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Keywords

contractequityappealbankruptcy

equityappealbankruptcy

Related Cases

Kham & Nate’s Shoes No. 2, Inc. v. First Bank of Whiting, 908 F.2d 1351, 59 USLW 2166, 23 Collier Bankr.Cas.2d 1118, 20 Bankr.Ct.Dec. 1305, Bankr. L. Rep. P 73,565

Facts

Kham & Nate's Shoes No. 2, Inc. filed for bankruptcy in 1984, having operated four retail shoe stores in Chicago. The First Bank of Whiting, a creditor, had extended credit to the debtor since 1981, but due to the debtor's financial struggles, the bank's secured claim was reduced to unsecured status in the reorganization plan. The bankruptcy judge found that the bank had behaved inequitably by terminating the line of credit and allowing suppliers to draw on letters of credit, which converted the bank's position from unsecured to super-secured. The judge confirmed a reorganization plan that allowed the debtor's principals to retain their equity interests based on their guarantees of new loans.

Kham & Nate's Shoes No. 2, Inc., ran four retail shoe stores in Chicago. It has been in bankruptcy since 1984, operating as a debtor in possession. First Bank of Whiting, one of Kham & Nate's creditors, appeals from the order confirming its plan of reorganization.

Issue

Did the Bankruptcy Court err in equitably subordinating the bank's claim and allowing the debtor's stockholders to retain their equity interests despite the absolute priority rule?

The bank was not guilty of any 'inequitable conduct' such as would permit equitable subordination of super priority claim which it brought pursuant to financing order previously entered by bankruptcy court.

Rule

Equitable subordination under 11 U.S.C. § 510(c) requires a finding of inequitable conduct by the creditor, an unfair advantage gained, and injury to other creditors. The absolute priority rule mandates that a class of creditors must be paid in full before a junior class can retain any property.

Equitable subordination usually is a response to efforts by corporate insiders to convert their equity interests into secured debt in anticipation of bankruptcy.

Analysis

The Court of Appeals found that the bank did not engage in inequitable conduct as it acted within its contractual rights to terminate further advances. The court emphasized that the bank's actions did not constitute an unfair advantage since it had not breached any promises to the debtor. Furthermore, the court ruled that the stock retained by the stockholders was considered property under the absolute priority rule, and the stockholders' guarantees did not qualify as 'new value' to justify their retention of equity interests.

Judge Coar gave two principal reasons for subordinating Bank's claim. One is that the 'Bank was fully aware of the Debtor's plight, and its reliance upon the line of credit, and disregarded the consequences for the Debtor and its creditors.' The other is that Bank obtained an 'unfair advantage' by inducing suppliers to draw on the letters of credit after the financing order, thus promoting its position on these advances from unsecured to supersecured.

Conclusion

The Court of Appeals vacated the Bankruptcy Court's order and remanded the case, ruling that the bank's claims should not be subordinated and that the stockholders could not retain their equity interests under the absolute priority rule.

Vacated and remanded.

Who won?

First Bank of Whiting prevailed in the case as the Court of Appeals ruled that the bank's claims should not be subordinated and that the stockholders could not retain their equity interests.

The Bank first extended credit to the Debtor in July 1981. This $50,000 loan was renewed in December 1981 and repaid in part in July 1982.

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