Caitlyn R. Marino
St. John's University School of Law
American Bankruptcy Institute Law Review Staff
In In re John Varvatos Enterprises Inc., the United States Court of Appeals for the Third Circuit held that evidence of misconduct by an individual employed by a firm is insufficient to meet the inequitable conduct requirement for an equitable subordination claim against the entire firm under section 510(c)(1) of title 11 of the United States Code (the “Bankruptcy Code”) .[1] In May 2020, John Varvatos Enterprises (“Varvatos”) filed for bankruptcy.[2] Although this became an atypical ending for many retailers in recent years, the nationwide menswear company’s reasoning was fueled by a financially strategic plan.[3]
In 2017, prior to filing for bankruptcy, Varvatos fell liable to a multi-million dollar class action regarding its policy of “giving free clothes to male, but not female, employees.”[4] A certified class of sixty-nine current and former sales professionals (collectively, the “Class”) commenced a sex-discrimination class action against Varvatos in the United States District Court for the District of Delaware, alleging the clothing allowance policy effectuated four separate violations.[5] Tessa Knox, a former employee of Varvatos, served as representative for the Class. On March 24, 2020, a jury awarded the Class $3,515,051.23.[6]
On May 6, 2020, Varvatos and two affiliate entities (collectively, the “Debtors”) filed voluntary petitions for relief under chapter 11 of the Bankruptcy Code in the U.S. Bankruptcy Court for the District of Delaware (the “Bankruptcy Court”). The Debtors executed an asset purchase agreement with Lion Hendrix Cayman Limited (“Lion”) that same day.[7] Lion agreed to buy “substantially all the Debtor’s assets for $19,450,000 in cash and a credit bid of $76 million in secured debt.”[8]
The Class then initiated an adversary proceeding in the Bankruptcy Court seeking to subordinate Lion’s claim and have their unsecured claims fully paid. [9] The Class alleged Lion “encouraged” and “facilitated” the “unlawful” clothing-allowance policy, and it would thus be “unjust” for Lion to be paid ahead of the unsecured creditors, like themselves.[10]
The Bankruptcy Court dismissed the Class’s complaint without leave to amend, holding the Class failed to state an equitable subordination claim. On the Class’s appeal, the United States District Court for the District of Delaware (the “District Court”) affirmed the Bankruptcy Court’s dismissal. The Class then appealed to the United States Court of Appeals for the Third Circuit (the “Court”), which affirmed the lower courts’ decisions.
Appellate courts exercise the same standard of review as district courts, reviewing de novo when assessing a district court’s appellate review of a bankruptcy court’s decision.[11] Appellate courts accept all factual allegations as true at the motion-to-dismiss stage in evaluating if the claim presents a “plausible claim for relief.”[12] However, such an assumption of truth is not applicable to hollow or bare recitals of a cause of action’s elements.[13] Even complaints consisting of well-plead allegations must be dismissed if they fail to “nudge[] the[] claims across the line from conceivable to plausible . . . .”[14] Creditor payments of a debtor are conditional to the fundamental Bankruptcy Code priority scheme.[15] The Bankruptcy Code permits an exception to the fundamental priority scheme under the principles of equitable subordination.[16]
The Court set forth two distinct holdings. First, the Court affirmed the District Court’s dismissal of the Class’s equitable subordination claim, holding no proof of inequitable conduct on the part of Lion was present.[17] Second, the Court affirmed, in reviewing de novo, the Bankruptcy Court’s denial of leave to amend. The Court affirmed the amendment would be futile due to the Class’s failure to indicate additional facts to support a reasonable inference of inequitable conduct by Lion.[18]
The Court turned to Winstar in affirming the lower courts’ holding that the Class failed to establish equitable subordination. The doctrine of equitable subordination permits “the court to subordinate distribution of all or part of a higher priority claim in favor of a lower priority claims where justice so requires.”[19] Winstar set forth a three-factor test that must be met for the doctrine to be applicable. First, “the higher priority creditor must have engaged in inequitable conduct . . . [second], that conduct injured a lower priority creditor or unfairly advantaged the misbehaving creditor, and . . . [third] claim subordination would not be inconsistent with the Bankruptcy Code.”[20] The Court, in referring to Citicorp Venture Cap., recognized inequitable conduct may arise through unfair conduct by the creditor, which “affects the bankruptcy results of other creditors.”[21]
In applying the Winstar test, the Court held the Class failed to establish the first-prong requirement of inequitable conduct.[22] The Court held the testimony does not suffice a reasonable conclusion of inequitable conduct by Lion to the Class[23] and only suggests that an individual from Lion Capital Fund III spoke to Varvatos about providing female associates with a benefit.[24]
The Court assessed the Bankruptcy Court’s conclusion that any amendment to the Class complaint would be “futile.”[25] The Class argued they could present facts to establish Varvatos would have changed its clothing-allowance policy in the absence of the AllSaints discount offered by Lion.[26] The Court rejected this argument, concluding such facts would not prove inequitable conduct by Lion and would only suggest misconduct by Varvatos.[27]
The Court’s decision in In re John Varvatos Enterprises Inc. emphasizes the importance of satisfying the inequitable conduct requirement of the Winstar test. It is insufficient to provide evidence of misconduct by an individual, like the head of the debtor's investment firm, when advancing an equitable subordination claim. There must be evidence of misconduct by a debtor-company against the lower-priority creditor to conclude the debtor-company engaged in inequitable conduct.
[1] See Knox. v. Lion Hendrix Cayman Ltd. (In re John Varvatos Enters. Inc.), No. 21-2766, 2022 U.S. App. LEXIS 17293, at *6 (3d Cir. June 23, 2022).
[2] Id. at *3.
[3] Id. at *1.
[4] Id. at *1–2 (“[Varvatos] gave its male sales professionals $12,000 a year in brand clothing to wear at work. Female sales professionals had no clothing allowance but were, in 2013, offered the ability to purchase clothes at a 50% discount from a different retailer, AllSaints.”).
[5] Id. (“[A]lleging that the company’s clothing-allowance policy violated the Equal Pay Act, the New York Equal Pay Act, the New York Human Rights Law, and Title VII of the Civil Rights Act of 1964.”).
[6] Id. at *2–3 (finding Varvatos liable for civil rights law violations and punitive damages under Title VII).
[7] Id. (“At the time, LHCL owned Lion/Hendrix Corp., which owned Varvatos. LHCL in turn was majority-owned and controlled by affiliates of Lion Capital Fund III Partnerships.”).
[8] Id. at *3.
[9] Id.
[10] Id. at *3–4 (Indicating Lion’s bankruptcy filing would leave the Class with only a fraction of the sum of the millions in damages awarded in their class action).
[11] See id. (citing In re Winstar Commc’ns Inc., 554 F.3d 382, 389 n.3 (3d Cir. 2009)).
[12] See id. (citing Ashcroft v. Iqbal, 556 U.S. 662, 678–79 (2009)).
[13] See id. (citing Iqbal, 556 U.S. at 678).
[14] See id. (citing Bell Atl. Corp. v. Twombly, 550 U.S. 544, 570 (2007)).
[15] See id.
[16] See id. at *4–5; see also 11 U.S.C.S. § 510(c)(1).
[17] Id. at *6.
[18] Id. at *7.
[19] See id. at *5 (citing Winstar, 544 F.3d at 411).
[20] Id.
[21] See id. (quoting Citicorp Venture Cap. Ltd. v. Comm. of Creditors Holding Unsecured Claims, 323 F.3d 228, 234 (3d Cir. 2003).
[22] See id. (affirming the Bankruptcy and District Court holdings that the Class failed to allege any inequitable conduct).
[23] Id.
[24] Id. The Class based its argument on a sole allegation, the testimony of Varvatos’s former Vice President of Human Resources, Ann Byron. Byron testified that Lion’s head spoke with Varvatos about their clothing-allowance policy and agreed to offer female employees the 50% discount for AllSaints, an additional retail store under Lion Capital Fund III. Id.
[25] See id. at *6–7 (“[R]eview[ing] a court’s ‘denial of leave to amend for abuse of discretion, and review de novo its determination that amendment would be futile.’”).
[26] Id.
[27] Id.