Sitting as courts of equity, bankruptcy judges have embraced an exceptionalist role whereby they exercise widespread discretion in deciding cases. The doctrine of equitable subordination epitomizes bankruptcy exceptionalism and its potential for market distortion.

The doctrine originated as a remedial measure to give innocent creditors of insolvent debtors priority over creditors that engage in malicious misconduct. The Supreme Court introduced equitable subordination in a bankruptcy case in which a parent company virtually preyed upon its subsidiary, effectively driving it into insolvency. The Court ruled that the subsidiary’s preferred shareholders should have priority over the parent’s intercompany debt claims against the subsidiary’s assets. For decades, in conformity with that case, equitable subordination required a showing of creditor misconduct.

In 1978, however, the newly enacted federal Bankruptcy Code codified the doctrine, referring simply to “principles of equitable subordination” and without providing standards. The legislative history was ambiguous about whether Congress intended equitable subordination to continue to require creditor misconduct. Some courts held that the doctrine should follow existing case law and continue that requirement. Other courts, however, decided to use their equitable powers to create a more flexible no-fault equitable-subordination jurisprudence. Those latter courts relied, at least partly, on a new Supreme Court decision that equivocally recognized the creditor-misconduct requirement as “influential” while observing that the development of the equitable subordination doctrine should be left “to the courts” and also stating that “we need not decide today whether a bankruptcy court must always find creditor misconduct before a claim may be equitably subordinated.”

That ambiguity allowed equitable subordination to devolve into a doctrine by which bankruptcy judges reform contracts by reallocating repayment priorities according to their individual perceptions of the equities of the case, increasing uncertainty and the cost of credit. The devolution followed classic slippery-slope logic. Courts applying no-fault equitable subordination originally limited it to intuitively appealing fact patterns, such as equitably subordinating government tax-penalty claims to ordinary creditor claims. Over time, however, the no-fault doctrine transcended those fact patterns.

In one case, for example, a bankruptcy judge equitably subordinated the claims of bank lenders because the lead bank was, as is commercially reasonable, motivated primarily by fees.

In another case, a bankruptcy judge held (and the federal district court affirmed, on appeal) that strictly enforcing a creditor’s contract rights can constitute a fault, justifying equitable subordination.

Scholars uniformly criticize judicial development of the no-fault doctrine as a potential threat to legal certainty and predictability. The law has myriad no-fault doctrines, but they generally are justified by other policy considerations. A no-fault legal doctrine that lacks a clear policy justification can be confusing and lead to arbitrariness.

No-fault equitable subordination also can distort the important commercial law policy of protecting market expectations. Lenders need certainty in order to function effectively. Certainty also is critical to achieve stability in financial markets. Additionally, it is well established that uncertainty can raise the cost of credit and its availability.

My new article reconceptualizes equitable subordination as a primarily fault-based doctrine, to try to achieve two goals: to minimize raising the cost of credit by protecting ex ante expectations, especially those of lenders; and to preserve the doctrine’s equitable benefits of penalizing misconduct to protect fairness. The article also analyzes what fault-based should mean. Among other things, it proposes that courts should avoid micromanaging or second-guessing creditor behavior; instead, in parallel to the business judgment rule, courts should give substantial deference to the good faith actions of non-insider creditors who are not otherwise conflicted. The article also shows how Congress should amend § 510 of the Bankruptcy Code to achieve these goals.

Finally, the article observes that the lesser-known doctrines of judicial recharacterization and disallowance often are conflated with equitable subordination, and their no-fault applications have the same potential as no-fault equitable subordination to raise the cost of credit. Under the doctrine of judicial recharacterization, for example, courts can recharacterize legitimate debt claims associated with ownership as equity interests, thereby subordinating them to other debt claims or, sometimes, confusingly disallowing them altogether. The article shows that these doctrines are confusing and irrelevant and have been sharply disparaged. It argues that these doctrines should be discarded.

This post comes to us from Steven L. Schwarcz, the Stanley A. Star Distinguished Professor of Law & Business at Duke University School of Law and a senior fellow at the Centre for International Governance Innovation (CIGI). It is based on his recent article, “The Inequities of Equitable Subordination,” available here.