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What is ‘Equitable Subordination’?

I recently discussed priority claims in New York bankruptcy in the context of the U.S. Supreme Court’s upcoming ruling on the future of “structured dismissals” in chapter 11. The case raises the issue of whether creditors can enter into an agreement, approved by the bankruptcy court, that repays some debtors ahead of others outside the order of priority claims. Another way payments to creditors can occur out of priority is through a doctrine called “equitable subordination,” which is less controversial, but something debtors may want to know about.

Subordination literally means placing something in a lower position than another. One situation in which it occurs that debtors might find familiar with is mortgage refinancing. If a debtor wants to refinance a senior mortgage, the senior mortgagee will not agree if the junior lienholder does not subordinate itself to the refinanced agreement. The parties enter into a subordination agreement that keeps the junior lienholder in its place to make the transaction worthwhile.

An equitable subordination works similarly: a creditor’s claim or interest in the bankruptcy estate is moved down a few pegs in the priority sequence. The section of the Bankruptcy Code enabling equitable subordination is 510(c). After the debtor or trustee initiates an adversary proceeding, the bankruptcy court can subordinate all or part of a creditor’s claim or interest, or it can order that any lien securing a subordinated claim be transferred to the bankruptcy estate.

The next question, of course, is: What makes this equitable?

The Bankruptcy Code doesn’t define the term, leaving it to existing case law, but the equitable subordination principle hinges on creditors engaging in some kind of wrongdoing or obtaining some unfair advantage that doesn’t always fit easily into the categories of preferential transfers or fraudulent conveyances. Usually this happens when the lender steps outside of its role as lender, like participating in the debtor’s business. The point is not to give money back to the debtor so much as to re-prioritize the creditors’ claims to minimize the damage the creditor has caused to the bankruptcy estate—and, ultimately, other creditors.

Because it’s a broad equitable remedy given to bankruptcy courts, they tend to use it narrowly to apply it consistently and fairly. Thus, bankruptcy courts seldom use it, and they ensure that doing so is not inconsistent with other provisions of the Bankruptcy Code. In practice, the most likely cases to see successful equitable subordination claims are ones in which the offending creditor is an insider or fiduciary of the debtor. Often these parties advance money to undercapitalized debtors or become their alter egos. These situations are similar to piercing the corporate veil in bankruptcy.

Equitable subordination gives bankruptcy courts another tool to ensure that bankruptcy is used fairly. If you have a complex bankruptcy case, then it’s essential to have an experienced New York bankruptcy lawyer handle your case.

For answers to more questions about bankruptcy, the automatic stay, effective strategies for dealing with foreclosure, and protecting your assets in bankruptcy please feel free to contact experienced Brooklyn bankruptcy attorney Bruce Weiner for a free initial consultation.

Rosenberg, Musso & Weiner, L.L.P
26 Court St # 2211
Brooklyn, NY 11242, USA

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