Two recent Federal appeals court decisions — one issued by the Fifth, the other by the Second Circuit — illustrate the dangers of careless drafting of bankruptcy and reorganization plans. In the Fifth Circuit decision, a drafting error prevented a company reorganized under Chapter 11 from suing the administrators of its property during its bankruptcy for fraud, breach of fiduciary duty and negligence, thereby potentially depriving its creditors of bankruptcy assets.

A recent decision of the Court of Appeals for the Seventh Circuit appears to have further raised the hurdle to equitably subordinate claims. Continuing what appears to be a move toward a narrower interpretation of equitable subordination, the Seventh Circuit held that misconduct alone does not provide sufficient justification to equitably subordinate a claim; injury to the interests of other creditors is required as well.

Fifth Circuit Court of Appeals: Insured Can Recover Damages for Mental Anguish under Louisiana Bad Faith Statute Where Insurer Acted in Bad Faith by Delaying Payments
January 9, 2009 | Print this page

The U.S. Court of Appeals for the Seventh Circuit ruled in October that a creditor’s misconduct must result in harm to other creditors to justify the equitable subordination of a claim under Section 510(c) of the Bankruptcy Code.  

In In re Entringer Bakeries, Inc.,1 the United States Court of Appeals for the Fifth Circuit affirmed the viability of the “earmarking doctrine” as a judicially-created defense to a preference action under section 547(b) of the Bankruptcy Code.

In recent opinions, the United States Courts of Appeals for the Fifth and Seventh Circuits have revisited the doctrine of equitable subordination and have underscored the requirement that, before a court can equitably subordinate a creditor’s claim, the court must find that other creditors have been harmed by the actions of the creditor. Importantly, both decisions stress that equitable subordination is meant to be remedial and not punitive, and may not be imposed merely because a creditor has engaged in misconduct.

The U.S. Court of Appeals for the Fifth Circuit held on March 25, 2009, that a bankruptcy court had improperly surcharged property in the hands of a credit bidding asset buyer with the expenses of the judicial sale. In re Skuna River Lumber, LLC, __F.3d ___, 2009 U.S. App. LEXIS 6175 (5th Cir. 3/25/09). Explaining that the “bankruptcy court had no jurisdiction to take such action,” the Fifth Circuit also vacated the district court’s improper ruling that the bankruptcy judge could enter a personal judgment against the asset buyer. Id., at *9.  

Facts

Troubled economic times predictably result in an escalation in bankruptcy filings. As the economy began to worsen last year, the U.S. Court of Appeals for the Fifth Circuit issued a reminder that courts can—and will—penalize parties that tax an already busy bankruptcy court system with bad faith filings.

A bankruptcy filing by a property owner may not be the only action that prevents foreclosure of a security interest in that property held by a secured creditor. In a growing list of cases, courts also have held the bankruptcy of a junior secured creditor with a lien on the property invokes the automatic stay against such action.

Directors and officers managing corporations, especially when the corporation is insolvent or operating in insolvency situations, need to be cognizant of their fiduciary duties. This alert provides a brief overview of these fiduciary duties, including practical considerations in the exercise of these duties.

Fiduciary Duties When a Corporation is Solvent