in time to permit payment) are conferred with second priority. Other tardily filed unsecured claims are relegated to third priority. Fourth, fifth, and sixth priorities are afforded, respectively, to: (a) certain fines...