Inequitable Subordination: Distressing Distressed Claims Purchasers by Propagating Subordination Benefit Elimination Theory

Abstract

This Article examines the application of equitable subordination under Title 11 of the United States Code to bankruptcy claims purchasing transactions that transpire after the occurrence of inequitable conduct by a third party. Although a significant issue with practical consequences, it has drawn relatively scant commentary. To the author’s knowledge, no scholarship to date has attempted to comprehensively discuss the issue or describe the indirect cleansing and washing of tainted claims resulting therefrom. While analyzing and criticizing the current state of the law, this Article introduces the concepts of the “subordination benefit,” “subordination benefit elimination theory,” and “limited subordination benefit theory” to facilitate and further conversations related to the intersection of equitable subordination and bankruptcy claims trading.

This Article primarily aims to promote an active, fluid bankruptcy claims trading market to, on an ex post basis, benefit creditors and, on an ex ante basis, reduce the cost, and induce the extension, of credit in the primary capital markets, thereby supporting the broader economy. Additionally, this Article seeks to reduce indirect cleansing of tainted claims and indirect claims washing through the bankruptcy claims market.

The subject matter is particularly timely and relevant, given the recent publication of the Final Report and Recommendations of the American Bankruptcy Institute Commission to Study the Reform of Chapter 11, the significant growth of the claims trading market and the increasing activity and sophistication of distressed investors, and the recent formation of the American Bankruptcy Institute’s Claims Trading Committee.

This Article argues that subordination benefit elimination theory, which represents the dominant theory propagated by courts and commentators, finds support in a misguided reading of caselaw and conflicts with sound economic policy and logic. Further, while acknowledging limited subordination benefit theory is a superior approach to subordination benefit elimination theory, this Article argues that limited subordination benefit theory also runs contrary to sound economic policy and logic. This Article requests commentators and courts halt and reverse the propagation of subordination benefit elimination theory and avoid disseminating limited subordination benefit theory. Instead, this Article proposes post-misconduct discounted claims purchasers be entitled to participate in the subordination benefit to the same extent as pre-misconduct claimholders.

If commentators and courts are unready to abandon both theories and if required to make a suboptimal binary choice, this Article suggests limited subordination benefit theory be propagated and utilized in lieu of subordination benefit elimination theory.

Keywords: bankruptcy, restructuring, bankruptcy claims, equitable subordination, claims trading, chapter 11, Cravath

JEL Classification: koo, k19, k22, g33