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Equitable Subordination Claims Info

Section 510(c) of the Bankruptcy Code (11 U.S.C. § 510(c) (1994)) permits the
bankruptcy court to subordinate, on equitable grounds, all or part of a lender’s allowed
claim or interest, to transfer any lien securing a subordinated claim to the bankruptcy
estate, or to disallow the claim entirely, in the appropriate circumstances, even if no
preferential transfer (under § 547 of the Bankruptcy Code) or fraudulent conveyance
(under § 548 of the Bankruptcy Code) has occurred. It is well established that a
bankruptcy court has the authority to subordinate a claim on equitable grounds.

The bankruptcy court generally invokes the sanctions set forth in § 510(c) when the
lender has engaged in overreaching or lender control, which occurs when the lender
steps beyond the traditional role of a lender and participates in the debtor’s business or
engages in other egregious conduct that justifies the use of the court’s equitable powers.
In these situations, the court may decide to subordinate, recharacterize, or even disallow
a transaction that would not constitute a preferential transfer or a fraudulent conveyance.

The principles of equitable subordination are not set out in the Bankruptcy Code, and are
defined by case law. Equitable subordination is an extraordinary remedy and courts have
generally held that the following conditions must be satisfied before the sanctions of §
510(c) will be imposed: the claimant must have engaged in some kind of inequitable
conduct; the misconduct must have resulted in injury to the creditors of the bankrupt or
conferred an unfair advantage on the claimant; and equitable subordination of the claim
must not be inconsistent with the provisions of the Bankruptcy Code. Because equitable
subordination is remedial, not penal, the claim will generally be subordinated only to the
extent necessary to offset the specific harm that the debtor and its creditors suffered on
account of the alleged inequitable conduct.

An equitable subordination claim has been deemed, under some circumstances, to be a
"core proceeding" under the Bankruptcy Code, and may "trump" a pending state
foreclosure action. In a recent Vermont bankruptcy case, In re CRD Sales and Leasing,
Inc., 231 B.R. 214 (Bankr. Vt. 1999), the debtors brought an adversary proceeding
against the mortgagee, and removed the mortgagee’s pending foreclosure action to the
bankruptcy court. The debtors sought equitable subordination of the mortgagee’s claim,
injunctive relief, and a determination of the validity and extent of the mortgagee’s lien.
The equitable subordination claim was based on alleged misconduct by the mortgagee,
including breach of contract, tortious interference with a contract, promissory estoppel,
violations of the Equal Credit Opportunity Act, violations of [a Vermont discrimination
statute], and negligence.

Although foreclosure proceedings in state court are generally deemed "non-core," where
the foreclosure action is based on the same facts as the debtor’s equitable subordination
claim, it may not be remanded to state court. This is so because if the automatic stay in
bankruptcy were terminated and foreclosure proceeded, the trustee (or debtor in
possession) would be deprived of the equitable foreclosure defense, which is available
solely as the result of federal bankruptcy law (§ 510(c) of the Bankruptcy Code). See In re

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CRD Sales and Leasing, Inc., supra, 231 B.R. at 218-20 ("Equitable subordination, for
lack of a better term, is the proverbial 500-pound gorilla of this case – the doctrine is not
bound by state law, and it can trump the state law foreclosure, even if that foreclosure is
legally valid"; the court also noted that "[b]ecause the equitable subordination claim
dominates this proceeding, we think that the entire matter is core under 28 U.S.C. §§
157(B)(K) & (O). Accordingly, mandatory abstention does not apply").

See also In re Poughkeepsie Hotel Ass. Joint Venture, 132 B.R 287, 292 (Bankr.
S.D.N.Y. 1991) ("If the automatic stay is terminated and the movant allowed to foreclose,
the estate would be deprived of these defenses [equitable subordination] in the
nonbankruptcy forum"; Aetna v. Danbury Square Ass. Ltd. Partnership (In re Danbury
Square Ass. Ltd. Partnership), 150 B.R. 544, 547 (Bankr. S.D.N.Y. 1993) (noting that
remanding the pending foreclosure action to state court would deprive the trustee of the
defense of equitable subordination); 9281 Shore Rd. Owners Corp v. Seminole Realty
Co. (In re 9281 Shore Road Owners Corp), 187 B.R. 837, 853 (Bankr. E.D.N.Y. 1995)
("The basis for these rules of equitable subordination is that the bankruptcy court has the
equitable power and the duty to sift the circumstances surrounding any claim to see that
injustice or unfairness is not done in administration of the bankrupt estate"); Walker v.
Bryans (In re Walker), 224 B.R. 239, 242 (Bankr. M.D. Ga. 1998) ("For example, this
Court might decide that the conduct of Defendant in the foreclosure warrants equitable
subordination of Defendant’s claim while, at the same time, a state court might rule that
foreclosure was proper and that no damages are warranted").

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