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Risks to Lenders of Equitable Subordination

Posted by ADMIN | PUBLISHED: July 12, 2013 at 18:35 PM | UPDATED: 18:36 PM

The entire lending industry is based on the assumption that lenders making loans secured by collateral will have their interest in the collateral protected in virtually all  circumstances.  In the world of risks that can create a catastrophic failure of collateral value to a lender, perhaps the murkiest and most difficult to quantify is the risk of equitable subordination under the Bankruptcy Code.

Section 510(c) of the Bankruptcy Code permits the Bankruptcy Court under certain circumstances to subordinate, on purely equitable grounds, all or part of a lender’s claim, including requiring the lender to transfer a lien securing its claim back to the bankruptcy estate, and including potentially disallowance of an entire claim under appropriate circumstances. Although lenders are well informed about the specific risks of receiving preferential payments or fraudulent transfers, and these risks can be evaluated fairly easily as part of an underwriting process, the risk of equitable subordination is evasive, significant and very difficult to quantify or understand specifically.  Some recent decisions suggest that courts may be more willing than ever to exercise equitable jurisdiction under Section 510(c) to punish creditors severely when they think they have overreached or acted unfairly in the context of a lending transaction.  No opinion letter of “non subordination” will protect a lender from a decision of the Bankruptcy Court that it has acted inequitably in a manner that justifies subordination.

Generally, in order to establish a case for equitable subordination, a debtor in bankruptcy, or another creditor of the bankruptcy estate, must establish that the lender has engaged in some type of inequitable conduct, that the misconduct resulted in an injury to creditors or given the lender an unfair advantage, and that equitable subordination will not be inconsistent with the provisions of the Bankruptcy Code.  In a recent decision the Bankruptcy Court in Montana entered an order, later vacated under circumstances not fully known, imposing severe sanctions on Credit Suisse, which was a secured lender to Yellowstone Mountain Club, an exclusive private ski resort in Montana that ultimately ended in bankruptcy.  Credit Suisse v. Official Committee of Unsecured Creditors, Case No. 08-6150-11, Adversary Proceeding No. 09-00014 (Bank. Dist. of Mont., May 13, 2009) (Docket No. 289).  The allegation before the Bankruptcy Court in Montana was that 94% of the loan proceeds of a $232 million first priority secured loan of Credit Suisse was used for purposes unrelated to the specific business needs of the debtor/borrower.  The Bankruptcy Court was highly critical of the lender’s receipt of large fees in connection with the origination of the loan, and its seeming disregard for the purposes to which the loan would later be put.  The Bankruptcy Court specifically found that “the only plausible explanation for Credit Suisse’s actions is that it was simply driven by the fees it was extracting from the loans it was selling, and letting the chips fall where they may.”  Although the Bankruptcy Court later vacated its Order, thus negating any chance the Order would be appealed and limiting its value as any kind of legally binding precedent, it is instructive that in circumstances where the lender acted in what is an entirely lawful manner, it still found its position severely criticized, and threatened, by the broad equitable characterization of court of its motives and behavior in making the loan.