Lenders Beware: The Threat of Equitable Subordination in Bankruptcy Cases

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Desperate times call for desperate measures, so in the next few years lenders are likely to see more threats by debtors, bankruptcy trustees or competing creditors to subordinate their claims. Section 510(c) of the Bankruptcy Code grants the bankruptcy courts authority to relegate certain creditors’ claims to the ‘bottom of the barrel’ in terms of priority of payment under the “equitable subordination” doctrine. However, exactly what constitutes sufficient grounds for equitable subordination in a particular case remains the subject of much dispute. This uncertainty, combined with the potential for a lender to suffer a tremendous loss, is precisely what makes the threat of equitable subordination so daunting in many cases.

In a successful equitable subordination action, all or part of any secured or unsecured claim may be subordinated. For example, a senior secured claim might be subordinated to a junior secured claim, or if a secured creditor’s conduct was particularly egregious, the court may subordinate a secured claim to the claims of all the debtor’s general unsecured creditors. In effect, the theory of equitable subordination allows a court to strip a secured creditor of all validly perfected lien rights.

The requirements for determining whether equitable subordination is merited have been summarized as follows....

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