ABI Rosenblatt11-08

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                           AMERICAN                             BANKRUPTCY                                    INSTITUTE

                                Issues and Information for Today’s Busy Insolvency Professional

No Court Approval Needed for Creditor Seeking
Equitable Subordination of Another’s Claim
                                                                                                   claims recharacterized as equity

                                                                                                   contributions as opposed to debt and (3)
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                                                              About the Author
                                                                                                   subordinate the claims to the claims of all
Andrew Rosenblatt

                                                                                                   other unsecured creditors.
Chadbourne & Parke LLP; New York
                                                    Andrew Rosenblatt is counsel in the
                                                                                                        In support of their claims, the plaintiffs
    n Algonquin Power Income Fund v.
                                                    Bankruptcy and Financial Restructuring
                                                                                                   alleged that: (1) the insider debt was not
    Ridgewood Heights Inc., 2007 Bankr.
                                                    Group of Chadbourne & Parke LLP in
                                                                                                   reflected on the debtors’ books and records;
    LEXIS 3004 (Bankr. N.D.N.Y. Aug. 30,
                                                    the firm's New York office, where he
                                                                                                   (2) the insider debt was incurred in
2007), the U.S. Bankruptcy Court for the
                                                    advises debtors, secured and
                                                                                                   violation of the prepetition financing
Northern District of New York addressed
                                                    unsecured creditors and other parties in
                                                                                                   documents that prohibited the incurrence
the issue of whether a creditor has standing
                                                    interest in bankruptcy cases, workouts
                                                                                                   of additional indebtedness; (3) the debtors
to prosecute an equitable subordination
                                                    and cross-border ancillary proceedings.
                                                                                                   knowingly misrepresented that they owed
action against another creditor without first     subordination is appropriate are the             no debt for borrowed money; (4) the
obtaining approval from the bankruptcy            following: (1) when a fiduciary of the           debtors concealed the existence and extent
court. The court held that a creditor does        debtor misuses its position to the               of the insider claims from the debtors’
have such standing. The court determined          disadvantage of other creditors; (2) when        lenders; and (5) the debtors were
that: (1) equitable subordination claims          a third party controls the debtor to the         undercapitalized at the time the insider debt
arising under §510(c) of the Bankruptcy           disadvantage of other creditors; and (3)         was allegedly incurred. The defendants
Code, unlike avoidance claims arising             when a third party actually defrauds other       filed a motion to dismiss the adversary
under §§547 and 548 of the Code, are not          creditors.                                       proceeding on several grounds, including
claims belonging to the estate; and (2) the           Courts have disagreed on which parties       that the plaintiffs lacked standing to bring
concerns necessitating bankruptcy court           have standing to assert equitable-               the action. The defendants argued that in
                     approval before a            subordination actions. Some courts have          bringing the subordination claim, the
                     creditors’ committee         held that equitable subordination is a
                     may       bring      an
                     e q u i t a b l e
                     subordination claim            Claims Chat
                     do not exist for
                     individual creditors.        creditor’s claim, while other courts have        plaintiffs were acting in a representative
                                                  held that subordination is strictly the          capacity and lacked standing to bring the
                      Equitable                   estate’s claim. In the latter situation,         claim because they failed to obtain
                      Subordination               therefore, a creditor (or creditors’             authority from the bankruptcy court to act
                       Equitable subord-          committee) may have standing, but only           on behalf of the other unsecured creditors.
Andrew Rosenblatt

ination, codified in §510(c) of the Code, is      after obtaining court approval when a                In support of their position, the
an equitable and extraordinary remedy that        debtor-in-possession or trustee has              defendants relied on cases for the
permits a court “to subordinate for purposes      unjustifiably declined to act.                   proposition that claims for equitable
of distribution all or part of an allowed
                                                                                                   subordination must be brought by a trustee
claim to all or part of another allowed claim
                                                                                                   or debtor-in-possession as a representative
                                                  Case Background
or all or part of an allowed interest to all or       In Algonquin, the debtors’ prepetition
                                                  lenders (the plaintiffs) commenced an            of the estate. The defendants then argued
part of another allowed interest.” In
                                                  adversary proceeding against certain of the      that an adversary proceeding commenced
general, equitable subordination applies
                                                  debtors’ affiliates and insiders (the            by a party in a representative capacity
only when a claimant has engaged in some
                                                  defendants) seeking to challenge the             cannot be maintained without (1) the
type of inequitable conduct and the
                                                  insiders’ intercompany claims, all of which      unjustifiable refusal of the trustee or debtor-
misconduct has resulted in injury to
                                                  appeared on the debtors’ schedules as valid      in-possession (DIP) to bring the suit and
creditors or equity holders or has conferred
                                                  claims. Specifically, the plaintiffs sought to   (2) court approval to act as a representative
an unfair advantage on the claimant. The
                                                  (1) expunge the insider claims, (2) have the     after the party seeking to act has moved the
most common scenarios when equitable
                                                                                                   court for permission to do so.
        44 Canal Center Plaza, Suite 400 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abiworld.org
     The plaintiffs countered by arguing that          Finally, the bankruptcy court
it would have been futile to have requested       distinguished a recent case decided by the
                                                                                                    Reprinted with permission from the ABI Journal,

the debtors to commence the adversary             Second Circuit Court of Appeals in In re
                                                                                                    Vol. XXVII, No. 9, November 2008.

proceeding given that the defendants were         AppliedTheory Corp., 493 F.3d 82 (2d Cir.
                                                                                                    The American Bankruptcy Institute is a multi-
affiliates of the debtors and that the debtors,   2007), which held that a creditors’
                                                                                                    disciplinary, nonpartisan organization
in their bankruptcy papers, had already           committee must seek court approval before
                                                                                                    devoted to bankruptcy issues. ABI has more
conceded the validity of the defendants’          bringing an equitable subordination action
                                                                                                    than 11,500 members, representing all
claims. The plaintiffs also argued that the       against a creditor. The bankruptcy court held
                                                                                                    facets of the insolvency field. For more
cases relied on by the defendants were            that the Second Circuit’s rationale for
                                                                                                    information, visit ABI World at
distinguishable and not relevant to the facts     requiring bankruptcy court approval before
at hand because they involved avoidance           a creditors’ committee can commence a
claims (i.e., preference and fraudulent           subordination action does not apply to
conveyance claims under §§547 and 548             individual creditors. Specifically, the
of the Code) which, pursuant to the Code,         bankruptcy court noted that unlike litigation
belong to the trustee or DIP. The plaintiffs      commenced by a committee, which is
noted that, unlike §§547 and 548 of the           funded out of the limited resources of the
Code, the language of §510(c) of the Code         estate, litigation commenced by an
does not provide that equitable                   individual will rarely be funded by the estate.
subordination claims belong to the estate.        Accordingly, the bankruptcy court reasoned
                                                  that cost monitoring and other administrative
Ruling                                            concerns relevant to a creditors’ committee
     The bankruptcy court adopted the             are not implicated when dealing with an
plaintiffs’ position and denied the               individual creditor. In short, the bankruptcy
defendants’ motion to dismiss. First, the         court held that the Second Circuit’s ruling
bankruptcy court rejected the defendants’         was limited to creditors’committees and did
position that the plaintiffs were acting in       not provide a basis for denying the plaintiffs
a representative capacity. The bankruptcy         the right to pursue the subordination action.
court made this determination despite the
fact that the plaintiffs sought to subordinate    Conclusion
the defendants’ claims to those of all other           Although the bankruptcy court’s ruling
unsecured creditors. In support of this           only addressed the narrow issue of whether
finding, the bankruptcy court adopted the         a creditor has standing to assert a
reasoning set forth by the Seventh Circuit        subordination claim against another creditor
Court of Appeals in In re Vitreous Steel          without prior court approval, the holding
Prods. Co., 911 F.2d 1223 (7th Cir. 1990),        raises questions that could have far-reaching
that equitable subordination is not a benefit     implications. For example, in rejecting the
to all unsecured creditors equally (in            notion that equitable subordination claims
particular the creditor whose claim is            reflect generalized harm to all creditors and
objected to) and therefore, a creditor that       must be brought in a representative capacity,
seeks equitable subordination is not              has the bankruptcy court implicitly held that
necessarily acting in the interests of all        debtors do not have standing to assert a
unsecured creditors.                              subordination claim? It is well established
     The bankruptcy court then rejected the       that a trustee in bankruptcy may only pursue
notion that a creditor must seek court approval   claims that belong to the estate itself and has
before bringing an equitable-subordination        no standing to sue third parties for injuries
claim. In reaching this conclusion, the           to the estate’s creditors. If Algonquin can be
bankruptcy court distinguished cases              interpreted as standing for the proposition
involving avoidance actions, which are estate     that equitable subordination claims should
claims that require prior court approval. In      be considered solely creditor claims, then
support for its holding, the bankruptcy court     that may preclude a debtor or trustee from
relied on a recent decision from the Eighth       asserting a subordination claim. If the
Circuit Bankruptcy Appellate Panel in In re       answer is that both debtors and creditors
Racing Services Inc., 363 B.R. 911 (8th Cir.      have standing to assert subordination
B.A.P. N.D. 2007), which held that although       claims, then that could lead to
a creditor must seek authority in order to have   administrative and procedural problems.
derivative standing to assert an avoidance             In short, Algonquin may have
action on behalf of the estate, a creditor is     generated more questions than it answers.
under no obligation to seek court authority to    Given the lack of any bright-line rule, the
assert a subrogation claim. The court’s           issue of creditor standing to assert an
reasoning was based on the language of            equitable subordination claim may be the
§510(c), which contains no restrictions on        subject matter of future bankruptcy
who may request the subordination of a            litigation. I

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