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SI Restructuring: Insiders May Provide a Secured Loan of Last Resort - If Careful
12/01/2008

The Fifth Circuit Court of Appeals recently provided guidance to Texas lawyers on the equitable subordination of insider loans of last resort to a financially troubled company. Equitable subordination generally has been understood to involve moving a creditor's valid claims behind the claims of others in order to remedy some misconduct by the creditor that harmed the debtor or other creditors. This judge-made doctrine predates the Bankruptcy Code (adopted in 1978), but its application, for the most part, has not changed. Section 510 of the Bankruptcy Code provides in relevant part that a bankruptcy court may, under principles of equitable subordination, subordinate for purposes of distribution all or part of one allowed claim to all or part of another. Courts in the Fifth Circuit and elsewhere have concluded that subordination requires three elements: (1) the claimant must have engaged in inequitable conduct; (2) the misconduct must have resulted in injury to the creditors of the debtor or conferred an unfair advantage on the claimant; and (3) subordination must not be inconsistent with the provisions of the Bankruptcy Code.

In Wooley v. Faulkner (In re SI Restructuring, Inc.), 532 F.3d 355 (5th Cir. June 20, 2008), the Fifth Circuit reversed the Bankruptcy Court for the Western District of Texas' decision to equitably subordinate the claims of former officers and directors of Schlotzsky’s, Inc. ("Schlotzsky's"). The officers and directors (the "Wooleys") had extended two secured loans of last resort to Schlotzsky's in the year prior to its bankruptcy filing. After the Wooleys filed secured claims in the bankruptcy proceeding, the unsecured creditors' committee brought an adversary proceeding seeking to equitably subordinate the claims. The committee argued that the Wooleys had breached their fiduciary duties to the company by presenting the second loan as the only option outside of an immediate bankruptcy filing. It also objected to the Wooleys obtaining security not only for the loan, but also for pre-existing guarantees of the company's debt - thus essentially "releas[ing] them as guarantors on the debt." The bankruptcy court agreed with the committee and subordinated the Wooleys' claims, and the district court affirmed.

The Fifth Circuit reversed this decision, holding that the loan did not harm the company's creditors or provide the Wooleys with an unfair advantage, and thus did not meet the second element of equitable subordination. Because the proceeds from the loan had been used to pay the claims of some unsecured creditors, the class of unsecured creditors as a whole had not been harmed. Perhaps individual creditors had been harmed by the company's decision to pay some creditors over others, but such individualized harm cannot support subordination. The Fifth Circuit also rejected the committee's theory of harm based on a deepening insolvency theory. Such a theory essentially argues that the extension of bad debt, by prolonging a company's ultimate demise, dissipates an entity's assets to the harm of its creditors. The Fifth Circuit refused to recognize such a theory, and noted in any event that the facts of the case did not support the theory. Finally, the court overturned the lower courts' ruling that the securing of the Wooleys' guarantees provided them with an unfair advantage. No unfair advantage arose under the facts of the case, explained the court, because the guarantees were never actually triggered.

This case provides both comfort and a warning to insiders considering a secured loan of last resort to a struggling company. Such a loan should not be equitably subordinated so long as the lender does not overreach. To avoid subordination, lenders should ensure that the loan proceeds are used to pay unsecured creditors. The payment need not necessarily be distributed equally among unsecured creditors, however, which should assist in paying those vital creditors needed to stave off bankruptcy. Additionally, insiders should be extremely careful in securing existing guarantees as part of the transaction. Although this did not result in subordination of the Wooleys' claim, the opinion contains a strong indication of a different result if the guarantees had in fact been triggered. Finally, insiders should be careful to avoid placing the company under potential duress by suggesting that the loan is the only alternative to immediate bankruptcy, as this is the type of arguably inequitable conduct which called the Wooleys' loan into question. Because of the disastrous consequences of subordination, insiders should always consult with counsel and specifically consider the SI Restructuring opinion before providing a loan of last resort.

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