Delaware Bankruptcy Court Ruling Highlights Potential Defenses to Equitable Subordination Action – Insolvency/Bankruptcy


On March 25, 2022, the U.S. Bankruptcy Court for the District of Delaware dismissed a lawsuit filed against a lender and other entities. An individual (and others) who previously controlled the bankrupt companies sued the creditor for equitable subordination of the lender’s claims under 11 USC § 510(c). The plaintiffs asserted that the claims of the lender (and others acting in concert with the lender) should be subordinated to the payment of the plaintiffs’ claims due to the lender’s unfair “scheme”. The court ruling provides a guide for lenders engaged in relief discussions or, if litigation is filed by a borrower, seeking to dismiss such litigation before the costly discovery process begins.

Facts underlying the equitable subordination claim

In In re Zohar III, Corp., 2022 WL 883325, – BR – (Bankr. D.Del. Mar. 25, 2022), obligors (the “Zohar Funds”) were a type of investment vehicle called a “secured loan obligation.” Obligors obtained funds from several classes of noteholders and used them to purchase a portfolio of discounted distressed senior secured loans and to provide high-interest loans to distressed companies (the ” portfolio companies”) in exchange for promises of repayment and equity. positions in portfolio companies. The investment strategy was developed by the principal of the debtors, Lynn Tilton, and she — personally or through other controlled entities — owned the equity in the portfolio companies. Ms. Tilton’s affiliated entities, the patriarch entities, served as collateral managers for the Zohar funds. Ms. Tilton has also established herself as a director and manager or CEO of each of the portfolio companies. The investment plan anticipated that some loans would underperform, but the collective portfolio would generate enough cash flow to repay noteholders the promised principal and interest.

The primary target of the fair subordination suit was MBIA Insurance. MBIA provided financial guarantee insurance to the categories of notes issued by obligors Zohar I and Zohar II. When these Zohar funds defaulted, MBIA paid a total of $919 million to insured Class A noteholders. In 2019, Zohar III also defaulted.

Years of negotiations and litigation preceded the filing for bankruptcy by the Zohar funds. After the bankruptcy petitions were filed, the plaintiffs (Ms. Tilton, the Patriarch Entities, and other related entities) sued MBIA and others to have the claims of the defendants in the bankruptcy cases subordinate to the claims held by the applicants. As summarized by the bankruptcy court in its decision, the plaintiffs’ claims alleged that “MBIA devised a plan to quickly take control and sell the portfolio companies, disregarding Ms. Tilton’s interests and ignoring the decline in value.” which resulted. The amended complaint alleges that the scheme orchestrated by MBIA amounts to years of unfair conduct….” Zohar, at 4 o’clock.

Elements of the Fair Subordination Claim

In dismissing the complaint, the bankruptcy court first addressed the elements of an equitable subordination cause of action and the different standards applicable to insiders versus non-insiders. The bankruptcy court first recognized that equitable subordination is a “drastic” and “unusual” remedy that should only be applied in limited circumstances. He then determined that to survive the motion to dismiss, the complaint had to sufficiently allege three conditions:

  1. the creditor whose claim is sought to be subordinated must have engaged in some type of unfair conduct;

  2. the fault must have caused injury to the creditors of the bankrupt company or conferred an undue advantage on the plaintiff; and

  3. the equitable subordination of the claim must not be inconsistent with the provisions of the Bankruptcy Act

The Importance of Insider Status vs. Non-Initiate Status

The bankruptcy court noted that there are key differences in considering the sufficiency of causes of action against an insider as opposed to causes of action against a non-insider. In addition to the statutory definition of an insider (including officers and directors), an “insider” under the Bankruptcy Code also includes an entity or person controlling the bankrupt entity. Outside the legal definition, insider status is inferred when a creditor has a close relationship with the debtor and something other than the close relationship suggests that their transactions were not conducted under fair conditions. full competition. If a creditor (such as a lender) is an insider, a plaintiff may support his claim with evidence of merely unfair or unfair conduct, as transactions between a debtor and an insider are subject to greater scrutiny. If the creditor is a layperson, however, proof of more egregious conduct, such as fraud, is required.

Arguments raised

The main arguments raised by MBIA (and his co-defendants) included that:

  1. the allegations in the complaint did not support the conclusion that they were insiders;

  2. certain issues had already been the subject of litigation in the context of litigation prior to the request;

  3. factually inconsistent allegations were raised in the complaint; and

  4. there were contractual provisions expressly allowing them to take the actions that constituted the alleged inequitable conduct.

Insider Status

An accused named in the Zohar III case was US Bank, which merely served as the indentured trustee for noteholders of the Zohar funds. The bankruptcy court determined that the complaint did not explain how US Bank possessed the necessary day-to-day control over the Zohar funds, let alone a relationship with them beyond its role as trustee under contract of trust…” . Identifier. At 11 o’clock.

With respect to MBIA and the “controlling class” of the Zohar Fund III who allegedly wanted to displace Ms. Tilton’s control of the Zohar Funds, the bankruptcy court found that these defendants were “insiders” (and therefore subject to higher level of control) only after control was wrested from Mrs. Tilton – i.e. after Mrs. Tilton and her patriarchal entities agreed, after litigation in other courts, to step down as collateral manager of the Zohar funds and to be replaced by turnaround experts (Alvarez & Marsal and Zohar Management “AMZM”), and therefore the stricter insider standard only applied at that time .

Factually inconsistent claims that the negotiations had an “illegitimate purpose”

Another category of allegations in the complaint related to MBIA’s negotiations to extend the maturity date of the Zohar I tickets. The bankruptcy court dismissed the plaintiff’s allegations that the negotiations were merely an effort to Mrs. Tilton.

The bankruptcy court said:

Plaintiffs admit that MBIA has repeatedly told Ms. Tilton and her advisers that they support a maturity date extension and global restructuring. Plaintiffs further tell a detailed story of the extensive efforts made by all parties to reach an agreement which lasted three years and ended one month before the due date of Zohar I. It is undisputed that final terms for an extension and restructuring were never agreed. From these facts, the plaintiffs ask the Court to infer that MBIA, facing serious financial difficulties, intentionally “threaded [Ms. Tilton] long’ for three years with the false promise of a maturity extension and comprehensive restructuring to cause Zohar I to default and allow it to implement a plan to steal and sell its assets. To arrive at such a conclusion from the facts presented would be unreasonable.

Identifier. to *22 (emphasis added).

Contractual provisions allowing the creditor to take the measures it has taken

The complaint also included allegations that “MBIA had the right under the Trust Indenture to direct that the [Zohar Fund’s]the guarantee is liquidated.” Identifier. At 11 o’clock. Further, the bankruptcy court noted, “MBIA and the Zohar III Control Class do not dispute that they selected AMZM and were able to run it, but contend that they were merely exercising the post-default rights granted to them in under the claims collection deeds.” Identifier. to *18. The bankruptcy court reiterated, “The Zohar III control class contends, and the plaintiffs do not dispute, that their pre-petition actions were, in fact, authorized by the plain language of the deed.” Identifier. to *19.

The bankruptcy court concluded:

Plaintiffs ask the Court to disregard objective realities (including the contractual rights of the parties and the successful litigation of those rights), arguing that Class Control Zohar III and MBIA (as well as AMZM) acted for a purpose illegitimate – take and sell Mrs. Tilton’s equity for their benefit and to harm her… But as a general rule the pursuit of her legal rights, including the exercise of contractual rights, may not constitute grounds for subordination fair even if the rights are harshly exercised and cause prejudice to other creditors.

Identifier. at *24.

The bankruptcy court found that “history has shown that MBIA and the Zohar Control Class III diligently and successfully enforced (and enforced by the Zohar Funds) their rights under the applicable transaction documents.” Identifier. to *25.


the Zohar The decision provides a number of suggested and potentially fruitful arguments for creditors who are defending against a fair subordination claim and can potentially dismiss such a claim at the litigation stage motion to dismiss. First, and to the greatest extent supported by the facts, creditors should rigorously oppose any effort to label them as insiders and subject their allegedly unfair conduct to a higher level of scrutiny. The decision also demonstrates that if a creditor has negotiated in good faith, but failed to reach an agreement, any argument that the negotiations give rise to an allegation of improper conduct must be vigorously contested. A creditor-defendant should also argue that issues previously addressed in pre-bankruptcy litigation need not be re-litigated. Finally, and perhaps most importantly, the Zohar The decision supports the proposition that a lender may be able to summarily rebut an allegation of inequitable conduct if it can demonstrate that it has exercised its rights consistently under the existing contracts between the parties, because, as recognized by the bankruptcy court, a claim to the contrary may be construed as an attempt to rewrite the terms of the agreements in question, and”[p]The parties have the right to enter into good and bad contracts, the law applies to both.” Identifier. (quoting Nemec vs. Shrader991 A.2d 1120, 1126 (Del. 2010)).

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.


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