The Inequities of Equitable Subordination.

• Author: Schwarcz, Steven L.

The doctrine of equitable subordination is extraordinary, enabling judges to change the relative repayment priorities of bargained-for creditor claims. The doctrine originated in 1939 to subordinate the intercompany claims of a parent company that plundered its subsidiary to the detriment of the subsidiary's innocent creditors. Over time, however, judges have inconsistently expanded the doctrine, sometimes to subordinate claims in a no-fault manner according to their personal views of equity. The resulting uncertainty distorts commercial expectations and raises the cost of credit. This Article examines how and why the doctrine devolved in this way and analyzes how the doctrine should be reconceptualized to preserve its equitable benefits while protecting fairness and ex ante expectations. Among other things, it argues that courts should adhere to a fault-based doctrine and that they should assess misconduct by a business judgment rule, similar to how courts assess corporate governance. Lastly, the Article explains why certain related doctrines of bankruptcy exceptionalism that often are conflated with equitable subordination--recharacterization and equitable disallowance--are confusing and irrelevant and should be discarded.

INTRODUCTION

Sitting as courts of equity, bankruptcy judges embrace an exceptionalist role whereby they exercise widespread discretion in deciding cases. (1) In this role, they "view their task of adjudication differently than other judges," (2) serving an equitable mission and applying "rough justice." (3) This enables bankruptcy judges to alter the relationships among debtors and creditors and to exercise significant powers in evaluating reorganisation plans, among other things. (4) While possibly inadvertent, this exceptionalist role has the potential to distort commercial transactions--and even financial markets--by up-ending participants' ex ante expectations.

Characterised by some courts as draconian, (5) the doctrine of equitable subordination epitomises bankruptcy exceptionalism and its potential for market distortion. Equitable subordination originated as a remedial measure to give innocent creditors of insolvent debtors priority over creditors that engage in malicious misconduct. The doctrine has devolved, however, into a practice where bankruptcy judges reform contracts by reallocating repayment priorities according to their individual perceptions of the equities of the case. (6) Sadly, the consequential uncertainty reduces fairness and increases the cost of credit. (7)

This Article begins by explaining equitable subordination and two related doctrines of bankruptcy exceptionalism--recharacterization and equitable disallowance--often conflated with equitable subordination. This Article seeks to demonstrate why these various principles should be replaced by a single integrated doctrine that protects market expectations while penalizing misconduct and preserving fairness, and to analyze that unified doctrine's design.

Part I of this Article explains equitable subordination's case law origins, while Part II discusses the doctrine's 1978 eponymous federal codification in the Bankruptcy Code (the "Code"), (8) including the ambiguous legislative history surrounding that codification. Part III of this Article examines how bankruptcy courts have turned equitable subordination into a no-fault and standardless doctrine that fosters uncertainty. Part III also compares equitable subordination to the related doctrines of recharacterization and equitable disallowance. Parts IV and V of this Article explain, respectively, why nofault equitable subordination can distort commercial expectations, thereby raising the cost of credit. Finally, Part VI of this Article reconceptualizes the doctrine of equitable subordination, analyzing how to reformulate it and proposing language to codify it as a primarily fault-based doctrine that penalizes misconduct while protecting innocent creditors' expectations. Part VI also rethinks recharacterization and equitable disallowance, proposing invalidation of these confusing and irrelevant doctrines.

1. ORIGIN OF THE DOCTRINE

   The Supreme Court effectively established the doctrine of equitable subordination in Taylor v. Standard Gas & Electric Co. ("Deep Rock"). (9) This case under [section] 77B of the Bankruptcy Act of 1898 (10) involved a debtor, Deep Rock Oil Corporation, controlled and dominated by its corporate parent, Standard Gas & Electric Company ("Standard"). (11) Standard owned all of the debtor's common stock; its officers, directors, and agents held the majority of the seats of the debtor's board of directors; and its officers and directors supervised and directed actions by the debtor's officers. (12) As a result of numerous intercompany transactions, Deep Rock stood "insufficiently capitalized", "topheavy with debt", and "in parlous financial condition." (13)

   Standard asserted a claim in the reorganization case for $9,342,642.37. (14) Deep Rock's trustee objected to the claim, as did two of Deep Rock's preferred shareholders, alleging that the claim sought recovery for fraudulent transactions. (15) Multiple rounds of negotiations resulted in a proposed settlement allowing Standard's claim for $5,000,00016 and, subsequently, a proposed reorganization plan developed by the case's reorganization committee.17 The plan called for formation of a new company to take over the debtor's assets, with the debtor's noteholders to receive debentures from the new company, some cash, and about 7% of the common stock in the new company, Standard to receive 73% of the common stock, and the preferred shareholders to receive about 20% of the common stock. (18)

   The district court approved the plan and the compromise of Standard's claim over the preferred shareholders' objections, (19) and the Tenth Circuit Court of Appeals affirmed those rulings, (20) rejecting the preferred shareholders' arguments that the so-called "instrumentality rule" (21) required both a finding that Standard rendered Deep Rock its instrumentality and a ruling denying both plan confirmation and allowance of Standard's claim. (22) One judge dissented, (23) agreeing with the preferred shareholders that Standard operated Deep Rock "as a mere adjunct, department or instrumentality" and that Standard's claim effectively comprised "presentation of a claim against itself in fraud of bona fide creditors." (24) The dissent detailed the facts in the record regarding the relationship between Standard and Deep Rock (25) and concluded not only that Standard's claim should have been disallowed completely under the instrumentality rule, but also that the plan confirmation and proposed payment scheme should have been disapproved as "a grave prejudice to the rights of others in interest." (26)

   At the Supreme Court, the preferred shareholders argued for reversal of the rulings below. (27) In a unanimous 8-0 decision, (28) the Court ruled in favor of the shareholders, agreeing with the dissenting Tenth Circuit judge's com elusion regarding the case, but differing on the basis for that result. (29) After summarizing the numerous transactions that benefitted Standard at Deep Rock's expense (30) "through the complete control and domination of Standard," (31) the Court concluded that all of Standard's intercompany debt claims against Deep Rock must be "subordinated" to the interests of Deep Rock's preferred stockholders. (32) The Court explained that "[n]o plan ought to be approved which does not accord the preferred stockholders a right of participation in the equity in [Deep Rock's] assets prior to that of Standard" (33) because "[e]quity requires the award to preferred stockholders of a superior position in the reorganized company." (34) The Court found the amount of Standard's allowed claim unimportant, so long as that claim received only stock in the new company subordinate to any stock awarded to the preferred shareholders. (35)

   The Supreme Court reaffirmed and, arguably, loosely expanded the doctrine of equitable subordination in Pepper v. Litton. (36) This case reached the Court as the result of a bankruptcy trustee's avoidance action regarding a fraudulent judgment and subsequent transfers to the benefit of a debtor's principal. (37) Referencing the Deep Rock case (38) and reversing the Fourth Circuit Court of Appeals, (39) the Court concluded that the principal's maneuvers to retain the debtor's assets required the court below to exercise its equitable powers to disallow his questionable claim. (40)

   Pepper remains vital for its well-known assertions regarding bankruptcy courts' equitable powers to avoid fraudulent actions, elevate substance over form, and ensure dispensation of justice. (41) The Court's reiterated maxim that "'courts of bankruptcy are essentially courts of equity, and their proceedings inherently proceedings in equity"' (42) remains a touchstone in modern bankruptcy case law. (43) Courts and parties on all sides of bankruptcy disputes quote and cite, in support of varied positions and outcomes, (44) the Pepper Court's explanation of the scope of bankruptcy courts' exclusive jurisdiction to exercise powers over, among other things,

   the allowance and disallowance of claims; the collection and distribution of the estates of bankrupts and the determination of controversies in relation thereto; the rejection in whole or in part 'according to the equities of the case' of claims previously allowed; and the entering of such judgments 'as may be necessary for the enforcement of the provisions' of the Act. (45) Courts continue to cite these formulae to justify rulings applying not only the doctrine of equitable subordination, but also the related doctrines of recharacterization (46) and equitable disallowance. (47)

   The year before the Bankruptcy Code codified the equitable subordination doctrine, the Fifth Circuit articulated a three-part test for its application that incorporated most of...