Delaware District Court: Using Contract Rights To Strategic Advantage Not Grounds For Equitable Subordination In Bankruptcy

• Published date: 08 December 2022
• Law Firm: Jones Day
• Author: Mr Oliver Zeltner and Mark Douglas

When lenders use an aggressive strategy to deal with a financially troubled borrower that ultimately files for bankruptcy protection, stakeholders in the case, including chapter 11 debtors, trustees, committees, and even individual creditors or shareholders, frequently pursue causes of action against the lenders in an effort to augment or create recoveries. The incidence of lender liability-type claims in bankruptcy in the guise of litigation seeking, among other things, to equitably subordinate lender claims or to recharacterize such claims as equity has led some lenders to second-guess how aggressively they can enforce their rights under a loan agreement, including the extent to which they can take an active role in the affairs of a borrower.

The U.S. District Court for the District of Delaware recently handed down a ruling that should be welcome news to lenders facing equitable subordination claims in this context. In Tilton v. MBIA Inc. (In re Zohar III, Corp.), 2022 WL 3278836 (D. Del. Aug. 11, 2022), appeal dismissed, No. 22-2695 (3d Cir. Nov. 10, 2022), the district court affirmed a bankruptcy court's dismissal of an adversary proceeding (the "Adversary Proceeding") filed by entities affiliated with chapter 11 debtors seeking to equitably subordinate the claims of the debtors' senior secured creditor and certain other defendants. According to the plaintiffs, these creditors had seized control and, ultimately, ownership of the debtors' assets through deception and misinformation that caused the debtors to default on their obligations and file for bankruptcy. "There is nothing inequitable," the district court wrote, "about using contractual rights to a strategic advantage."

Equitable Subordination

Equitable subordination is a remedy that was developed under common law prior to the enactment of the Bankruptcy Code to remedy misconduct by a creditor or equityholder of the debtor that results in injury to other creditors or shareholders. Where a creditor is shown to have engaged in such misconduct, the bankruptcy court has authority to subordinate the creditor's claim to the claim of a particular creditor injured by the misconduct, to the claims of an injured class of creditors, or to all other claims, depending on the circumstances.

Equitable subordination is expressly recognized in section 510(c) of the Bankruptcy Code, which provides that the bankruptcy court may, "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 or all or part of an allowed interest to all or part of another allowed interest." However, the Bankruptcy Code does not elaborate on the "principles of equitable subordination" referred to in section 510(c) or set forth a particular standard for courts to apply when evaluating an equitable subordination claim.

In In re Mobile Steel Co., 563 F.2d 692 (5th Cir. 1977), the U.S. Court of Appeals for the Fifth Circuit articulated what has become the most commonly accepted standard for equitable subordination of a claim. Under this standard, a claim can be subordinated if the claimant engaged in inequitable conduct that resulted in injury to creditors (or conferred an unfair advantage on the claimant) and if equitable subordination of the claim is consistent with the provisions of the Bankruptcy Code. Id. at 700. Courts have refined the test to account for special circumstances. For example, many courts make a distinction between insiders (e.g., corporate fiduciaries) and non-insiders in assessing the level of misconduct necessary to warrant...