5th Circuit Rejects Equitable Subordination Claim With Deepening Insolvency Aspect; Insiders Not Subordinated for Stoking the Fires of a Sinking Ship

The Fifth Circuit has ruled that insiders who “grabbed for as much as they could get” were not subject to equitable subordination where the bankruptcy court did not find sufficient harm resulting from their conduct. The court rejected a theory of damages which it equated to deepening insolvency. Matter of S.I. Restructuring, Inc., 2008 U.S. App. LEXIS 13140 (5th Cir. 6/20/08).

Background

S.I. Restructuring involved the Schlotzsky’s sandwich chain. At the time, John and Jeffrey Wooley were officers, directors and the largest shareholders of the company. In April 2003, the Wooleys made a secured loan to the company for $1 million. The company and the Wooleys were each represented by separate counsel, the transaction was approved by the company’s audit committee and board of directors and the loan was reported in the company’s SEC filings.

The company’s finances continued to deteriorate and in October 2003, it sought financing from International Bank of Commerce. IBC declined to make a loan to Schlotzsky’s, but agreed to loan the money to the Wooleys for them to loan to the company. The board of directors was given just three days notice of the meeting to approve the loan, but were provided with copies of the proposed loan documents along with emails from the company’s assistant general counsel.

In mid-2004, the Wooleys were removed as officers and directors and the company for chapter 11 shortly thereafter. The unsecured creditors committee brought a complaint for equitable subordination against the Wooleys. The bankruptcy court found that John and Jeffrey Wooley, as fiduciaries, engaged in inequitable conduct in relation to the November transaction and that their conduct conferred an unfair advantage upon them. Specifically, the court found that the Wooleys breached their fiduciary duties by: (i) presenting the loan proposal to the board as a fait accompli; (ii) by securing the loan with the “crown jewel” of the Debtor’s assets; and (iii) by securing their contingent liability as guarantors. As a result, the bankruptcy court subordinated the secured claims to the level of the unsecured creditors.

Fifth Circuit Ruling

The Fifth Circuit reversed and rendered. The Fifth Circuit characterized equitable subordination as an “extraordinary remedy” and recited the following test from In re Mobile Steel Corp., 563 F.2d 692 (5th Cir. 1977): “(1) the claimant must have engaged in inequitable conduct; (2) the misconduct must have resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant; and (3) equitable subordination of the claim must not be inconsistent with the provisions of the Bankruptcy Code.” The Court also noted an additional requirement that “a claim should be subordinated only to the extent necessary to offset the harm which the debtor or its creditors have suffered as a result of the inequitable conduct.”

Applying this test to the April 2003 transaction, the appellate court found that the bankruptcy court had not made any findings of inequitable conduct or unfair advantage. As a result, it was necessary to reverse the subordination of this debt.

When examining the November 2003 transaction, the Fifth Circuit assumed without deciding that the record supported the findings of inequitable conduct and unfair advantage. The court went on to state, “However, the bankruptcy court made no finding of harm, and the record does not support a finding that either the debtor or the unsecured creditors were harmed by the November transaction.”

The Plan Administrator argued that the securing of the loan harmed the Debtor by diminishing the pool of assets available to unsecured creditors. On a certain level, the Plan Administrator was correct. Creditors would have been better off if the Wooleys had made unsecured loans to the company. However, the Fifth Circuit did not penalize the Wooleys for protecting their own interest. Instead, the court noted that the bankruptcy court had expressly found that the debtor needed the money and that the money had been used to pay unsecured claims. The Court stated:

“Because the loan proceeds were used to pay current unsecured creditors, unsecured creditors as a class, were not harmed when the Wooleys obtained security for for the November loan. The general unsecured creditors who were paid from the proceeds of the November loan may have benefitted to the detriment of another group of unsecured creditors, but this does not mean that unsecured creditors were harmed when the Wooleys obtained security for their loan.”

The Fifth Circuit also rejected the argument that the Wooleys harmed the company by loaning it additional funds which allowed it to continue operating until its condition worsened. Although the Appellee denied that it was relying upon deepening insolvency, the court found that this was exactly what was being alleged and rejected the theory. The Court stated that, “Deepening insolvency has been defined as prolonging an insolvent corporation’s life through bad debt, causing the dissipation of corporate assets.” The Court went on to state that:

“A deepening insolvency theory of damages has been criticized and rejected by many courts. We agree with the Third Circuit Court of Appeals, which recently concluded that deepening insolvency is not a valid theory of damages. The court recognized that deepening insolvency as a measure of harm depends on how the company uses the proceeds of the loan in question and ‘looks at the issue through hindsight bias.’”

As a result, the Fifth Circuit reversed and rendered.

What About Herby’s Foods?

S.I Restructuring has some factual similarities to Matter of Herby’s Foods, 2 F.3d 128 (5th Cir. 1993), an earlier decision which upheld equitable subordination. How then to reconcile the two cases?

In Herby’s Foods, the parent company purchased the debtor less than two years before it failed. Part of the consideration was payment of a debt to another entity. In return for this payment, the parent company took a lien against the debtor’s assets. Another related entity extended a secured line of credit to the company. Another insider made unsecured advances to the company. The secured claims were not perfected until shortly before bankruptcy. During the time between the acquisition and the bankruptcy filing, unsecured claims grew from about $900,000 to $4,600,000. The unsecured creditors’ committee sought to avoid the liens as preferential, to recharacterize the loans as equity and to subordinate the insider debts to the level of equity. The bankruptcy court granted all of the relief requested. On appeal, the Fifth Circuit affirmed, finding that the requisites for equitable subordination had been established, but did not reach the issue of recharacterization.

The Fifth Circuit found that a combination of undercapitalization, failure to disclose the existence of unfiled liens and advancing funds as loans rather than capital constituted inequitable conduct. The Fifth Circuit found that unsecured creditors were harmed by the fact that the amount of unsecured debt owed to third parties increased dramatically.

“The bankruptcy court found that the Insiders’ conduct harmed Herby’s outside creditors by significantly increasing their trade credit exposure and by reducing their ultimate dividend in the liquidation. Most importantly, the court found that the Insiders had secured an unfair advantage by structuring their cash contributions to Herby’s as loans, rather than as equity capital. If the Insiders were allowed to retain their ranking as unsecured creditors, they would have gained an advantage in the priority scheme by encouraging outside creditors to increase their credit to Herby’s. Their efforts were successful; those trade creditors substantially increased their credit to Herby’s during the period in question.”

Herby’s at 134.

The Court in Herby’s accepted the “deepening insolvency” model of damages which was expressly rejected in S.I. Restructuring. However, they did not call it deepening insolvency, a term which was not in vogue in 1993. Instead, the court analyzed the case as one involving deception and trickery. The bad Insiders (referred to with a capital I in the opinion) tricked the trade creditors into advancing more credit by advancing debt rather than infusing equity, by failing to timely record their liens and by failing to adequately record the loans on the company’s books, thus giving the appearance that the company was adequately capitalized. This caused the unsecured creditors to extend trade credit. The court did not cite any evidence that creditors had relied on the company’s books. It simply found that an increase in trade debt was enough to prove harm. However, the court in S.I. Restructuring expressly rejected an argument that an increase in trade debt standing alone was evidence of harm.

Scott Ritcheson (see Acknowledgement below) suggests that Herby’s Foods is best understood as a recharacterization case which was decided based upon equitable subordination. Section 510(b) allows the court to recharacterize a debt as equity without regard to inequitable conduct, while Section 510(c) is based upon principles of equitable subordination which courts have interpreted to require proof of inequitable conduct. In the Herby’s case, the evidence of inadequate capitalization, failure to record loans on the books and failure to treat the insider loans as debts would be evidence to support a finding of recharacterization (which was one of the grounds found by the bankruptcy court but not addressed by the court of appeals). On the other hand, in S.I. Restructuring, the company was publicly traded and the transactions were approved by an audit committee of outside directors and the full board and were reported as loans to the SEC. This greater level of formality may be the factor which reconciles the two apparently contradictory opinions.

Acknowledgement

My analysis in this article was strongly influenced by an excellent paper presented by Scott Ritcheson to the Annual Meeting of the Bankruptcy Section of the State Bar of Texas on June 26, 2008 entitled “Issues and Trends in Equitable Subordination.” Anyone litigating an equitable subordination issue would benefit significantly from reading Scott’s scholarly, comprehensive article. Scott can be reached at scottr@rllawfirm.net.