What Is Equitable Subordination in Bankruptcy?

Equitable subordination is a remedy a bankruptcy court uses to adjust the priority of a creditor’s claim, ensuring a fair distribution to other creditors. This legal doctrine is a corrective measure, not a punishment, applied when one creditor’s misconduct harms others. It allows a court to demote a specific claim in the payment hierarchy, meaning the offending creditor gets paid after others, if at all. The principle is designed to prevent a creditor who has acted improperly from benefiting at the expense of those who have acted in good faith.

Core Conditions for Subordination

For a court to apply equitable subordination, a three-part test established in the case Benjamin v. Mobile Steel Co. must be met. The party requesting subordination must prove three conditions. The first is that the creditor engaged in inequitable conduct. Second, this conduct must have injured other creditors or created an unfair advantage. Finally, applying subordination must be consistent with the U.S. Bankruptcy Code.

Inequitable Conduct

Inequitable conduct can include actions like fraud, misrepresentation, or a breach of fiduciary duties owed to the company and its stakeholders. The level of misconduct that must be proven varies significantly depending on the creditor’s relationship to the debtor company. A court’s analysis is highly specific to the facts of each case.

When the creditor is an insider, such as a corporate officer, director, or controlling shareholder, the standard for proving misconduct is lower. These individuals have a fiduciary responsibility to act in the best interests of the corporation. Actions like using their position to grant themselves a loan on preferential terms as the company is failing can be grounds for subordination. Courts scrutinize their actions closely because of their access to internal information and power to influence company decisions.

For non-insider creditors, like a bank or trade supplier, the bar for proving inequitable conduct is much higher. The conduct must be egregious, often described as “gross misconduct” similar to fraud. This could involve a lender exerting excessive control over the debtor’s business for its own benefit and to the detriment of other creditors. Merely exercising rights under a loan agreement is not enough; the behavior must be manipulative or deceptive.

Injury to Other Creditors or Unfair Advantage

The second condition requires a direct link between the creditor’s misconduct and a tangible harm to other creditors, such as a diminished financial recovery. This means other creditors will receive less than they would have if the misconduct had not occurred. The harm must be specific and quantifiable.

Alternatively, the conduct may have given the misbehaving creditor an unfair advantage. For example, an insider using knowledge of impending failure to convert their equity into secured debt gains an unfair advantage over other creditors. The court’s goal is to reverse that advantage and restore creditors to the financial position they would have occupied without the misconduct.

Consistency with the Bankruptcy Code

The final condition is that applying equitable subordination must not conflict with the Bankruptcy Code’s rules. This ensures a judge’s use of this power does not override the statutory framework. Section 510 of the Bankruptcy Code grants courts this authority, so its use aligns with the code’s intent.

Parties Subject to Subordination

Equitable subordination can be applied to different types of creditors, with the level of scrutiny depending on their relationship to the debtor. The Bankruptcy Code distinguishes between insiders and non-insiders, which influences how their actions are judged.

Insiders

Insiders are individuals or entities with a close relationship to the debtor, such as directors, officers, and controlling parties. The Bankruptcy Code also includes their relatives and business partners in this definition. Because they owe fiduciary duties and have the potential for self-dealing, their claims face the highest degree of scrutiny.

A common scenario involves an owner or director loaning money to their financially distressed company. While not automatically improper, the loan becomes suspect if its terms give the insider an advantage over other creditors. For instance, if an insider secures their loan with the company’s best assets right before a bankruptcy filing, a court may see this as an attempt to get paid first, justifying subordination.

Non-Insiders

Claims from non-insiders, like banks or suppliers, can also be subordinated, though this is rare as courts are reluctant to interfere with arm’s-length transactions. The party seeking subordination must prove the creditor engaged in egregious conduct.

This requires showing the non-insider exerted such control over the debtor’s business that it essentially operated as the debtor’s alter ego. This control must have been used to benefit the creditor at the expense of others. For example, a court might consider subordination if a lender forces a debtor to make decisions that harm other creditors while protecting the lender’s own claim.

The Subordination Process in Bankruptcy

The process for seeking equitable subordination is a formal legal action within the larger bankruptcy case. It is not a simple motion but follows a structured procedure with specific rules. This process ensures that a creditor’s claim is not demoted without due process.

Initiating the Action

The authority to pursue an equitable subordination claim rests with the bankruptcy trustee or the debtor-in-possession in a Chapter 11 case. These parties are responsible for investigating misconduct and have a duty to maximize recovery for all creditors. If they find evidence that a creditor’s actions have harmed the estate, they can file a claim.

A creditors’ committee may also be granted court permission to pursue the action on behalf of the estate. Less commonly, an individual creditor can receive court approval to file a subordination lawsuit if the trustee refuses to do so. This requires the creditor to show that the action would likely benefit the bankruptcy estate.

The Adversary Proceeding

An equitable subordination claim must be brought as an “adversary proceeding,” which is a formal lawsuit filed within the bankruptcy case. It is governed by procedural rules that mirror a regular civil lawsuit. The process begins with a formal complaint detailing the allegations of inequitable conduct and the resulting harm.

The defendant creditor must file an answer, after which the parties engage in discovery to gather evidence through document exchanges and depositions. If not settled, the case proceeds to a trial where the bankruptcy judge hears the evidence and issues a ruling.

Burden of Proof

The burden of proof in an adversary proceeding for equitable subordination is a shifting one. Initially, the plaintiff seeking subordination must present sufficient evidence to support the allegations of inequitable conduct.

If the plaintiff presents a credible case, the burden of proof shifts to the defendant creditor. The challenged creditor must then prove their actions were fair and did not harm other creditors or provide an unfair advantage. If they cannot rebut the plaintiff’s case with a satisfactory explanation and evidence, the court will likely subordinate the claim.

Consequences for Creditor Claims

When a court warrants equitable subordination, the consequences directly affect the priority and potential recovery of the offending creditor’s claim. The primary result is a change in the payment order, which is different from having a claim completely disallowed.

Reordering Claim Priority

The most direct consequence is the reordering of the creditor’s claim in the bankruptcy distribution hierarchy, which determines when it gets paid. For example, a secured claim that would normally be paid first could be demoted to the status of an unsecured claim. This would place it in the same payment pool as general unsecured creditors like suppliers and service providers.

In severe cases, an unsecured claim could be subordinated to be paid only after all other general unsecured creditors are paid in full. Because funds in a bankruptcy estate are often insufficient to pay all unsecured creditors, this level of subordination means the offending creditor may receive no payment. The court has the flexibility to decide the claim’s new, lower priority.

Distinction from Disallowance

Equitable subordination should be distinguished from claim disallowance. A disallowed claim is found to be invalid or unenforceable and is completely eliminated. A creditor with a disallowed claim has no right to any recovery from the bankruptcy estate.

In contrast, a subordinated claim remains a valid debt; subordination only changes its place in the payment line. The creditor’s right to payment is deferred until higher-priority claims are satisfied. If funds remain after paying all other creditors, the subordinated creditor is entitled to payment.

Scope of Subordination

A court can tailor the scope of subordination to the case’s specific circumstances, as the remedy is remedial, not punitive. The subordination should only extend as far as necessary to correct the harm caused. For instance, if misconduct caused a specific, quantifiable loss, the court might subordinate only a portion of the claim equal to that loss.

If the misconduct was minor or the harm was limited, the court may order a less severe form of subordination. However, if the conduct was egregious and harmed all other creditors, the court might subordinate the entire claim to the lowest possible priority.