Claim Avoidance and Subordination Actions

Bankruptcy Litigation Sub-AreasThe bankruptcy litigators at Mark Anchor Albert and Associates can skillfully prosecute and defend against claim avoidance and subordination actions in bankruptcy court.

The Bankruptcy Code allows a bankruptcy trustee or debtor-in-possession to assert certain “avoidance powers” that are found at Bankruptcy Code sections 544 through 549. These statutes allow the trustee or debtor-in-possession to file “adversary proceedings” (lawsuits pending before the bankruptcy court) to recover certain property that a debtor transferred to other entities before the commencement of the bankruptcy case, or to avoid liens that were not properly perfected, among other things.

Avoidance actions may be brought by the trustee or by a debtor-in-possession under Chapter 11 of the Bankruptcy Code. A debtor may generally bring avoidance actions in connection with exempt property if (1) it is avoidable by the trustee under sections 544 or 548, (2) the trustee does not seek to avoid the transfer, (3) the debtor could exempt the property, (4) the transfer was involuntary, and (5) the debtor did not conceal the property.

Any avoidance action is an adversary proceeding under Rule 7001 et seq. of the Federal Rules of Bankruptcy Procedure. As a general rule, only the trustee or debtor-in-possession may bring the avoidance action. A creditor committee or creditor may initiate a proceeding, however, if it requests the debtor-in-possession or trustee to prosecute the avoidance action, the debtor or trustee refuses, and the committee or creditor demonstrates a colorable claim of benefit to the estate and an unjustifiable refusal by the trustee or debtor to act. A creditor also may institute an action on behalf of the debtor in possession or trustee, if authorized by the bankruptcy court.

A creditor may, with court permission, bring a derivative action in the name of the debtor. A party other than the debtor or the trustee may prosecute avoidance claims in a Chapter 11 case if it is appointed to do so and if it is acting as a representative of the estate under Bankruptcy Code section 1123(b)(3)(B). 11 U.S.C. § 1123(b)(3)(B).

The trustee or debtor-in-possession is treated as a bona fide purchaser and lien creditor in order to avoid—i.e., to set aside—various types of transfers. Accordingly, the trustee or debtor-in-possession has the power under the Bankruptcy Code to set aside unrecorded liens, deeds, contracts, and suits for which no lis pendens has been filed. These suits or transactions are not void but are simply voidable in an adversary proceeding.

Equitable subordination also is provided for in 11 U.S.C. § 510. Subpart(b) provides for mandatory subordination of claims “arising from rescission of a purchase or sale of a security ..., for damages arising from the purchase or sale of such a security, or for reimbursement ... on account of such a claim ....” The conduct of the creditor is irrelevant under subpart (b). Subpart (c) permits subordination “under principles of equitable subordination ....”

Subsection 510(b) of the Bankruptcy Code sets out the requirements for the mandatory subordination of a claim and provides as follows:

“For purposes of distribution under this title, a claim arising from rescission of a purchase or sale of a security of the debtor or of an affiliate of the debtor, for damages arising from the purchase or sale of such a security, or for reimbursement or contribution allowed under section 502 on account of such a claim, shall be subordinated to all claims or interests that are senior to or equal the claim or interest represented by such security, except that if such security is common stock, such claim has the same priority as common stock.”

In summary, subsection 501(b) of the Bankruptcy Code provides that a claim for damages or for contribution or reimbursement arising from the purchase, sale, or rescission of a purchase or sale of securities of the debtor or an affiliate is subordinated to senior or equal claims.

Equitable subordination exists to offset an inequality in the claim position of a creditor that will produce injustice or unfairness to other creditors in terms of bankruptcy results. Trone v. Smith (In re Westgate-California Corporation) (9th Cir. 1981) 642 F.2d 1174, 1177.

The Bankruptcy Code separates subordination into several subsections. As noted above, subsection (b) specifically addresses damage claims by security holders connected with the rescission of a purchase or sale of securities. Subsection (b) provides that these claims are subordinated automatically.

In the Ninth Circuit, a three-part test is used to determine the appropriateness of equitable subordination. The test requires the court to find: a) the claimant engaged in some type of inequitable conduct, b) the misconduct injured creditors or conferred unfair advantage on the claimant, and c) subordination would not be inconsistent with the Bankruptcy Code. In re Lazar (9th Cir. 1996) 83 F.3d 306, 309. The court must find that all of these elements are present before subordinating the claim. Ibid.

Under section 501(c), after notice and a hearing, the court may, “(1) under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or part of another allowed interest; or (2) order that any lien securing such a subordinated claim be transferred to the estate.” Under this subsection, a secured creditor who has a valid claim that has been allowed may nonetheless have its claim subordinated to another creditor’s claim, even if it is not secured.

In bankruptcy litigation, in an effort to subordinate a secured claim of a creditor with priority over claims the proponent wishes to advance in line for payment, inequitable conduct on the part of the secured creditor usually must be demonstrated to the satisfaction of the court.