When Equitable Subordination Isn’t Equitable.
Most insolvency practitioners are familiar with the fighting which often ensues when creditors jockey for position over a troubled firm’s capital structure.Â From Kansas, a recentÂ decision issued in February highlights the standards which apply to claims that a senior creditor’s claim ought to be “subordinated” to those of more junior creditors or equity-holders.
QuVIS, Inc. (“QuVIS”),Â a provider of digital motion imaging technology solutions in a number of industries, found itself the target of an involuntary Chapter 7 filing in 2oo9.Â The company converted its case to one under Chapter 11 and thereafter sought to reorganize its affairs.
QuVIS â€™ debt was structured in an unusual way.Â When presented with some growth opportunities in the early 2000’s, the company issued secured notes under a credit agreement that capped its lending at $30,000,000.Â â€śInvestorsâ€ť acquired these notes for cash and received a security interest, evidenced by a UCC-1 recorded in 2002.Â One of QuVIS’ “investors” was Seacoast Capital Partners II, L.P. (“Seacoast”), a Small Business Investment Company (â€śSBICâ€ť) licensed by the United States Small Business Administration.Â Between 2005 and 2007, Seacoast lent approximately $4.25 million through a series of three separate promissory notes issued by QuVIS.Â In 2006, and consistent with the purposes of the Small Business Investment Act of 1958, under which licensed SBICs are expected to provide management support to the small business ventures in which they invest, Seacoast’s Managing Director, Eben S. Moulton (â€śMoultonâ€ť), was designated as an outside director to QuVIS’ board.
In 2007, it came to Seacoast’s attention that, despite its belief to the contrary, a UCC-1 had never been filed on Seacoast’s behalf regarding its loans to QuVIS.Â Nor had the earlier (and now lapsed) UCC-1 filed regarding QuVIS’ other “investors” ever been modified to reflect Seacoast’s participation in the company’s loan structure.Â Seacoast immediately filed a UCC-1 on its own behalf in order to protect its position.Â Some time after QuVIS found itself in Chapter 11 in 2009, the Committee of Unsecured Creditors (and other, less alertÂ “investors”) sought to subordinate Seacoast’s position.
The Committee’s argument was based exclusively onÂ 11 U.S.C. Â§ 510(c), which provides, in pertinent part:
Notwithstanding subsections (a) and (b) of this section, after notice and a hearing, the court mayâ€” (1) under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim …
“Equitable” subordination is based on the idea of “inequitable” conduct –Â such asÂ fraud, illegality, or breach of fiduciary duties.Â Where an “insider” or a fiduciary of the debtor is the target of a subordination claim, however, the party seeking subordination need only show some unfair conduct, and a degree of culpability, on the part of the insider.
Seacoast sought summary judgment denying the subordination claim.Â In granting Seacoast’s request, Judge Nugent of the Kansas Bankruptcy Court distinguishedÂ Seacoast’sÂ Managing DirectorÂ from Seacoast, finding that though Moulton was indeed an “insider,” Seacoast was not.Â Â Therefore, Seacoast’s claim was not subject to subordination for any “unfair conduct” which might be attributable to Moulton.Â To that end, Judge Nugent also appeared to go to some lengths to demostrate that Mr. Moulton’s conduct was not in any way “unfair” or detrimental to the interests of other creditors.
Subordination claims are highly fact-specific.Â With this in mind, the facts of the QuVIS decisionÂ afford instructive reading for lenders whose lending arrangements may entitle them to designate one of the debtor’s directors.