Posted by Kathy Bazoian Phelps
The tool of equitable subordination in a Ponzi scheme case can have a significant impact on the ultimate distributions in the case. Whether used by a trustee seeking to subordinate a claim, or challenged by a creditor seeking to hold on to the priority of its claim, § 510(c) of the Bankruptcy Code can cause significant swings in the manner in which claims are ultimately allowed and paid in a Ponzi scheme case.
The standards for equitable subordinate were best defined in In re Mobile Steel Co., 563 F.2d 692, 700 (5th Cir. 1977), which stated in part that a court can equitably subordinate a claim when the claimant has “engaged in some type of inequitable conduct” and the “misconduct must have resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant.”
In the past year, we have seen some high profile decisions and discussion on the topic, which leave room for questioning exactly what standard is applied. In the Bernie Madoff Ponzi scheme case, the trustee sought to have the claims of Saul B. Katz and related defendants subordinated based on allegations that the defendants did not receive fraudulent transfers in good faith and that they had engaged in inequitable conduct. Picard v. Katz, 462 B.R. 447 (S.D.N.Y. 2011). The court declined to dismiss the complaint, finding that, “this alleged misconduct would have injured any investors who invested in Madoff Securities based on the impressive returns others appeared to receive.” In other words, a trustee in a Ponzi scheme could subordinate claims of investors by proving that they acted “with knowledge, or in reckless disregard” of the fraud. This could be a powerful tool for trustees to reprioritize claims and bump certain investor claims ahead of others.
On the other hand, just last month, the Seventh Circuit held that equitable subordination of a bank’s claim was inappropriate because “gross and egregious misconduct” had not been demonstrated. In re Sentinel Management Group, Inc., 2012 U.S. App. LEXIS 16546 (7th Cir. Aug. 9, 2012). In that case, the debtor was supposed to maintain customer assets in segregated accounts, but instead had pledged hundreds of millions of dollars in customer assets to secure a loan from the Bank of New York. The trustee sued the bank, alleging that the bank knew that that debtor had fraudulently used customer assets to finance the loan and that the bank acted inequitably and unlawfully.
The Sentinel court held that equitable subordination of the bank’s claim was inappropriate because the bank was negligent, not fraudulent. The court noted, “Perhaps the bank should have known that [the debtor had] violated segregation requirements, but as the district court found, ‘such a lack of care does not rise to the level of the egregious misconduct necessary for equitable subordination.’”
The Sentinel court was quite critical of the bank officials, calling them “such artless liars that they couldn’t have been concealing deliberate wrongdoing. Instead, the bank officials were simply trying to cover up their own incompetence . . . . And incompetence alone, however problematic, won't require the equitable subordination of the bank’s lien.”
The juxtaposition of these two cases leaves the standard for equitable subordination confused. In one case, Picard v. Katz, equitable subordination is a possibility where there is an investor accused of not accepting transfers in good faith and allegations that other investors might have invested based on the impressive returns paid to the defendant investor.
Picard v. Katz Score Card
Inequitable conduct – Yes
Harm to other creditors – Maybe
Equitable Subordination – Yes
In the other case, In re Sentinel Management, the bank is alleged to have known about the fraud, but the court merely found it incompetent. Rather than speculating that others might be damaged, many investors were actually damaged when the bank accepted the investors’ supposedly segregated funds as collateral for a loan. Equitable subordination was not allowed in Sentinel despite the actual harm to the investors.
Sentinel Score Card
Inequitable conduct (defined as “egregious conduct”) – No
Harm to other creditors – Yes
Equitable Subordination – No
These cases demonstrate that some form of inequitable conduct makes all the difference. But what is “inequitable conduct”? Sentinel says that “gross incompetence” - sufficient to cause a district court judge to call you an “artless liar” - is not inequitable conduct. However, the Sentinel court appears to have morphed the "inequitable conduct" test of Mobile Steel into an “egregious misconduct” test. The Katz court, on the other hand, was more focused on some form of wrongful conduct which harmed other creditors or conferred an unfair advantage on the claimant.
The question that is left open after these two cases is whether the “inequitable conduct” test of Mobile Steele was intended to cover any wrongful conduct, even negligence, for the purpose of protecting creditors whose conduct was wholly innocent. In any event, an equitable subordination claim is by definition an equitable claim that should not be subject to rigorous "elements," but rather a weighing of all of the circumstances. However, while the standard is a bit gray, the consequences can be black and white on the issue of whether a particular creditor will receive any payment in a Ponzi case.
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