Claims Trading and Equitable Subordination

Marc P. Barmat
Furr and Cohen, P.A.
One Boca Place, Suite 337 West
2255 Glades RoadBoca Raton, FL 33431
mbarmat@furrcohen.com

Creditors in bankruptcy proceedings often have to wait years to receive a distribution of an unknown amount on their claim. To remove the uncertainty, some creditors elect to sell their claims to a third party in exchange for cash or something else of value. This is a practice know as claims trading and is authorized under the Federal Rules of Bankruptcy Procedure, Rule 3001(e). A creditor benefits from claims trading by opting out of the uncertainty of a future payment and assuring an immediate payment from the purchaser of the claim. In turn, the claim purchaser becomes an investor in the bankruptcy estate and bets that the future payout will eventually be more than the claim’s purchase price.

Equitable subordination, which does not necessarily arise in the context of claims trading, allows the bankruptcy court to reprioritize a claim if it determines that the claimant is guilty of misconduct that injures other creditors or confers an unfair advantage on the claimant. In re Lifschultz Fast Freight, 132 F.3d 339 (7th Cir. 1997) (citing Benjamin v. Diamond (In re Mobile Steel Co.), 563 F. 2d 692 (5th Cir. 1977). Equitable subordination is authorized in the Bankruptcy Code at 11 U.S.C. §510(c). The usual result of equitable subordination is that the claimant receives less money than it otherwise would (or none at all), but that is not the goal. Equitable subordination is remedial, not punitive, and is meant to minimize the effect that the misconduct has on other creditors. Mobile Steel, 563 F.2d at 700-01.

Although claims trading and equitable subordination are two concepts which do not often interact, the interplay between them was recently addressed by the Seventh Circuit Court of Appeals in In re Kreisler, 546 F.3d 863 (7th Cir. 2008). In Kreisler, two Chapter 7 debtors, under joint administration, formed a corporation to purchase a secured claim against their own estates. The bankruptcy court viewed the debtors’ actions as misconduct and invoked the doctrine of equitable subordination. Id. at 865. The result was that their corporation’s claim was given last priority, meaning it could be paid only after the claims of every unsecured creditor. Not surprisingly, there wasn’t enough money to pay all the unsecured claims, so the corporation ended up with nothing. An appeal was taken to the district court, which affirmed. The corporation appealed to the circuit court, which reversed.

In reversing the district court, the circuit court determined that the only issue in the case was whether the bankruptcy judge properly applied equitable subordination. Id. at 866. The circuit court found that equitable subordination is generally appropriate only if a creditor is guilty of misconduct that causes injury to the interests of other creditors. Id. The circuit court found that the debtors’ formation of a corporation to purchase a secured claim against their own estates may have amounted to misconduct, but it did not harm the other creditors, who were in the same position whether the original creditor or the debtors’ corporation owned the secured claim. Id. at 867.

Based upon the case law, it would therefore be permitted for an owner of a debtor company to buy a creditor’s claim in his company’s bankruptcy estate, so long as it did not harm the position of the other creditors. Bankruptcy practitioners should be aware of this as it can open up some very interesting tactics in dealing with debt in troubled companies.