Creditor dissatisfaction with bankruptcy is again peaking as the number of consumer bankruptcy filings is on an upswing. As a result, creditor-sponsored bills pending in Congress attempt to restrict the use of straight bankruptcy for "higher income" filers. Still overall, the present day treatment of business failure may have improved as compared to past cultures. In 16th century Italy, for instance, a debtor seeking discharge would have to 'go naked in a public and notorious place', "like the Piazza". [James Q. Whitman, The Moral Menace of Roman Law and the Making of Commerce: Some Dutch Evidence, 105 Yale L.J. 1841, 1871 (1996), quoting Matteo Bruno, Tractatus Matthaei Bruni Arimineni de Cessione Bonoru 115 [v] (Venice 1561)]. There the debtor would have to " 'strike [ ] his backside' "three times against something called "The Rock of Shame," while "crying out, ' I DECLARE BANKRUPTCY,' " Id.
While today we are more relaxed about business failure, the devil continues to be in the details.
II. THE LIMITS OF RECLASSIFICATION OF INSIDER CREDITOR CLAIMS THROUGH EQUITABLE SUBORDINATION
A.Equitable Subordination.
Section 510(c) of the Bankruptcy Code allows bankruptcy courts to apply judicially developed principles of equitable subordination. Section 510(c) provides:
(1)under principles of equitable subordination, subordinate for purposes of distribution all of part of an allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or part of another allowed interest; or
(2)order that any lien securing such a subordinated claim be transferred to the estate.
11 U.S.C. Sec. 510(c).
On its face, it appears Congress granted broad equitable powers to the Bankruptcy Court to reorder creditor priorities depending upon the circumstances. Section 510(c) is silent as to the principles to be utilized for such reorderings. To date, the most influential decision addressing the issue has been the 1977 opinion of the 5th Circuit in In re Mobile Steel Co., 563 F.2d 692. (5th Cir. 1977). Mobile Steel set down three conditions a Bankruptcy Court must find to exist before it equitably subordinates a claim. First, "[t]he claimant must have engaged in some type of inequitable conduct", Mobile Steel Co., 563 F.2d at 700. Second, "[t]he misconduct must have resulted in injury to the creditors of the bankrupt or conferred some unfair advantage on the claimant". Third, "[e]quitable subordination of the claim must not be inconsistent with the provisions of the Bankruptcy [Code]". Id.
Mobile Steel therefore requires the Bankruptcy Court to search for inequitable conduct as a first step. If there is no inequitable conduct, a Bankruptcy Court cannot subordinate a claim. In re Lifschultz Fast Freight, 132 F.3d 339 (7th Cir. 1997). U.S. v. Noland, 517 U.S. 535, ____, 116 S.Ct. at 1526-27.
In the context of equitable subordination, "inequitable conduct" generally falls into the following categories: "(1) fraud, illegality, breach of fiduciary duties; (2) undercapitalization; and (3) claimant's use of the debtor as a mere instrumentality or alter ego." In re Lifschultz, supra. See also, Asa S. Herzog & Joel B. Zweibel, The Equitable Subordination of Claims in Bankruptcy, 15 Vand. L.Rev. 83, 90 (1961).
B.Recalling the Context.
Before proceeding further in reviewing the Lifschultz application of equitable subordination of insider claims, it may be useful to recall the typical factual context in which the Courts are attempting to resolve the claims' priorities. In a particularly well reasoned decision, the 7th Circuit dealt with the attempts by insiders to lend money to save a failing business. In Lifschultz Fast Freight, 132 F.3d 339 (7th Cir. 1997) the Court described a typical case:
"A business is ailing. Revenues are down, profits gone. Rather than let it lie, the owners decide to try reviving it. Doing so will require an infusion of new funds. The owners drum up the needed funds but face a choice: which legal form should the owners use, equity or debt?
If the business is closely held, the advantage will be to debt, prefereably secured. Equity classically carries the right to the firm's residual earnings. But in a closely-held company, this advantage means little, for the owners already have it through their pre-existing equity stakes. A loan, on the other hand, will provide the firm with needed funds while limiting the owners' risk that the company will go brankrupt and the new funds will end up in the wallets of the unsecured creditors. Tax advantages might also accrue. Of course, in opting for debt, the owners also accept a trade-off: outside lenders will or ought to be more reluctant to extend credit to what is now a more heavily-leveraged firm.
An unfair advantage to the owners, allowing them to reap the benefits of both debt and equity? Maybe. Will a bankruptcy court respect this choice of form? Not always. The power of equitable subordination, codified at 11 U.S.C. Section 510(c), allows a bankruptcy court to relegate even a secured claim to a lower tier, even to the lowest - the equity tier."
In Lifschultz itself, the debtor had been in the shipping business since the turn of the century. However, deregulation and the extreme level of competition in the trucking business lead the company to lose money in the later 1980's beginning with a $400,000 loss in 1985 and up to a $5.5 million loss in 1989. The insiders attempted to revive the company. The insiders created a new company to which funds were lent by one of the insiders' affiliated companies, Salson Express Company, Inc. The monies lent by Salson were borrowed by individual shareholders of Lifschultz and Salson and the insiders in turn lent the money on a secured basis to Salson Express which in turn lent the money to the debtor under a loan agreement. Thereafter, additional financing was found with a factoring company. With the factors' loan the debtor paid off all but $300,000 of the insider secured loan at the time of the bankruptcy petition. The additional loans and capital did not stop operating losses and bankruptcy ensued. The trustee attacked the loan agreement and the remaining $300,000 owed primarily on the basis that the debtor was "undercapitalized" at the time of the insider transaction.
After reviewing the principles of equitable subordination described above, the 7th Circuit made an excellent analysis of the use of undercapitalization as a possible factor to indicate inequitable conduct but held undercapitalization itself is not inequitable conduct in and of itself sufficient to justify equitable subordination. While conceding that under capitalization "sounds bad", the Court explained that under capitalization "just means that the company does not have enough funds on its balance sheet or in its till. It is a common token of declining business fortune." Id. at 345. The Trustee had argued that "insufficient capital leads to financing the operation with secured debt, and that exposes the unsecured commercial creditors to greater risk of loss." The Court in Lifshultz agreed, but again, asked "where is the wrong?" Id. at 346. The Court noted that "creditors take the risk of dealing with undercapitalized firms and are free to adjust their credit terms or lend elsewhere." Id. at 346. The Court, however, noted that the "morals of the marketplace" forbid deceit and that insiders may not take advantage of their superior knowledge of the company to deceive outsiders. So, if the borrowing company misleads a lender or creditors regarding its financial health, this can constitute the lack of fairness to lead to a finding of inequitable conduct. The Court also distinguished the facts before it from situations where an insider converts a preexisting equity claim into debt. Ryckman v. Envirodyne Indus., Inc. ___ U.S. ___, 117 S.Ct. 77, 136 LEd.2d 36. (1996). In Lifschultz the insiders had contributed fresh working capital.
The 7th Circuit then discussed the problem arising from wrongful or unpredictable subordination by courts and the creation of legal uncertainty of a particular type: "the risk that a court may refuse to honor an otherwise binding agreement on amorphus grounds of equity." The 7th Circuit noted that if a court wrongfully subordinates its claim, "other investors are sure to take heed." The Court in Lifschultz for these reasons stated that the Bankruptcy Court "should be doubly wary of using its power of equitable subordination." The Court concluded that "under capitalization alone, without evidence of deception about the debtor's financial condition or other misconduct, cannot justify equitable subordination of an insider's debt claim." Id. at 349.
C.Further Limitations on Treating the Shareholder/Debtor as a Disfavored Class are Given by the Supreme Court in Noland.
In applying equitable subordination some Courts have held that certain categories of claims required no showing of inequitable conduct for subordination. The most recognized category of such claims was the equitable subordination of non-pecuniary loss tax penalty claims. Some courts have extended this exception to the requirement for a showing of inequitable conduct, to in some instances, "reclassifying" shareholder loans from debt to equity. See e.g., SPC Plastics Corp. v. Griffith (In re Structure Light Plastics Corp.), 193 B.R. 451 (Bankr.S.D.Ohio 1995) (where the Court reclassified shareholder loan for redemption of the shareholder's shares and subordinated this as equity and subordinated the shareholder's interest to claims of the unsecured creditors.) However, the Supreme Court in U.S. v. Noland, 517 U.S. 335, 116 S.Ct. 1524, 134 L.Ed.2d (1996) reversed the 6th Circuit and held that bankruptcy courts could not categorically equitably subordinate tax penalty claims.
The Supreme Court in Noland reasoned that had Congress intended to categorically equitably subordinate tax penalty claims, that Congress would have said so in its priority scheme. The Court intended to give bankruptcy courts some power to apply equitable subordination to the circumstances but it did not intend to give the bankruptcy courts the power to legislate:
[T]he adoption in Sec. 510(c) of "principles of equitable subordination" permits a court to make exceptions to a general rule when justified by particular facts . . . . But if the provision also authorized a court to conclude on a general, categorical level that tax penalties should not be treated as administrative expenses to be paid first, it would empower a court to modify the operation of the priority statute at the same level at which Congress operated when it made its characteristically general judgment to establish the hierarchy of claims in the first place. That is, the distinction between characteristic legislative and trial court functions would simply be swept away, and the statute would delegate legislative revision, not authorize equitable exception. We find such a reading improbable in the extreme. Id., 116 S.Ct. at 1527; citations omitted; emphasis added.
This language would appear to bar all forms of "categorical equitable subordination" including subordination of shareholder loans through simple "reclassification". However, the Supreme Court later in its opinion attempted to limit its holding:
"Given our conclusion that the Sixth Circuit's rationale [for equitable subordination of the tax penalty] was inappropriately categorical in nature, we need not decide today whether a bankruptcy court must always find creditor misconduct before a claim may be equitably subordinated. We do hold that . . . the circumstances that prompt a court to order equitable subordination must not occur at the level of policy choice at which Congress itself operated in drafting the Bankruptcy Code . . . .
In this instance, Congress could have, but did not, deny noncompensatory, postpetition tax penalties the first priority given to other administrative expenses, and bankruptcy courts may not take it upon themselves to make that categorical determination under the guise of equitable subordination."
Id. at 1528; citations omitted; emphasis and bracketed material added.
Despite the Court's attempt to limit its holding, the language utilized by the Supreme Court in its analysis is not confined solely to the context of tax penalties. The Court's admonition that "the circumstances that prompt a court to order equitable subordination must not occur at the level of policy choice at which Congress itself operated . . . " appear to apply to all forms of categorical equitable subordination. Arguably, if Congress had intended to subordinate shareholder loans regardless of the circumstances, then Congress could have done so in the priority statutes. See D. Schechter, "Inequitable Subordination: The End of Categorical Equitable Subordination?" Bankr. Lit. Vol. 4 No. 2, p. 3 (1996).
The Supreme Court in Noland appears to say that bankruptcy courts are not free to rewrite the bankruptcy priorities. Noland indicates bankruptcy courts must cease categorical equitable subordination type reasoning and find evidence of misconduct on the part of the former shareholders. With the Supreme Court's restrictions in Noland, bankruptcy courts may increasingly rely upon undercapitalization as the standard. However, under the reasoning in Noland and Lifschultz, the undercapitalization itself must also be accompanied by some other inequitable conduct.
III. THE LIENHOLDER'S RIGHT TO ADEQUATE PROTECTION
When Bankruptcy is filed, Section 362 of the Bankruptcy Code provides for an automatic stay of, among other things, a lienholder's action to realize the value of collateral given by the debtor. Under certain circumstances, the lienholder may obtain relief from stay under Subsection 362(d) which reads, in part, as follows:
"On request of a party in interest and after notice and a hearing, the Court shall grant relief from the stay provided under Subsection (a) of this section, such as by terminating, annulling, modifying, or conditioning such stay: (1) for cause, including the lack of adequate protection of an interest in property of such party in interest; or (2) with respect to a stay of an act against property under Subsection (a) of this section, if: (a) the debtor does not have an equity in such property; and (b) such property is not necessary to an effective reorganization."
Section 361 of the Code attempts to define adequate protection:
"When adequate protection is required under Section 362 . . . of this title of an interest of an equity in property, such adequate protection may be provided by: (1) requiring the trustee to make a cash payment or periodic cash payments to such entity, to the extent that the stay under Section 362 of this title . . . results in a decrease in the value of such entity's interest in such property; (2) providing to such entity an additional or replacement lien to the extent that such stay . . . results in a decrease in the value of such entity's interest in such property; or (3) granting such other relief
. . . as will result in the realization by such entity of the indubitable equivalent of such entity's interest in such property.
The Supreme Court in United Savings Association of Texas v. Timbers of Inwood Forest Associates, Ltd., 484 U.S. 365, 108 S.Ct. 626, 98 L.Ed.2d 740 (1988) articulated the rights of the under-secured creditor in bankruptcy under Section 362(d). In Timbers, the debtor filed its bankruptcy on March 4, 1985. On March 18, 1985, the secured creditor moved for relief from the automatic stay claiming lack of adequate protection of its interest in property. The debt was established to be $4,366,388.77. The evidence indicated the value of the collateral was between $2,650,000.00 and $4,250,000.00. The collateral was appreciating in value slightly. The creditor was therefore under-secured. The debtor had agreed to pay the creditor post-petition rents from the apartment project as provided in the security agreement, minus operating expenses. The secured creditor contended that it was entitled to additional compensation.
The Bankruptcy Court continued the stay conditional upon the payment by the debtor of interest on the estimated amount realizable at foreclosure of $4,250,000.00 commencing six months after the filing of the bankruptcy petition to reflect a normal foreclosure delay. The Bankruptcy Court held the post petition rents could be applied to those payments.
In its analysis, the Supreme Court first distinguished the situation before it based upon the lack of declines in the value in the apartment project collateral.
The Court noted that if the apartment project had been declining in value, the petitioner would have been entitled under Section 362(d)(1) to cash payments or additional security in the amount of the decline as described in Section 361. Id. 108 S.Ct. 630. Here, the issue was the secured parties' right to take immediate possession of its collateral.
The Court then analyzed the meaning of Section 362 in the context of the statutory scheme of the Bankruptcy Code. The Court proceeded to review the rights of the secured creditor to interest under Section 506. The Court noted that under Section 506(b), the secured creditor is entitled to post petition interest only where that creditor is an over-secured creditor. As to under-secured creditors, interest is disallowed. The Court concluded it would be incongruous to award adequate payments to the under-secured creditor as adequate protection given the lack of such entitlement as a matter of the claim of an under-secured creditor under Section 506. Id. 108 S.Ct. 631.
The Court refuted the secured creditor's contention that the under-secured creditor would face inordinate delay. The Court noted that once a movant under Section 362(d)(2) establishes that he is an under-secured creditor, it is the burden of the debtor to establish that the collateral at issue is necessary for an effective reorganization under Section 362(g). The Court held that this means both that the property will be needed for an effective reorganization and that the reorganization is in prospect. The Court ruled there must be a reasonable possibility of a successful reorganization within a reasonable amount of time. The Court noted the cases are numerous where relief from stay has been granted within less than a year from the time of filing a bankruptcy petition. While the Bankruptcy Court will demand a less detailed showing during the four months the debtor is given the exclusive rights to formulate a plan, (11 U.S.C. Section 1121(b), the lack of a realistic prospect of an effective organization if shown within even that period will require relief from stay.
The holding in Timbers is that the under-secured creditor is not entitled to post petition interest as compensation for the delay occasioned by reorganization where the collateral is not shown to be declining in value.
A.The Effect of Timbers on the Oversecured Creditors' Equity Cushion
Under the "Equity Cushion" theory developed in the case law, if a debtor has equity in property sufficient to shield the creditor from the declining value of the collateral or an increase in the claim from accrual of interest or expenses, then the creditor is adequately protected. Heritage Savings & Loan Ass'n. v. Rogers Development Corp. (In re: Rogers Development Corp.), 2 B.R. 679 (Bankr. E.D.Va. 1980) Vlahos v. Pitts (In re: Pitts), 2 B.R. 476 (Bankr. C.D.Cal. 1979). The equity cushion line of cases is consistent with the treatment of the claim of the over-secured creditor under Section 506. Under Section 506(b), an over- secured creditor has a secured claim for post petition interest and reasonable attorneys' fees (if provided for in the loan agreement) up to the excess value of the collateral over the creditors allowed pre-petition claims for principal and interest. United States v. Ron Pair Enters., Inc., 489 U.S. 235, 109 S.Ct. 1026, 103 L.Ed.2d 290 (1989).
In general, "case law has almost uniformly held that an equity cushion of 20% or more constitutes adequate protection. Under 11% is insufficient to constitute adequate protection. Case law is divided on whether a cushion of 12% to 20% constitutes adequate protection." In re: Kost, 102 B.R. 829, 831 (D.Wyo. 1989).
However, several courts since Timbers have reconsidered and rejected the equity cushion theory. See, In re: Lane, 108 B.R., 6 (Bankr. D.Mass. 1989). One decision from the Western District has joined this line of cases.
B.In re: Westchase I. Associates
The Western District's decision In re: Westchase I Assocs. L.P. 126 B.R. 692, (W.D.N.C. 1991) joined other cases in rejecting the equity cushion theory. Judge Mullen of the Western District, relying upon the holding of Timbers, held that so long as the value of the collateral itself is not declining, the creditor is not entitled to protection of the accruing interest value of its claim. Id. (Citing United Savings Association of Texas v. Timbers of Inwood Forest, Ltd., 484, U.S. 365, 372-373, 108 S.Ct. 626, 631, 98 L.Ed.2d 740 (1988)). Judge Mullen found that since the value of the property itself was not declining in the case before him, the creditor would not be entitled to protection of the accruing interest portion of its claim. Therefore, the District Court reversed the requirement of monthly interest payments to the secured creditor to protect its equity cushion during the reorganization. Thus, under Westchase, the Bankruptcy Court should order adequate protection only where the value of the security itself is declining and thereby reducing the value of the secured creditor's claim.
IV. DEALING WITH FORECLOSURE - ARE THERE ALTERNATIVES?
A.Workouts
1.Dealing with the fraudulent transfer issue
Section 548(a)(2) of the Bankruptcy Code allows the trustee or the debtor-in-possession to avoid any transfer of property made while the debtor was insolvent, under- capitalized, or incurring debts beyond the debtor's ability to pay if the debtor received "less than reasonably equivalent value in exchange for such transfer." Section 544 incorporates state law fraudulent transfer law. Sections 544 and 548(a)(2) can therefore be the basis for the undoing of a workout if bankruptcy follows. In such circumstances, transfers of collateral pursuant to a workout may be attacked as fraudulent conveyances. The secured creditor will have the burden of establishing the value given in exchanges for such transfers was reasonably equivalent. 11 U.S.C. Section 548(a)(2)(A). State laws set similar standards. The secured creditor may also want to consider whether or not he will be able to establish the debtor was not insolvent on the date of the transfer and did not become insolvent as a result of the transfers in any workout. 11 U.S.C. Section 548(a)(2)(B).
In weighing the relative advantage of attempts to workout defaults versus foreclosure, the Supreme Court has recently greatly diminished the possibility of a fraudulent transfer attack on properly conducted state law foreclosures.