The Bank must be cautious in its dealings with a borrower in financial distress. Certain conduct may make the Bank the target of an equitable subordination claim if the borrower files bankruptcy.
Section 510(c) of the Bankruptcy Code permits the Bankruptcy Court to (i) re-order the priorities of creditors and subordinate all or part of a lender’s allowed claim or interest, (ii) transfer any lien securing a subordinated claim of the bankruptcy estate, or (iii) disallow a claim entirely.
Equitable subordination is an extraordinary remedy and Bankruptcy Courts have generally held that the following conditions must be satisfied before the sanction of equitable subordination will be imposed:
•the claimant, such as a Bank, must have engaged in some kind of inequitable conduct;
•the misconduct must have resulted in injury to the creditors of the debtor or conferred an unfair advantage on the claimant; and
•equitable subordination of the claim must not be inconsistent with the provisions of the Bankruptcy Code.
Because equitable subordination is remedial, not penal, the claim will generally be subordinated only to the extent necessary to offset the specific harm that the debtor and its other creditors suffered on account of the alleged inequitable misconduct.
The types of misconduct found by Bankruptcy Courts to have justified equitable subordination of a lender’s claim include:
•a creditor engaged in conduct that was tantamount to overreaching;
•a lender’s agent misrepresented the availability of construction and take-out financing;
•a secured creditor misrepresented the debtor’s ability to pay trade creditors (resulting in the subordination of the secured claim to the unsecured claims of a trade creditor); and
•a lender controlled the debtor’s plant and cash disbursements and had received a voidable preference.
The Bankruptcy Court generally invokes these sanctions when the lender has engaged in overreaching or lender control, which occurs when the lender steps beyond the traditional role of a lender and participates in the debtor’s business or engages in other egregious conduct that justifies the use of the court’s equitable powers. As mentioned above, in these situations the court may decide to subordinate, recharacterize, or even disallow a transaction. In general, the equitable subordination doctrine is limited to reordering priorities, and does not permit total disallowance of a claim. However, if the conduct of the creditor is so egregious that it affects the validity of the claim under applicable principles of law, the debtor can ask the court to disallow it in full as part of the claims avoidable project.