Court Refuses to Equitably Subordinate Because Conduct Was Consistent With the Contract

Contributed by Jessica Diab

Generally, the priority scheme in section 507 of the Bankruptcy Code dictates the order in which a creditor is paid. For this reason, creditors can usually predict their standing among the other creditors awaiting payment. Section 510(c) of the Bankruptcy Code, however, permits the bankruptcy court to, among other things, subordinate, on equitable grounds, all or part of a creditor’s allowed claim or interest. In exercising such authority, the bankruptcy court is, in effect, altering creditors’ expectations in the name of “equity.” When it is appropriate to equitably subordinate a claim is left to a court’s determination and requires a court’s examination of the creditor’s conduct. This issue was recently considered by the Bankruptcy Court for the District of Maryland in Atlantic Builders Group, Inc. v. Old Line Bank (In re Prince Frederick Investment, LLC). The decision serves as a reminder that bankruptcy courts may be hesitant to equitably subordinate a claim of a creditor whose conduct, though perhaps inconsiderate or self-interested, was consistent with the contractual terms governing its behavior.
The debtor, an entity formed for the purpose of operating a medical center, entered into an agreement with Atlantic Builders Group, Inc. for the construction of the medical center. Shortly after ABG commenced construction, the debtor obtained a loan from Old Line Bank to fund the construction of the center and to pay ABG for its construction services. The loan was secured by a first-priority lien in the medical center and was guaranteed by the debtor. The bank and ABG entered into a separate agreement providing, among other things, that (1) ABG could not terminate performance (i.e., construction) under its contract with the debtor due solely to a default of the debtor without first affording the bank an opportunity to remedy the default, and (2) ABG was required to submit to and seek approval from the debtor and the bank of its monthly payment applications, including any proposed change orders (i.e., proposed charges for work not included in the original scope of construction project).
As construction progressed, the bank discovered that the debtor was undercapitalized and that the loan proceeds would be insufficient to pay ABG for the construction of the center. Nonetheless, the bank continued to approve each of ABG’s applications for payment and any and all change orders.
Ultimately, the debtor filed for chapter 11 protection before the completion of and payment for the medical center. As of the date of petition, the debtor owed the bank $3,194,640.00 under the loan; fortunately for the bank, its claim against the debtor was secured by a lien on the medical center, which was valued at $3,151,526.00. ABG, by contrast, had only an unsecured claim for the outstanding construction costs.
ABG commenced an adversary proceeding against the debtor and the bank, seeking a determination that the bank’s secured claim and liens should be equitably subordinated pursuant to section 510(c) of the Bankruptcy Code. In particular, ABG alleged that the bank purposefully withheld from ABG the fact that the debtor was undercapitalized and that loan would not cover ABG’s construction costs to induce ABG to finish the construction. ABG also alleged that the bank benefited from such withholding because the construction contractor’s continued work on the medical center enhanced the value of the bank’s collateral.  In response, the debtor and the bank filed a motion to dismiss and argued that, among other things, ABG’s complaint failed to state a cause of action for equitable subordination. The bankruptcy court agreed.
The concept of equitable subordination is codified in section 510(c) of the Bankruptcy Code; however, in determining whether a claim should be equitably subordinated, courts often rely on the common law principles enunciated in the Fifth Circuit’s decision in Benjamin v. Diamond (Mobile Steel). The bankruptcy court began its analysis with a summary of the oft-cited Mobile Steel test, which requires the party seeking to subordinate the claim of another claimant to demonstrate that:
(1) The claimant engaged in some sort of inequitable conduct;
(2) The conduct resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant; and
(3) Equitably subordinating the claim is not inconsistent with the provisions of the      Bankruptcy Code.
First, the bankruptcy court considered whether, as asserted by ABG, the bank engaged in inequitable conduct by knowingly withholding the fact that the debtor was undercapitalized.   According to the bankruptcy court, in order for ABG’s asserted conduct to amount to “inequitable conduct” ABG needed to establish not only that the debtor was undercapitalized, but also that the bank “engaged in egregious conduct that shocks the conscience of the court.”
Because the parties agreed that the debtor was undercapitalized, the bankruptcy court began by analyzing whether the bank’s conduct shocked the conscience of the court. According to the bankruptcy court, the determination of what would shock the court’s conscience would depend, in part, on whether the bank owed a fiduciary duty to the debtor and its creditors. Generally, lending institutions do not owe a fiduciary obligation to their customers and, in the rare circumstances that such a duty does exist, it requires a finding that the lending institution was exerting “dominion and control” over the debtor. According to the bankruptcy court, the exercise of “dominion and control” exists where the lending institution directs activities of the debtor (i.e., exercises managerial control) and is not present where the lending institution is merely exercising its contractual rights, including the right to monitor the debtor’s finances and make business recommendations. On these facts, the bankruptcy court found that the bank’s contractual right to review and approve payment applications and change orders on the construction of the center did not amount to the sort of “dominion and control” that would give rise to a fiduciary duty.
The bankruptcy court went on to consider whether, absent a fiduciary duty, the bank’s conduct nonetheless shocked the conscience of the court thereby warranting subordination. Ultimately, the bankruptcy court found insufficient evidence of egregious conduct. Quite simply, the parties had entered into an agreement that established the express rights and duties of the bank and ABG. Nothing in the agreement required the bank to keep ABG up-to-date on the loan relative to the costs being incurred by the debtor, and the court was not willing to infer any such duty. Finally, the court noted that the agreement, in fact, imposed a duty on ABG to notify the bank of any default, an aspect of the agreement with which ABG failed to comply. This irony was not lost on the bankruptcy court, which commented that ABG wrongfully sought to impose a duty on the bank that was not required by the agreement, all the while failing to comply with the agreement itself.
In sum, the bankruptcy court concluded that, absent a duty on the bank’s part, its conduct did not amount to the type of egregious conduct that would warrant the subordination of its claim. Accordingly, the bankruptcy court granted the motion to dismiss, holding that ABG did not state a plausible claim for equitable subordination.
This decision serves as a reminder that a claim for equitable subordination requires evidence of more than conduct that is (perhaps) inconsiderate and self-interested, particularly where such conduct is consistent with the terms of the parties’ agreement.