Advanced Distressed Debt Lesson - Equitable Subordination

One of the best things about the Distressed Debt Investors Club is the collective knowledge of a group of very strong analysts and portfolio managers that have trafficked in a number of very complicated bankruptcy proceedings. No two bankruptcy cases are exactly alike. For various reasons (judges, capital structure and guarantees, covenants, outside interest), the chips can fall in a number of different ways in the same bankruptcy proceeding. The bankruptcy code and each of its articles can be interpreted differently by numerous parties. It is what makes distressed debt investing so fascinating.

With that said, DDIC member Paul has penned a piece for us on equitable subordination. Given the complexities of capital structures that have evolved over the past cycle, it is a crucial concept for distressed investors to understand. Enjoy

Equitable Subordination

Analyses of distressed investments often range from the relatively straightforward to the mind numbingly complex. For investments in companies with a simple capital structure, investors will focus on factors such as cash flows, collateral value and terms of the governing credit document.

In larger, more complex companies, investors might have to analyze many additional issues involving restricted and non-subsidiaries, guarantees, security, baskets, carve outs, and covenants, just to name a few. When a company files for bankruptcy protection, additional considerations arise requiring an understanding of the bankruptcy code. One of these considerations involves equitable subordination.

Equitable subordination is a doctrine outlined in Article 510(c) of the Bankruptcy Code. The language from the Code states that equitable subordination allows a court to “subordinate for purposes of distribution” all or part of an allowed claim to another allowed claim when equitable principles require. Interestingly, the Bankruptcy Code does not provide guidance on when equitable subordination should apply. The Court, instead, typically relies on a standard created by the Court of Appeals for the Fifth Circuit involving three conditions:

1. Inequitable conduct by the claimant
2. Misconduct causing injury to creditors or the bankruptcy estate or conferring an unfair advantage to the claimant
3. The finding of equitable subordination must be consistent with bankruptcy law

Distressed investors should bear in mind a few additional principles when evaluating potential equitable subordination issues. One is these issues involves the distinction between an insider and non-insider. An insider’s conduct is subject to a higher level of scrutiny than the conduct of a non-insider. Another issue involves the application of remedies in equitable subordination cases. In equitable subordination Orders, the Court will offset the harm suffered by creditors on account of inequitable, or unfair conduct. The Court, however, will not necessarily subordinate the full value of a claim as part of the remedy.

Equitable subordination is frequently alluded to in bankruptcy cases by investors who have witnessed a steep fall in the value of their securities. Courts, however, do not often find that questionable tactics prior to a bankruptcy filing meet the high standard of egregious misconduct required in equitable subordination cases. A recent exception to this rule of thumb is Yellowstone Mountain Club, a bankruptcy filing in the District of Montana. In this case, Debtor and the creditor committee claimed that a secured loan in the amount of $375 mm constituted a fraudulent transfer. Without getting bogged down in the legal details of the case, the Court ruled in favor of the Debtor and creditor committee, finding that the lender’s actions “were so far overreaching and self serving that they shocked the conscience of the Court.” As a remedy, the Court subordinated the lender’s secured claim to the claims of unsecured creditors in the case.

With a robust understanding of equitable subordination, distressed investors should tread carefully as they evaluate purchasing senior securities that may have unfairly disadvantaged junior securities in a capital structure.