United States: Loan Groups Protest Enron Equitable Subordination Ruling

A bankruptcy judge for the U.S. District Court for the Southern District of New York has issued a troubling and controversial ruling holding that claims held by innocent parties who purchased in good faith may be subject to equitable subordination if the previous holder engaged in inequitable conduct.

The holding in Enron Corp. v. Avenue Special Situations Fund II, LP (In re Enron Corp., et al.), Case No. 05-01029 (Bankr. S.D.N.Y. Nov. 17, 2005), has prompted the Loan Syndications and Trading Association (LSTA) and other trade groups to file an amicus brief seeking interlocutory review.

The decision "could negatively impact the market for bankruptcy claims," stated the LSTA in a statement statement [link: http://www.lsta.org/story.asp?id=1653]. Such impacts include added costs to conduct due diligence on claim holders, as well as increased litigation costs for lenders seeking indemnification for subordinated claims.

The Enron case concerned a $1.7 billion short-term credit agreement Enron entered into with a number of banks in May 2001. As part of this agreement, Fleet National Bank loaned Enron more than $53 million. When the company declared bankruptcy in December. Citibank, as lead bank, entered a proof of claim on the agreement. Fleet transferred its interests in the claim to the defendants in the instant action, Avenue Special and several other financial institutions.

In 2003, Enron brought an adversary proceeding, referred to as the "Megacomplaint Proceeding," against the defendant banks and others, including Fleet. The complaint included a claim that Fleet, and an entity organized by Fleet, had entered into two series of prepaid forward transactions with Chase and Citibank, aiding and abetting Enron’s accounting fraud. Because of Fleet’s actions, Enron’s general unsecured creditors were misled as to the company’s true financial condition, Enron alleged.

The debtor further claimed that Fleet had received partial repayments for these transactions that constituted preferences or fraudulent conveyances. Even though the transactions were unrelated to the short-term credit agreement claims, debtor-Enron sought to have the claims held by the defendants equitably subordinated on the grounds of Fleet’s alleged inequitable conduct.

Writing for the U.S. Bankruptcy Court for the Southern District of New York, Judge Arthur J. Gonzalez identified three issues before the court:

Enron argued that claims subject to equitable subordination on the date of the bankruptcy petition should be subject to subordination thereafter, and that the purchasers of the claims should have protected themselves by demanding indemnities. The debtor further argued that preventing the claims from being subordinated based on the transferor’s innocent conduct would encourage wrongdoers to "wash" their claims by transferring them.

The defendant banks argued that under § 510(c), subordination does not follow the claim, but serves to punish claimants found to have acted inequitably. Equitable subordination is not warranted where a good faith and innocent purchaser acquired a claim for fair value without knowledge of the alleged wrongful conduct by the seller or the transferor, the defendants claimed.

The defendants further noted that Enron could seek, and indeed had sought, a remedy in its Megacomplaint Proceeding directly against Fleet.

The court first addressed the issue of whether § 510(c) grants a court the authority to subordinate claims that did not arise from misconduct, but are nevertheless held by a creditor that is found to have engaged in inequitable conduct.

The court noted that "[l]imiting subordination only to those claims related to the inequitable conduct would unnecessarily deprive the aggrieved creditors of the full benefit of the remedy of equitable subordination, when the uncompensated injury caused by such claimant exceeds the amount of those claims."

As long as the claims to be subordinated do not exceed the injury suffered, the claims of a creditor found to have engaged in inequitable conduct may be subordinated, whether or not the claims stemmed from the conduct at issue, the court concluded. Hence, even though the claims in the case at hand derived from the credit agreement Fleet entered into with Enron and were not part of the prepaid forward transactions in which Fleet was accused of inequitable conduct, the former were subject to equitable subordination.

Next, the court addressed whether the claims at issue could be subject to equitable subordination after they had been transferred by Fleet. The court concluded that "[t]here is no basis to find or infer that transferees should enjoy greater rights than the transferee."

The court rejected the defendants’ contention that equitable subordination applies to the conduct of the claimant rather than the claim. The plain language of § 510(c)(1) states that courts may "‘under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim’… (emphasis added)," noted the court.

"Had Congress meant for the application of equitable subordination to be limited to an original claimant or a claimant at the time of the presentment of the claim, rather than the ‘claim’ itself, it would have provided such a limitation."

The court also rejected the defense that a debtor should be forced to bring legal actions against creditors found to have engaged in inequitable conduct, rather than employing the remedy of equitable subordination: "The litigation process would not only prolong the time required to collect these funds for distribution to the creditors, but also would create uncertainty concerning recover of these funds for the estate."

Similarly, the court rejected the defendants’ arguments that they should be protected by the "good faith" policy underlying various provisions of the Bankruptcy Code that deal with avoided transfers—particularly section 550.

Section 550 addresses transfers that are avoided under certain enumerated sections, and was not intended by Congress to deal with the equitable subordination of claims under §510(c), the court stated. "Had Congress meant to apply the ‘good faith’ defense of § 550(b) to the transfer of claims equitably subordinated by § 510(c), it would have included § 510(c) among the sections referenced in 550(a)."

The distinction makes sense from a policy perspective, the court noted, because the "good faith" defense was created to protect transfers of property that were part of the bankruptcy estate. However, the claims subject to subordination were never part of the estate and therefore not in need of protection, the court concluded.

Further, the good faith defense "does not protect a purchaser who either knows or should have known of potential challenges to a transferor’s right to the property at issue," the court stated. The purchaser of a bankruptcy claim "by definition, knows that it is purchasing a claim against a debtor and is on notice that any defense or right of the debtor, including equitable subordination, may be asserted against that claim."

Probably the most troubling portion of the decision is where the Court attempts to expand its holding beyond bankruptcy traded claims when it states, in a footnote, that "no legal and policy analysis supports the premise that transferees of bonds and notes should be treated differently than those holding the transferred loan claims. All the post-petition transferees assume the risk that their claims may be subject to subordination." However, the Uniform Commercial Code provides that a holder in due course of a negotiable instrument takes free and clear of defenses and claims, and many promissory notes are negotiable instruments. While it is true that the holder must take the instrument in ‘good faith’ to be a holder in due course, generally such a holder does not have a duty to actively inquire into the seller’s relationship with the borrower. This case will be hotly debated on appeal, and during the appeal process, buyers of claims will heighten their due diligence process and attempt to negotiate broad indemnification provisions. It is too early to tell how the claims trading market and deal pricing will react.

This article is presented for informational purposes only and is not intended to constitute legal advice.