AMERICAN INSTITUTE JOURNAL Issues and Information for Today’s Busy Professional Equitable Subordination: Good-Faith Transferees Beware

Written by: About the Author Bankruptcy Court’s Decision Jeffrey D. Saferstein In its decision, the bankruptcy court Paul, Weiss, Rifkind, Wharton Jeffrey Saferstein is a partner and the first examined the language of §510(c) & Garrison LLP; New York deputy chair, and Penny Dearborn is an and found that its purpose is to advance [email protected] associate, in the Bankruptcy and equitable distribution among .1 Penny Dearborn Corporate Reorganization Department The bankruptcy court then analyzed the Paul, Weiss, Rifkind, Wharton of Paul, Weiss, Rifkind, Wharton & controlling three-part test for determining & Garrison LLP; New York Garrison LLP. if a claim should be equitably subor- [email protected] dinated, which was first articulated in Benjamin v. Diamond (In re Mobile Steel Editor’s Note: Paul, Weiss represents a adversary proceeding against various Co.), 563 F.2d 692 (5th. Cir. 1977).2 The party in the matter. , including Fleet. In that action, bankruptcy court next considered whether Enron alleged, among other things, that n a recent decision in the Enron §510(c) grants a court authority to Fleet and other named defendants chapter 11 case, Enron Corp. v. equitably subordinate claims unrelated to (1) received preferential and fraudulent Avenue Special Situations Fund II L.P. any misconduct, but that are held by a I transfers, and (2) participated in pre- (the “Enron Opinion”), Judge Arthur alleged to have engaged in petition inequitable misconduct with Gonzales of the U.S. Bankruptcy Court inequitable conduct regarding the . respect to Enron, which injured Enron’s for the Southern District of New York The bankruptcy court ruled that it has creditors and gave an unfair advantage ruled that bank claims held by post- petition transferees may be equitably subordinated pursuant to §510(c) of the Bankruptcy Code, 11 U.S.C. §§101, et Feature seq., on the basis that the transferors to Fleet and the other named defendants. engaged in inequitable pre-petition such authority, citing as support the Fleet and the other bank defendants have conduct. This is an unprecedented pronouncement in Mobile Steel that vigorously contested these allegations, expansion of the doctrine of equitable “[i]mproper acts unconnected with the which have yet to be adjudicated by the subordination, and the decision’s acquisition or assertion of a particular bankruptcy court. significance extends beyond Enron and claim have frequently formed at least a In early 2005, Enron commenced an threatens serious disruption to the part of the basis for the subordination of adversary proceeding against the distressed debt-trading markets. that claim.” Enron Opinion, p. 23. purchasers of the claims (collectively, the Next, the bankruptcy court considered Background “defendants”) in which it sought, among whether claims that could have been Prior to filing for chapter 11 other things, equitable subordination of equitably subordinated in the hands of the protection, Enron borrowed $3 billion the claims based on the alleged original transferor remain subject to under short- and long-term credit misconduct of Fleet. The defendants subordination in the hands of a transferee. agreements from a consortium of banks, moved to dismiss the adversary Commenting that “[t]here is no basis to including Fleet National Bank. proceeding asserting that they, unlike Subsequent to Enron’s filing, Fleet Fleet, were not alleged to have engaged 1 Section 510(c) of the Code provides, in relevant part: “Notwithstanding subsections (a) and (b) of this section, after notice and a hearing, the transferred 100 percent of its claims in any inequitable conduct. The court may...(1) under principles of equitable subordination, subordinate defendants argued that their claims cannot for purposes of distribution all or part of an allowed claim to all or part against Enron, pursuant to these credit of another allowed claim....“ 11 U.S.C. §510(c). agreements (the “claims”), to various be equitably subordinated because 2 The Mobile Steel test provides that a claim may be subordinated upon §510(c) of the Code requires inequitable three essential findings: entities; some of these claims were 1. The claimant must have engaged in some type of inequitable subsequently transferred to other conduct by the party holding the subject conduct. claims. On Nov. 17, 2005, the bankruptcy 2. The misconduct must have resulted in injury to the creditors...or purchasers. conferred an unfair advantage on the claimant. Almost two years after Enron’s court denied the defendants’ motion to 3. Equitable subordination of the claim must not be inconsistent with the provisions of the Bankruptcy Act. In re Mobile Steel, 563 F.2d at chapter 11 filing, Enron commenced an dismiss. 700 (citations omitted).

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find or infer that transferees should enjoy be asserted against the claim. transferor. The bankruptcy court instead greater rights than the transferror,” the attempts to justify its holding on “two bankruptcy court concluded that §510(c) The Appeal inapposite areas of the law: the law of permits a court to subordinate a claim The defendants immediately appealed assignments and case law addressing held by an innocent transferee based the decision, asserting that the bankruptcy transferees of priority wage claims.” solely on the misconduct of a court had erred in holding that (1) §510 Appeal Brief, p. 14. The defendants were predecessor-in-interest. Enron Opinion, of the Code permits subordination of a especially troubled by the bankruptcy p. 29. In reaching this conclusion, the claim in the hands of a transferee based court’s reliance on Shropshire as bankruptcy court relied on case law solely on the fact that a predecessor in authority for its holding because, in the dealing with the law of assignments and interest—but not the transferee—engaged defendants’ view, Shropshire is addressing transferees of priority wage in misconduct; and (2) the defense of inapplicable in the context of the claims. In particular, the bankruptcy court good faith was not available to an equitable subordination of transferred focused on a decision in Shropshire, innocent transferee who acquired a claim claims. The defendants contend that the Woodlife & Co. v. Bush, 204 U.S. 186 in good faith and for value. The “statutory priority of wage claims (1907), a case involving the priority of defendants also argued in the appeal that derives from the ‘character’ of the claim assigned wage claims. in making its decision, the bankruptcy itself” and that “the character of the In Shropshire, the U.S. Supreme Court court failed to take into account the claim, i.e., a claim for wages, does not found that an assignment of a wage claim, profoundly disruptive effect its ruling will change upon its assignment.” Appeal voluntarily assigned pre-petition, does not have on the distressed-debt markets. In Brief, p. 16. By invoking the holding in affect the statutory priority afforded to that addition to the briefs filed by the Shropshire, the defendants assert that the claim. The Shropshire court reasoned that defendants, an amici brief was filed in bankruptcy court erroneously concluded because the statutory priority attached to support of the appeal by certain industry that the priority adjustment of a claim the wage claim as the debt was incurred, participants (the “amici”), including the due to equitable subordination derives the right to such priority is not altered Loan Syndications and Trading Asso- from the “character” of the claim, when simply because it is asserted by an ciation. in fact, the priority adjustment of a claim assignee. The bankruptcy court analogized Principles of Equitable derives from a particular claimant’s the circumstances in Shropshire to those misconduct. The defendants insist that in the present case and found that a Subordination the principles of equitable subordination transferee steps into the shoes of the On appeal, the defendants argued that offer no support for the bankruptcy transferor at the time of the transfer. in deciding that §510(c) permits a court court’s finding that “the adjustment of To support its decision, the bank- to subordinate a claim held by an priority of a claim resulting from ruptcy court relied heavily on policy innocent transferee based solely on the subordination is attached to such claim concerns. Specifically, the court was misconduct of a predecessor in interest, and it travels with any subsequent concerned with the burden that a debtor the bankruptcy court disregarded the transfer.” Appeal Brief, p. 16 (quoting might face if it were not permitted to legislative history of §510(c), which in Enron Opinion, p.33). subordinate the claims of innocent their view demonstrates Congress’ intent transferees based on the misconduct by that misconduct by the holder of a claim Protection for Good Faith, their predecessors in interest. It found be an essential element in equitably Value Transferees that the “necessity of collecting subordinating a claim. The defendants Both the amici and the defendants damages in lawsuits against each of the further assert that the bankruptcy court’s argue in their respective briefs that the original or previous holders who holding contradicts the clear language of bankruptcy court failed to apply the well- engaged in inequitable conduct” would Mobile Steel’s controlling three-part test established equitable principle that affords “delay the ultimate distribution by the for determining if a claim can be protection to transferees that acquire debtor, which delay is contrary to the equitably subordinated. The first of the claims in good faith and for value. The goal of the Bankruptcy Code.” Enron three essential elements is that there must defendants note that several sections of Opinion, p. 36. be a finding of misconduct on the part of the Code provide protection for innocent As for defenses, the bankruptcy court the particular claimant holding the claim. transferees. Specifically, the Code states held that its construction of §510(c) The defendants contend that the that while §550(b)(1) provides that a affords no protection to transferees that bankruptcy court’s holding “contort[s] the trustee may sue to recover transferred acquire claims in good faith and for value. definition of ‘claimant’ to mean ‘the property or its value from a subsequent The bankruptcy court based its holding in claimant or any party that previously transferee, it also provides a defense for part on the absence of any explicit asserted the claim,’” a construction that “a transferee that takes for value...and provision in the Code establishing a plainly contradicts the clear language of without knowledge of the viability of the defense to equitable subordination under Mobile Steel and its progeny. Appeal transfer avoided.” The defendants §510(c) for good-faith transferees. The Brief, p. 13. contend that the inclusion of a good-faith bankruptcy court further reasoned that the The Appeal Brief also highlights the defense in §550(b)(1) demonstrates “(a) good-faith defense is not applicable in the bankruptcy court’s failure to offer any where Congress intended to impose context of equitable subordination authority for the proposition that liability on subsequent transferees, it because all claim transferees by definition principles of equitable subordination knew how to do so (and chose not to do know they are purchasing a claim against permit the subordination of claims held so in §510(c) by not referring to a debtor and know that any defense, by an innocent, for-value transferee transferees); and (b) where Congress did including equitable subordination, may based solely on the misconduct by a create a remedy against subsequent

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transferees, it provided protection to In addition, the defendants and amici buyer, who may discount their bids good-faith purchasers for value.” Appeal contend that equitable subordination is accordingly. The amici argue that the Brief, p.17. merely a supplemental remedy to the bankruptcy court’s analysis, with its The defendants and the amici primary form of relief: the right to sue an myopic focus on the supposed benefits continue their criticism by asserting that alleged wrongdoer for damages resulting its decision would provide to , the bankruptcy court’s holding prevents from the alleged inequitable conduct. fails to account for the tremendous a transferee from ever establishing the Accordingly, the defendants and amici burdens its decision places on market prerequisite of a good-faith defense. argue that facilitating the use of this participants and the judicial system. The According to the bankruptcy court’s supplemental remedy, plus any purported defendants and amici contend that the opinion, because all claims transferees, incremental “administrative burden” on decreased liquidity in the bankruptcy by definition, know they are purchasing a debtor unable to assert an equitable claims market, due to higher risk a claim against a debtor and are on notice subordination claim against an innocent premiums and fewer claims buyers, will that a fiduciary is charged with transferee, cannot justify the disruptive result in higher credit costs for investigating each claim and asserting any effect the decision will have on the borrowers. A primary mechanism for a defense, including equitable subor- claims-trading market and the unfair lender to stem its losses if a borrower dination, all claims transferees are on burden it imposes on innocent transferees. defaults is its ability to sell its claims, and notice of the risk of equitable The defendants and amici argue that the viability of this exit strategy is subordination. The defendants and the the bankruptcy court downplayed the dependent on the availability of a liquid amici argue that this interpretation of effect its decision would have in that market for claims trading. If “exit-by- “good faith” is unprecedented and market and erred in citing secondary sale” becomes a less-attractive option for untenable. Notice of a debtor’s sources to justify its holding, rather than lenders due to claim buyer’s demand for bankruptcy at the time a claim is relying on the views of actual market greater discounts, the result will be that purchased is not an element of an participants (such as the amici). lenders will demand more stringent equitable subordination action; by It is the amici’s position that this terms, which could price many distressed adopting such a test, the bankruptcy court decision will have profound effects on the borrowers out of credit markets and is, in essence, defining away the good- market for bankruptcy claims and could increase the number of . faith defense as “any purchaser of a decrease liquidity in what is otherwise an bankruptcy claim must, by definition, be efficient, healthy market. One such effect Conclusion on notice of the debtor’s bankruptcy.” is that claim buyers, in order to analyze The bankruptcy court’s holding in Appeal Brief, p. 20 their increased risk, will require more Enron Corp. v. Avenue Special Situ- extensive due diligence into the actions ations Fund II L.P. disregarded Decision’s Effect of all previous claim owners—slowing traditional principles of equitable on Distressed Markets the claims-trading process and increasing subordination, centuries of precedent The defendants and the amici further costs. with regard to good-faith purchasers and assert that although the bankruptcy court Other effects may include the the serious potential disruption to the devoted much of its opinion to a series requirement of indemnities from sellers distressed claims-trading market that of “policy arguments” as justification for in order to minimize the new risk of will result if the bankruptcy court’s its decision, it ignored the crippling effect equitable subordination. As indemnities opinion remains law. It is bad law for this decision will have on the entire are only as valuable as the financial distressed companies, traders of dis- claims trading market. condition of the indemnifying party, the tressed debt and the distressed-debt The bankruptcy court’s policy jus- claims purchaser will require more markets as a whole, and should be ■ tifications for its decision focus on the extensive due diligence on the credit- overturned on appeal. burden a debtor might bear if it was not worthiness of the seller. In addition, there Reprinted with permission from the ABI permitted to subordinate the claims of is a potential for a stream of litigation up Journal, Vol. XXV, No. 3, April 2006. innocent transferees based on the the chain of title when claims are bought The American Bankruptcy Institute is a misconduct of their predecessors in and sold multiple times. For example, if multi-disciplinary, nonpartisan orga- interest. The potential burdens the a debtor brings an equitable subor- nization devoted to bankruptcy issues. ABI bankruptcy court was concerned about dination suit against the ultimate buyer has more than 11,000 members, include the administrative burden of of a claim, the buyer would bear the cost representing all facets of the insolvency collecting damages in lawsuits against and expense of such litigation, plus any field. For more information, visit ABI World previous holders who engaged in litigation necessary to enforce any at www.abiworld.org. misconduct, and the uncertainty and delay indemnification rights it may have attendant to litigation. The defendants and against the transferor of that claim. In amici argue, however, that the bankruptcy turn, the transferor, if it is not the court’s reasoning ignores the fact that wrongdoer, would most likely bring suit before a debtor can subordinate a claim, against its respective transferor and, it must first establish the misconduct of where a claim has been transferred the claim’s original holder. This multiple times, so on up the chain of title requirement means that the debtor must until the litigation reaches the transferor still engage in time-consuming and who engaged in inequitable conduct. uncertain litigation, and thus the burden These additional risks of litigation will or delay will not be appreciably different. have to be considered by any claims

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