Equitable Disallowance Rears Its Head in 'WaMu'
Lisa Schweitzer and Martin Kostov ContactAll Articles
New York Law Journal
December 5, 2011
In bankruptcy, a creditor's ability to recover on its claim against a debtor results from two basic factors—the amount for which the claim is allowed and the priority granted to the claim in the waterfall of payments made by the debtor under a chapter 11 plan.
In addition to applying the statutory priorities for certain categories of claims and seeking subordination of claims under §510 of the Bankruptcy Code,1 debtors and other parties in interest have in certain instances sought—with varying success—the equitable disallowance of claims. A recent decision in the Washington Mutual (WaMu) chapter 11 case pending in the U.S. Bankruptcy Court for the District of Delaware again raises the possibility that equitable disallowance of claims may be within the power of bankruptcy courts, although the WaMu court did not actually disallow claims in its ruling or define the precise standards for granting such a remedy.2
Equitable Disallowance
Since the enactment of the Bankruptcy Code in 1978, courts have split as to whether the remedy of equitable disallowance of a claim exists in addition to the statutory claims provisions set forth under the Code. However, in considering this question, courts generally start at the same place—by examining the other remedies that indisputably do exist.
Section 510 of the Bankruptcy Code, aptly titled "Subordination," sets forth three instances in which an otherwise allowed claim may be subordinated in payment priority.3 First, §510(a) provides that a bankruptcy court will respect a contractual subordination agreement to the same extent as enforceable under non-bankruptcy law.
Second, §510(b) provides for the statutory subordination of claims arising from the rescission of a securities transaction or damages arising from a securities transaction, which subordination is generally intended to prevent an otherwise subordinated securities holder from improving its recovery against the debtor by asserting additional contract or tort claims.4 Finally, §510(c) provides that a court may "under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim [or interest] to all or part of another allowed claim [or interest]" or transfer any lien securing such a claim to the debtor's estate.5
Courts have occasionally grappled with the question of whether an additional remedy—equitable disallowance of a claim—exists in addition to the codified subordination provisions. This analysis usually begins with an examination of the historic availability of equitable disallowance, starting with the seminal 1939 U.S. Supreme Court decision in Pepper v. Litton.6
In Pepper, the trustee sought to disallow a claim based on a state court judgment obtained on account of alleged salary claims by the dominant controlling stockholder of the bankrupt company. The prior judgment and underlying claim were alleged to be the result of a "planned and fraudulent scheme."7 The Supreme Court, reversing the U.S. Court of Appeals for the Fourth Circuit, held that the bankruptcy court had the equitable power to subordinate or disallow the claim based on a prior court judgment, where there was evidence of collusion in obtaining the judgment or no valid underlying debt existed, particularly where the claim would inure to the benefit of an insider such as an officer, director or shareholder.8
Several decades later, shortly before the adoption of the Bankruptcy Code that replaced the prior Bankruptcy Act, the U.S. Court of Appeals for the Fifth Circuit again considered the issue in In re Mobile Steel.9 There, the Fifth Circuit was presented with the question of whether two groups of claims—one based on alleged contributions to capital in the form of debentures, and another based on promissory notes given for the purchase of commercial property—should be disallowed or subordinated based on the inequitable conduct of the debtor's directors and officers.
In reversing the lower court's exercise of equitable disallowance, the Court of Appeals concluded that recognizing an independent remedy of equitable disallowance would not aid creditors who would be fully protected by subordination alone, and it seemed superfluous to remedy instances of particularly extreme behavior, where a claim should be defeasible without the exercise of the court's general equitable powers.10
With this backdrop, both proponents and opponents of equitable disallowance look to the legislative history surrounding §510 to support their position as to whether the remedy should be recognized. The House Judiciary Committee Report accompanying the bill proposing a subordination provision (which provision ultimately was codified as §510(b)) explained that it intended to codify decisions such as Pepper and the provision "is not intended to limit the court's power in any way…[nor] preclude a bankruptcy court from completely disallowing a claim in the appropriate circumstances."11
However, a bill proposed by the Senate Judiciary Committee contained a subsection specifically providing for the equitable disallowance of claims that ultimately was not included in the Bankruptcy Code.12 Courts rejecting the authority to equitably disallow claims have relied on the considered omission of an equitable disallowance remedy and on the Mobile Steel13 decision to demonstrate equitable disallowance neither exists nor is necessary, while courts ruling the other way cite to Pepper and to bankruptcy courts' generally broad equitable powers.14
The WaMu court fell squarely in the second camp. In WaMu, the official committee of equityholders brought a motion for standing to pursue the equitable subordination and equitable disallowance of certain noteholders' claims. In support of their motion, the equityholders alleged the noteholders had engaged in insider trading during the time they were negotiating a settlement with WaMu in its bankruptcy case.
In partly granting the motion, U.S. Bankruptcy Judge Mary Walrath held that the equity committee lacked standing to seek equitable subordination of the noteholder claims under §510(c), as such a remedy (which only would subordinate the noteholder claims to other claims) would not affect equityholders' recoveries in the case. However, the court granted the equityholders standing to pursue equitable disallowance of the noteholder claims. While conceding that its authority should be exercised in only extreme instances, the WaMu court determined that based on the legislative history of §510 and the Pepper decision, it had the authority to equitably disallow claims in certain extreme and rare circumstances.15 The court did not make any ruling with respect to the ultimate merits of whether the noteholder claims should be disallowed.
The Standard
Since the adoption of the Bankruptcy Code, equitable disallowance has been recognized as an available remedy in only one other bankruptcy case, In re Adelphia Communications Corp.,16 while several other courts have considered and rejected the existence of this potential remedy.17 In Adelphia, as in the recent WaMu decision, the court did not articulate a precise standard to determine whether the claims in question (claims of bank creditors that were challenged by the official creditors committee appointed to the case) could be either equitably subordinated or disallowed.
Rather, Judge Robert Gerber of the U.S. Bankruptcy Court for the Southern District of New York described equitable disallowance as a "draconian" remedy only appropriate in extreme and "perhaps very rare" situations.18 On appeal, the U.S. District Court for the Southern District of New York affirmed the availability of equitable disallowance and concurred with the bankruptcy court's limitations regarding the actual exercise of equitable disallowance.19 The Adelphia courts did not have to articulate a more precise standard or rule on the facts at hand, as the equitable subordination and disallowance actions were dismissed in that case for failure to allege an injury.
Characterization of equitable disallowance as a rare and draconian remedy is understandable when one considers the availability of alternative remedies that would be sufficient for most circumstances. Equitable subordination, which is generally available on a showing of inequitable conduct and injury to other creditors or unfair advantage to the claimant, demotes a claimant's right to get paid behind the claims of other creditors, and in most cases effectively deprives the claimant of the right to get paid at all.
Furthermore, claims may be disallowed based on other available non-bankruptcy defenses. As the Mobile Steel court noted, "if the misconduct directed against the bankrupt is so extreme that disallowance might appear to be warranted, then surely the claim is either invalid or the bankrupt possesses a clear defense against it."20
Given the existence of these alternative remedies and other available defenses and counterclaims to a claim that a debtor likely would have in the face of egregious conduct by a claimant, it remains to be seen whether an instance exists where debtors are not adequately protected by such other rights and remedies. In fact, the WaMu court did not prejudge the adequacy of other alternative remedies in that case, noting that the debtors could well have a defense to the challenged claims outside of bankruptcy, under securities law.21 Although the remark is not entirely clear, the suggestion may be that both remedies are valid and available. Why equitable disallowance should be necessary or whether it should be granted in the presence of an alternative securities law defense is a question WaMu does not address.
Who Is at Risk?
The WaMu decision raises further questions regarding whether equitable disallowance is intended to remedy inequities in having to make distributions on a specific claim, to a specific creditor, or both. The WaMu decision indicates in a footnote that to the extent claims are equitably disallowed, they would be disallowed regardless of who holds them. The court does not elaborate on this statement, which potentially raises its own questions.
Taken at its face, the proposition articulated by the WaMu court could be argued to be noncontroversial. If a court were to rule that a claim should be equitably disallowed, such disallowance cannot subsequently be remedied merely by selling or transferring the disallowed claim to a third party. However, it is less clear whether a court would equitably disallow a claim held by a transferee who purchased the claim in good faith and both without knowledge of and prior to any allegation of the alleged inequitable conduct (such as a transferee of notes held by a target noteholder in the WaMu case). In fact, in other circumstances, courts have concluded that similar equitable remedies do not necessarily travel with a claim.
In In re Enron Corp., the debtors filed an action seeking equitable subordination under §510(c) and disallowance of certain claims under §502(d),22 based on the alleged inequitable conduct of the claims' original holders.23 The debtors sought subordination or disallowance of the claims held by good-faith purchasers for value as well. The U.S. District Court for the Southern District of New York declined to subordinate or disallow the claims held by purchasers, ruling that subordination is a "personal disability" of the original creditor that travels with claim assignment, but not in a sale of the claim.24 While Enron does not address equitable disallowance directly, the court's broad policy reasoning—that equitable subordination is remedial instead of penal and that a good-faith purchaser need not suffer from the wrongful conduct of the original claimant—could certainly apply to a situation in which equitable disallowance is sought with respect to a claim. The importance of whether an equitable disallowance remedy is personal to a claimant or follows a claim is particularly heightened where, as in WaMu, the claim arises from public securities of a debtor freely and regularly traded by parties on an arms-length basis prior to and during a debtor's bankruptcy case.
To Be Continued
It remains to be seen whether equitable disallowance will ever become a firmly recognized remedy available in bankruptcy cases. The WaMu decision is currently on appeal to the District Court for the District of Delaware (pending the mediation appointed by the bankruptcy court), so a district court may have the chance to further consider the availability of such a remedy. Moreover, both the Adelphia and WaMu courts recognized that to the extent such a remedy is available, its use would be reserved for the most extreme and rare circumstances of egregious conduct.
However, the WaMu decision serves as a reminder to creditors and claimants regarding the importance of dealing with a debtor in good faith, both prior to and during a bankruptcy proceeding, and the willingness of bankruptcy courts to consider what remedies may be available to address wrongful conduct to protect the interests of the debtor and its stakeholders.
Lisa Schweitzer is a partner, and Martin Kostov an associate, at Cleary Gottlieb Steen & Hamilton.