In today's lending world, where lenders often market themselves as their borrowers' partners, lenders increasingly attempt to be part of the solution rather than simply be a borrower's main problem when a loan goes south. In their role as problem-solvers, lenders are encouraging (and sometimes insisting) that their borrowers take certain actions, such as hiring a turnaround manager, as a condition for the lender's providing forbearance or cooperation.

The questions then arise: Can a lender require a borrower to hire a specific turnaround manager as a condition of forbearance, and how much other control can a lender properly assert over a debtor?

Equitable Subordination: The Penalty for Stepping over the Line

In a bankruptcy context, the most common relief requested to remedy a lender's undue influence over a debtor is equitable subordination under 11 U.S.C. §510(c). Section 510(c) authorizes a court to subordinate an allowed claim to the interest of another or to order a lien securing an allowed claim to be transferred to the estate. 11 U.S.C. §510(c).

Generally, a creditor has no fiduciary obligations to a debtor. In re WT Grant Co., 699 F.2d 599, 609 (2d Cir. 1983). A creditor may use its bargaining power, "including [its] ability to refuse to make further loans needed by the debtor, to improve the status of [its] existing claims." Id. at 610.

Testing the Limits

In cases where equitable subordination of a secured creditor's claim is sought, courts have examined the extent to which a lender can condition the forbearance of its rights and its post-petition financing on its ability to make decisions for the debtor company, require new management or even appoint a specific professional. A three-pronged test, enumerated under the Bankruptcy Act (prior to 1978), is recognized as the applicable standard in determining the propriety of equitable subordination:

1. The claimant must have engaged in some type of inequitable conduct;
2. The misconduct must have resulted in injury to the creditors of the bankrupt or confirmed an unfair advantage on the claimant; and
3. Equitable subordination of the claim must not be inconsistent with the provisions of the Bankruptcy Act (prior to 1978).

In re Mobile Steel Co., 563 F.2d 692, 699-700 (5th Cir. 1977) (citations omitted). The third element of the equitable-subordination test has been adopted by courts since the enactment of the Bankruptcy Code. See, e.g., In re Clark Pipe Supply Co. Inc., 893 F.2d 693, 699 (5th Cir. 1990).

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Secured lenders will be allowed a fair amount of latitude in their involvement with the operations of a debtor company, such as giving advice on operational and other key decisions and even requiring the hiring of a lender-approved manager.

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The bankruptcy court for the Western District of Michigan addressed the issue of equitable subordination in the Auto Specialties Mf'g. Co. case and applied the Mobile Steel test. In re Auto Specialties Mf'g. Co., 153 B.R. 457 (Bankr. W.D. Mich. 1993) The court noted the higher standard of conduct to which a fiduciary is subject and stated that a "lender may become a fiduciary of the debtor and possibly the debtor's creditors if it uses its leverage to take over operation of the company and thus step into the shoes of the traditional corporate fiduciaries." Id. at 478. A creditor assumes the fiduciary duties of a debtor's officers and directors when it has operating control of the debtor's business. Id., quoting In re Badger Freightways, 106 B.R. 971, 977 (Bankr. N.D. Ill. 1989).

Cross the Line from Recommendations to Control

The Auto Specialties case involved a chapter 7 trustee who sought equitable subordination of a fully secured creditor's claim, claiming that the bank assumed the duty of the debtor's fiduciary by conditioning further lending for an attempted reorganization on the debtor's firing its president and chairman and replacing a second board member with an outside manager to be approved by the bank. Auto Specialties at 465.

The court cautioned that a lender who merely offers advice or closely monitors the debtor's activities is not subject to fiduciary obligations. Id. at 479. However, "the line between debtor and lender is crossed where the lender exercises control over all or substantially all aspects of the finances and operations of the debtor." Id., quoting In re American Lumber Co., 7 B.R. 519, 529 (Bankr. D. Minn. 1979). Moreover, that the bargaining power is skewed heavily in favor of the lender is not sufficient evidence of control. Auto Specialties at 480. The lender must "supplant management" to have control of the debtor. Id. at 481.

The Auto Specialties court examined the chapter 7 trustee's allegations, including, inter alia, that the bank was "intimately involved" in key operational decisions, made the debtor hire a specific manager, refused to allow the debtor to fire that manager and required the manager to make decisions with bank approval. Id. The court failed to find sufficient evidence that the bank constantly directed the debtor's day-to-day business decisions. Id. at 482. The court also failed to find sufficient evidence of control via the hiring of a specific manager. Id. at 483. It noted that requiring replacement management "has long been a legitimate condition of forbearance, the exercise of which will not subject a lender to a fiduciary duty," and held that there was no direct support of the trustee's allegation that the bank controlled the debtor by selecting the specific manager hired. Id. Ultimately, the court declined to subordinate the bank's claim. The Auto Specialties court also evaluated whether the bank was subject to equitable subordination under the non-fiduciary standard—egregious conduct proven with particularity—and again held equitable subordination to be inappropriate.

The Auto Specialties court did not need to determine whether a lender can require the appointment of a specific manager. However, given the facts and findings in this case, it can be reasonably inferred that a lender may require the hiring of replacement management and even recommend a specific manager, but that it is inadvisable for the lender to insist on a specific individual to serve as the replacement manager.

The Auto Specialties court looked to Badger, 106 B.R. 971, in evaluating when a lender exercises control through an outside manager. Auto Specialties at 485. In Badger, two outside managers with a preexisting relationship with the lender were hired at the lender's recommendation. Badger at 978. The Badger court held that, absent allegations showing "the existence of an arrangement to control" the debtor, the lender's recommendation of the managers and subsequent management of the debtor was insufficient to establish dominion and control. Id. The Auto Specialties court agreed that evidence of an arrangement is necessary for the lender to survive summary judgment on the issue of equitable subordination. Auto Specialties at 485.

In opposition to the Auto Specialties case and with reasoning specifically rejected by the Auto Specialties court, Auto Specialties at 481, In re Aluminum Mills held that the unsecured creditors committee's equitable subordination claim would survive the lender's motion to dismiss in spite of the absence of day-to-day control. In re Aluminum Mills Corp., 132 B.R. 869 (Bankr. N.D. Ill. 1991). The Aluminum Mills case involved allegations that the lender controlled the debtor by effectively making several key decisions, including the replacement of the debtor's president and other officers, the payment of certain obligations, and consulting and management fees, and by controlling such things as the debtor's rights and abilities to make investments, enter into contracts, borrow money and compensate employees. Id. at 895. The court allowed the equitable subordination claims to stand, holding that "operating control does not necessarily mean day-to-day control, but may simply be control over the decisions that a corporate fiduciary is expected to make." Id. at 895.

Secured creditors concerned with the potential subordination of their claim should also consider In re American Lumber Co., 5 B.R. 470 (D. Minn. 1980), a case decided under the Bankruptcy Act (prior to 1978). The court stated it could think of "few cases where application of the doctrine
of equitable subordination is more appropriate." Id. at 479. In American Lumber, the court reviewed the lender's appeal of the bankruptcy court's finding that the debtor's transfers of certain security interests to the bank were voidable as preferences and fraudulent transfers, entitling the U.S. Trustee to subordination on the bank's claim. Id. at 472.

As evidence of the bank's control of the debtor, the court found, inter alia, the following: The bank had a right to controlling interest in the debtor's stock; the bank placed the debtor in its coercive power by refusing to honor its payroll checks; the bank's foreclosure of certain security interests deprived the debtor of its only source of operating cash, forcing the debtor to take further loans; the bank forced the debtor to execute security agreements on its only remaining assets; and the bank allowed the debtor to pay only those creditors that would benefit the bank's position. Id. at 478. The Minnesota District Court held that this control constituted inequitable conduct under the Mobile Steel test and was intended to "perpetrate a fraud upon the general unsecured creditors of [the debtor]." Id. at 478-79.

Conclusion

Secured lenders will be allowed a fair amount of latitude in their involvement with the operations of a debtor company, such as giving advice on operational and other key decisions and even requiring the hiring of a lender-approved manager. However, a fine line exists between these actions and those that constitute "inequitable conduct," the crossing of which may result in considerable penalties.