Article Courtesy of Margaret G. Parker-Yavuz (Akin Gump Strauss Hauer & Feld LLP); Secondary Contributor Troy DeLeon (Akin Gump Strauss Hauer & Feld LLP)
Tilton v. MBIA Inc. (In re Zohar III, Corp.), 639 B. R. 73 (Bankr. D. Del. March 25, 2022)
Overview:
Plaintiff creditors filed a complaint with the U.S. Bankruptcy Court for the District of Delaware seeking a judgment to equitably subordinate certain other creditors’ claims against Chapter 11 debtors to the plaintiffs’ own claims pursuant to section 510(c) of the Bankruptcy Code. The court dismissed the complaint, finding that it failed to allege sufficient facts from which the court could infer that defendants behaved inequitably.
Full Summary:
The debtors in this Chapter 11 case (the “Debtors”) include, among other affiliated entities, three collateralized loan obligation (CLO) funds, Zohar CDO 2003-1, Limited (“Zohar I”), Zohar II 2005-1, Limited (“Zohar II”) and Zohar III, Limited (“Zohar III” and, together with Zohar I and Zohar II, the “Zohar Funds”). The Zohar Funds invested funds provided by several noteholder-investor classes in purchasing distressed senior secured loans at a discount and in originating high-interest rate loans to distressed companies. MBIA Insurance Corporation (together with its affiliates, “MBIA”) provided financial guaranty insurance on certain classes of notes issued by the Zohar Funds.
The Zohar Funds were originally managed by entities controlled by Lynn Tilton (“Tilton”), who also held positions of control as director, manager or officer at the Zohar Funds’ portfolio companies and as sole director of each Zohar Fund. Through personal investment vehicles, Tilton owned preference shares in the Zohar Funds, invested in loans and equity of the portfolio companies and invested in the Zohar Funds as a noteholder.
Following the 2008-2009 financial crisis, the ability of the Zohar Funds to repay their notes at maturity was uncertain. Restructuring discussions were unsuccessful and, in 2015 and 2017, two of the Zohar Funds defaulted, resulting in MBIA paying over $900 million to insured noteholders. In 2016, MBIA instructed the indenture trustee, U.S. Bank, N.A. (“US Bank”), to conduct an auction of Zohar Fund collateral (including equity in portfolio companies that had been owned by Tilton and her affiliates) in which MBIA was the winning bidder. Also in 2016, after Tilton affiliates resigned as collateral managers for the Zohar Funds (which Tilton alleged they were induced to do by MBIA based on false promises), MBIA and controlling noteholders selected Alvarez & Marsal Zohar Management (“AMZM”) as the successor collateral manager. On the instructions of MBIA and controlling noteholders, AMZM removed Tilton from her board positions at certain portfolio companies. AMZM filed lawsuits to validate the removals and filed a civil RICO claim against Tilton and her affiliates.
In order to stay ongoing litigation and preserve value, Tilton caused the Zohar Funds to seek Chapter 11 bankruptcy protection. Tilton and her affiliates (“Plaintiffs”) subsequently filed the action at issue in this case against MBIA, US Bank, AMZM and a group of controlling noteholders (“Defendants”) to equitably subordinate the Defendants’ claims against the Debtors pursuant to section 510(c) of the Bankruptcy Code. Plaintiffs alleged that the Defendants, led by MBIA, orchestrated a scheme to obtain liquidity by taking control of and selling the portfolio companies – to the detriment of the Zohar Funds and Tilton’s interests in them – and that they engaged in several categories of inequitable conduct in doing so.
In examining Plaintiffs’ equitable subordination claim, the court noted that section 510(c)(1) of the Bankruptcy Code provides the court with the authority to “subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim…”, and that subordination under this provision is remedial and flows from bankruptcy courts’ traditional powers as courts of equity to undo or offset inequalities in the claim position of a creditor that will produce bankruptcy results that are unjust or unfair to others creditors. The court noted that equitable subordination is a “drastic” remedy and should be applied only in limited circumstances. It set out the test for appropriate exercise of the power, which requires the satisfaction of three conditions: (1) the claimant must have engaged in some type of inequitable conduct, (2) the misconduct must have resulted in injury to the creditors of the bankrupt party or conferred an unfair advantage on the claimant, and (3) equitable subordination of the claim must not be inconsistent with the provisions of the Bankruptcy Code.
With respect to the first condition for equitable subordination and whether the Defendants in this case engaged in inequitable conduct, the court noted that the most important factor in determining whether a creditor engaged in inequitable conduct for purposes of equitable subordination is whether the creditor was an insider or outsider to the debtor at the time of the act. If the creditor is an insider, the plaintiff must present material evidence of only “unfair conduct”, since dealings between debtors and insiders are rigorously scrutinized. If the creditor is a non-insider, the plaintiff must show more egregious conduct such as fraud, spoilation or overreaching. Section 101(31)(B) of the Bankruptcy Code sets forth several categories of insiders, including a “person in control of the debtor”. In order for a creditor to constitute a statutory insider based on control, the creditor must have day-to-day control over the debtor, such that it dictates corporate policy and disposition of corporate assets without limits. A non-controlling creditor can be considered a non-statutory insider if it has a close relationship with the debtor and some other factor suggests that their transactions were not at arms’ length. As an example of a non-statutory insider, the court cited Schubert v. Lucent Technologies, Inc. (In re Winstar Communications, Inc.), in which the Third Circuit found that the creditor – a major lender and supplier to the debtor – used the debtor to inflate its own financial appearance by forcing the debtor to purchase goods to the debtor’s detriment and involving the debtors’ employees in improper transactions.
Regarding the second condition for equitable subordination and determining whether the misconduct resulted in injury to creditors or conferred an unfair advantage on the claimant, the court noted that a claim should be subordinated only to the extent necessary to offset the harm suffered by the bankrupt party and its creditors due to the inequitable conduct.
On the third condition for equitable subordination and whether a claim is inconsistent with the Bankruptcy Code, the court noted that the doctrine of equitable subordination is not a mechanism for courts to change the statutory scheme to arrive at a result that the court considers more equitable.
In applying the conditions for equitable subordination to Plaintiffs’ complaint, the court found that, at the time of the relevant conduct for which the complaint provided support for a potential finding of inequitable conduct, all of the Defendants were insiders other than US Bank. Applying the relevant standards, the court found that Plaintiffs failed to show sufficient facts to establish that any of the Defendants acted inequitably. With respect to certain of the inequitable conduct allegations, the court found that Plaintiffs were collaterally estopped from seeking equitable subordination on those particular issues because they were previously litigated. In arriving at its finding, the court observed that, as a general matter, a party’s pursuit of its legal rights, including the exercise of contractual rights, may not be ground for equitable subordination even if the rights are exercised harshly or cause harm to other creditors. While certain cases have held that a creditor’s pursuit of its rights can be considered inequitable conduct, the court found those cases to be distinguishable because the creditor exceeded its authority under the loan agreement or acted inequitably in exercising its rights.
