Equitable Subordination Flashcards
What is the purpose of equitable subordination?
It recognizes that insiders and some creditors can sense financial difficulty early and act to protect themselves
What are the two main situations where a stockholder’s debt claim is equitably subordinated?
1) The stockholder (usually parent) leaves the company undercapitalized and manages it for the parent’s benefit (Deep Rock)
2) A controlling shareholder finances a buyback or dividend with a note from the company
What is the equivalent of equitable subordination that is easier to get?
Reclassify debt as equity
Is bad faith conduct required for equitable subordination?
No
When (in theory) should courts equitably subordinate? When should they not?
They should when: The benefit of the new debt issue accrues to the equity holder and harms the creditors
They should not when: The new debt funds a worthwhile investment which ex-ante would not harm the creditors, but the bad outcome came up and the optics for undercapitalization are bad (use would exacerbate the debt overhang problem)
What is a solution to the debt overhang problem without running the risk of equitable subordination?
Buy back the group that will look like they were harmed by the debt if the bad outcome happens
What is partnership liability? What indicates a GP has formed?
a GP can be created by accident and partners become jointly liable for the partnership’s debts
A GP forms when a lender exercises control over daily operations, there are no loan formalities in place, no maturity/interest rate, high claim on residual profits, right to repayment is contingent on profits
When is a debt reclassification argument made?
When the claim is first being allowed, a party will object and say that it’s equity instead of debt
(non-equitable) subordination of securities law claims comes from a reaction to which case?
Oppenheimer. Which allowed defrauded shareholders to have their securities law claims enter as unsecured debt (above their normal claim)
What is the 510(b) rule?
Claims arising out of the recession of a purchase/sale of securities is subordinated to the class of security issued (except for common stock)
What are the reasons in favor of the 510(b) rule?
The buyers of securities are better able to handle risk
What are the reasons against the 510(b) rule
The buyers of securities might have accepted some risk, but they did not accept the risk of fraud
This weakens securities law protections exactly when they are needed
What are the 2 best options for defrauded securities holders in a bankruptcy?
Go after the underwriter (claim no stayed and they are probably still solvent)
Try to equitably subordinate some of the other senior claimants if there is a case that they knew something about the fraud (American Lumber style)
What was the development in SEC v Worldcom
the SOX fair funds for investors act allows the SEC to fine bankrupt firms for wrongdoing and distribute the value to the investors
The amount of the fine cannot be a function of the amount lost by investors
What makes the test for equitable subordination of a creditor’s claim so unpredictable?
The court is trying to parse impermissible control of the debtor from lawfully exercising rights under the loan agreement and the distinction is fairly illusory
What are the main reasons for equitably subordinating a creditor’s claim?
punishment/deterrence, jurisdictional concerns about hearing a case about breach of fiduciary duty
What is good advice to give to a creditor to avoid equitable subordination?
Make sure your phrasing makes it clear that you are suggesting action and leaving management in control
Behave well - don’t pull an American Lumber
What is lender liability?
When creditors leverage their power under loan agreements to direct managerial changes, they could be on the hook for lender liability under theories like (fraud, breach of good faith, and duress)
How does a creditor avoid lender liability
Same advice as with equitable subordination: leave management in charge, let them see the incentives and make the decisions
What is Agency liability?
If a creditor really takes charge of a debtor day to day instead of just exercising veto power, it could be liable as principal for all of the debtor’s debts
The latest restatement of agency however does require the agent to consent to the principal’s control, so this reduces the risk for creditors
