Claim Purchasers Beware: No Good-Faith Defense to Equitable Subordination

Claim Purchasers Beware: No Good-Faith Defense to Equitable Subordination

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In a recent decision in the adversary proceeding styled as Enron Corp. v. Avenue Special Situations Fund II L.P., Adv. No. 05-01029 (the “Enron Opinion”), Judge Arthur Gonzalez of the U.S. Bankruptcy Court for the Southern District of New York determined that the remedy of equitable subordination was not limited “only to those claims related to the inequitable conduct that caused the injury to the creditor class.” Rather, equitable subordination pursuant to 11 U.S.C. §510(c)1 could be used to subordinate other claims held by the creditor alleged to have committed the inequitable conduct. Judge Gonzalez also concluded that the remedy of equitable subordination “remains with the claim” and could be used to subordinate claims held by a subsequent transferee of the original claimant, even when the transferee paid value for such claim and did not engage in any inequitable conduct.



The facts of this case were not very complicated. Prior to filing for bankruptcy, Enron had entered into two revolving credit agreements—a $1.75 billion short-term credit facility and a $1.25 billion long-term revolving credit agreement. Fleet National Bank was a participant in both facilities and was owed approximately $53.67 million thereunder (the “facility claims”). Subsequent to the petition date, Fleet subsequently transferred 100 percent of the Facility Claims to various claims purchasers.

Following the transfer of the facility claims and nearly two years after the commencement of the case, Enron commenced an adversary proceeding (the “Mega-Complaint Proceeding”) against a number of banks, including Fleet. In the Mega-Complaint Proceeding, Enron asserted several preference and fraudulent-transfer claims against Fleet, among other banks, relating to two series of prepaid financial transactions. In addition to these claims, Enron alleged that Fleet (as well as the other named bank defendants) “aided and abetted Enron in engaging in accounting fraud,” which injured Enron’s creditors and gave an unfair advantage to Fleet.2

Following the commencement of the Mega-Complaint Proceeding, Enron initiated an adversary proceeding against the claims purchasers in which Enron sought to subordinate the claims purchased by the claims purchasers, contending, inter alia, that these claims, had they not been transferred, would have been subordinated pursuant to §510(c). In response, the claims purchasers filed a motion to dismiss asserting that they, unlike Fleet, were not alleged to have committed any inequitable conduct and that pursuant to §510(c), “the party whose claims are subordinated must have engaged in inequitable conduct causing injury to the creditors or the estate.” Enron Opinion, p. 12.


In his decision, Judge Gonzalez first examined the language of §510(c) and found that “[t]he purpose of §510(c) of the Bankruptcy Code is to correct inequitable conduct and ensure that no creditor is given an unfair advantage in the distribution of the estate.” Enron Opinion, p. 20. The court then examined the test for equitably subordinating a claim, first enunciated by the U.S. Court of Appeals for the Fifth Circuit in the case of Benjamin v. Diamond (In re Mobile Steel Co.), 563 F.2d 692, 700 (5th Cir. 1977). According to Judge Gonzalez, the “Mobile Steel court found that when a court considers equitable subordination of a claim, the inequitable conduct does not have to be related to such claim to justify the subordination.” Enron Opinion, p. 23. Consequently, Judge Gonzalez reasoned that “the remedy of equitable subordination can be applied against claims not related to any inequitable conduct.” Id.3 Judge Gonzalez did temper his ruling by stating that the remedy of equitable subordination is limited in scope and “[s]ubordinating any amount of [the] claim in excess of the established injury would be punitive.” Enron Opinion, p. 28.

Having concluded that §510(c) could be used to subordinate claims unrelated to the “inequitable conduct,” Judge Gonzalez then found that any subsequent transfer of such claims would not “cleanse” them. Rather, such claims would be subject to subordination to the same extent that they would be subject to subordination in the hands of the original transferor. According to Judge Gonzalez, “[t]he purchase of the claims in a bankruptcy proceeding should not grant a transferee any greater rights than [held by] the transferor.” Enron Opinion, p. 31. Judge Gonzalez also found support for this proposition from a public policy perspective. By permitting a debtor to refrain from making a distribution on account of the transferred claim, the debtor avoids having to litigate or pursue the initial transferee for any distributions made on account of the transferred claim.4 Burdening the estate with the necessity of collecting damages to effectuate the remedy of equitable subordination would undermine the remedy itself. Enron Opinion, p. 35. According to Judge Gonzalez, “the remedy of §510(c) is intended to apply without the debtor engaging in a collection effort.” Id.

Judge Gonzalez was also unimpressed with the claims purchasers’ arguments that by adopting this approach, it would create “uncertainty” in the claims-trading market as well as become a “burden” on transferees. In rejecting these contentions, Judge Gonzalez opined that “[p]articipants in the claims-transfer market are aware, or should be aware of, the risks and uncertainties inherent in the purchase of claims associated with post-petition debtors, including the possibility of claims being subordinated, and they assume the liabilities arising from the post-petition transfer of claims... The risk that a full recovery may not be available is a risk factor that must be assessed by a purchaser.” Enron Opinion, p. 39.5 By balancing the harm to the debtors’ other creditors versus the risks to a claim purchaser, the court found that the interests of the creditor class would prevail as “[a] claim purchaser, by definition, engages in a high-risk transaction with a number of risks, including the potential for equitable subordination of the claim.” Enron Opinion, p. 41.6

Finally, the court rejected the claims purchasers’ argument that 11 U.S.C. §550(b)(2)7 provided them with a “good-faith” defense to the potential subordination. While acknowledging that the express language of §510(c) does not explicitly provide for such a defense, the claims purchasers urged the court to extend §550(b)’s “good-faith” defense to the purchase of claims. In particular, the claims purchasers argued that (1) they acted in good faith and paid fair value for the claims; (2) there are no allegations of misconduct with respect to their purchase of such claims; and (3) they had no knowledge of any of Fleet’s alleged wrongdoing, having purchased the claims more than a year before the commencement of the Mega-Complaint Proceeding.

In rejecting these contentions, Judge Gonzalez first found that §550(b) was not intended to deal with the possible subordination of claims under §510(c) of the Bankruptcy Code. Moreover, even if §550(b) applied to the subordination of claims pursuant to §510(c), Judge Gonzalez found that the claims purchasers were not good-faith purchasers as “a purchaser of a claim, by definition, knows that in purchasing a claim against a debtor...[i]t is on notice that any defense or right of the debtor, including equitable subordination, may be asserted against that claim.” Enron Opinion, p. 48. According to Judge Gonzalez, the claims purchasers “knew or should have known that Enron, as a debtor-in-possession (DIP), is under a fiduciary obligation to ensure a just and fair distribution to creditors and therefore is obliged to investigate each filed proof of claim in order to determine whether there is any issue, including equitable subordination, that should be raised regarding the claims.” Enron Opinion, p. 49. The court observed that such constructive knowledge should be imputed to the claims purchasers, even though the claims were purchased a year before the Mega-Complaint Proceeding was commenced.8 Accordingly, even if §550(b) were to apply to the purchase of claims, a “transferee could not establish that it ‘took’ without knowledge or notice that an action might be brought against the claim. Therefore, such defense would have to fail.” Id.9

Analysis and Comment

While Enron’s relatively quick emergence from bankruptcy was due in no small part to the efforts of Judge Gonzalez, this decision is somewhat troublesome. While there maybe a certain poetic justice in subordinating the claims of Fleet (or any subsequent assignee) arising in connection with the prepay transactions that are the subject of the Mega-Complaint Proceeding, practitioners should be troubled by the extension of this proposition to include otherwise “legitimate” claims. If one takes the opinion at face value, a DIP or trustee could equitably subordinate a creditor’s claims, even though that creditor itself committed no wrongdoing. For example, assume you have a situation where two banks merged (i.e., Fleet merged with Bank of Boston). Prior to the merger, Fleet loaned money to the debtor. Assume these loans were legitimate and were the result of arms’-length transactions. Assume further that neither Fleet nor any of its agents committed any inequitable conduct in connection with such loans. However, suppose that Bank of Boston also loaned money to a debtor but did so under “dubious” circumstances. Suppose further that Bank of Boston was alleged to have committed inequitable conduct in connection with such loans. Under Judge Gonzalez’s interpretation of §510(c), one could argue that by virtue of the merger of Bank of Boston and Fleet, Bank of Boston’s inequitable conduct could be imputed to Fleet and, consequently, Fleet’s claims against the debtor could be subordinated.

One can also question the issue of whether Judge Gonzalez’s decision distorts the concept of equitable subordination as well as the holding of Mobile Steel. According to the Mobile Steel court, the purpose of equitable subordination is “‘to prevent the consummation of a course of conduct by [a] claimant which...would be fraudulent or otherwise inequitable’ by subordinating his claims to the ethically superior claims asserted by other creditors.” Mobile Steel, 563 F.2d at 699 (quoting Heiser v. Woodruff, 327 U.S. 726, 733 (1946)).10 However, if the debtor’s estate is permitted to continue to prosecute the claimant for such wrongdoing and the claimant is found liable and forced to pay monetary damages to the debtor’s estate, is not the estate obtaining a double recovery if the claimant’s claim, resulting from the inequitable conduct, also subordinated? Presumably, the amount of money paid by the claimant to the estate should be the measure of damages incurred by the estate and should be sufficient to make the estate whole. While one can understand why the estate should be permitted to subordinate the claim that resulted from the wrongdoing pending its receipt of damages from the claimant, once the claimant has paid such damages, has not the estate been made whole? By permitting an estate to subordinate other “legitimate” claims of the creditor (separate and apart from the claim that resulted from the alleged wrongdoing) and still recover damages from that creditor, is not the estate obtaining a windfall? Finally, while Judge Gonzalez is correct that an assignee should have no greater rights than its assignor, should an assignee be subject to the same liabilities of an assignor? Clearly, common law and even the Code recognize situations wherein a “good-faith” purchaser is not subject to such liabilities, and one could argue that this decision imposes too great a burden upon such purchasers, particularly in the area of constructive notice. It is true that debtors/trustees have a fiduciary duty to examine every claim at issue; the claims purchasers were also selective with the types of claims they purchased. They did not purchase any claim that had a “taint” or other “cloud of title.” Instead, they went out of their way to purchase claims that even Enron acknowledged were otherwise legitimate.


This should serve as an urgent warning to those in the business of buying or selling distressed debt/unsecured claims. It may not be the last word. The LSTA has indicated its intent to join in an amicus curiae brief relating to the claims purchasers’ appeal from this decision. Nevertheless, if the decision stands (and is followed by other bankruptcy courts), a prudent practitioner should definitely include the standard representation and warranty provisions contained in the form LSTA Purchase and Sale Agreement for Distressed Debt, as well as the indemnity provisions contained therein. n



1 11 U.S.C. §510(c) provides:
(c) Notwithstanding subsections (a) and (b) of this section, after notice and a hearing, the court may—
(1) under principles of equitable subordination, subordinate for purposes of distribution all or 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.
2 Notwithstanding these allegations, Enron did not allege any wrongdoing with respect to the credit agreements or that any payment of principal or interest under the agreements was either preferential or fraudulent.
3 Judge Gonzalez further reasoned that this conclusion “conforms with public policy underlying the Bankruptcy Code that a court can exercise its authority to subordinate a claim in order to rectify the harm to the estate or its creditors and achieve a fair distribution to creditors. If Congress had intended to limit equitable subordination to only those claims directly related to the inequitable conduct, it would have manifested such intent.” Enron Opinion, p. 27.
4 Judge Gonzalez noted that this “litigation process would not only prolong the time required to collect these funds for distribution to the creditors, but [it] also would create uncertainty concerning recovery of these funds for the estate. Unavoidably, the consequence of being unable to subordinate claims in the hands of the transferees would delay the ultimate distributions by the debtor, which delay is contrary to the goal of the Bankruptcy Code.” Enron Opinion, p. 36. Such a process would also increase the administrative costs incurred by the debtors’ estates.
5 The court noted that the Loan Syndications and Trading Association Inc. (LSTA), the industry association that provides guidance regarding the purchase and sale of such claims, “has promulgated standardized provisions relating to transferred rights, assumed obligations, buyer’s rights and remedies” including, without limitation, provisions that address the “consequences of a claim not being paid.” Enron Opinion, pp. 39-40. Not surprisingly, LSTA has indicated that it intends to file an amicus curiae brief in the appeal of this opinion.
6 The court also noted that the marketplace could address such risks in the pricing associated with such trades. “Apprehending higher risks associated with these securities, the purchaser may demand further discounts on the prices.” Enron Opinion, p. 41.
7 11 U.S.C. §550(b)(2) provides:
(b) The trustee may not recover under §(a)(2) of this section from—
(1) a transferee that takes for value, including satisfaction or securing of a present or antecedent debt, in good faith, and without knowledge of the voidability of the transfer avoided; or
(2) any immediate or mediate good-faith transferee of such transferee.
8 The court did concede that “the knowledge that the obligation of a trustee or DIP to investigate matters related to claims against the estate does not equate to specific knowledge of any wrongful conduct on the part of the transferor of a claim against the debtor; nevertheless, it is hardly speculative or hypothetical that such wrongful conduct may be alleged following the investigation.” Enron Opinion, p. 50.
9 The court also opined that the value paid by the claims purchasers for the facility claims would also remove the transfer from the protection of §550(b). According to the court, “[i]mplicit in the ‘value’ requirement of §550(b) of the Bankruptcy Code is that the value paid is determined without knowledge of the potential voidability of the transfer of the property. By contrast, in the claims-transfer market, the possibility of equitable subordination of a claim is not purely speculative or hypothetical. The value of a claim is set by the market place’s view of the abundant risks, including equitable subordination, in the bankruptcy process... Thus, the value paid for a claim in the marketplace has already taken into account the bankruptcy risks either by discount, indemnification or both. Consequently, immunizing a transferred claim from subordination would alter the risk factors associated with the claim and would artificially enhance its value in the claims-transfer market.” Enron Opinion, p. 51.
10 Ironically, the Mobile Steel court, overturning the decisions of the bankruptcy court and district court, did not permit the equitable subordination of the claims at issue—finding that subordination of such claims was an abuse of discretion by the bankruptcy court.

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Wednesday, February 1, 2006