Fifth Circuit Stresses Limits on Equitable Subordination

August 5, 2008
Law360
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A recent Fifth Circuit decision overturning a bankruptcy court ruling is good news to directors or controlling shareholders of a financially troubled company who are willing to lend money to it  only on terms providing reasonable assurance of repayment. The bankruptcy court had equitably subordinated the secured claims of two former officers and directors of a bankrupt company to the unsecured claims of other creditors. The two former officers and directors had made secured loans to the company before it went into Chapter 11. In its decision the Fifth Circuit stressed there were limits on equitable subordination, and noted that the bankruptcy court had ignored them.

In particular, the Fifth Circuit made clear that a secured creditor's claim can not be equitably subordinated, unless there are specific findings, supported by the record, that other creditors were harmed as a result of "inequitable conduct" by the secured creditors, which the bankruptcy court did not make. Also, if the proceeds of a challenged transaction flow to unsecured creditors, reducing the size of that claims pool, as occurred in this case, unsecured creditors as a class aren't harmed. And without a showing of harm, they aren’t entitled to equitable subordination.