The Inequities of Equitable Subordination

Abstract

The Supreme Court originated the doctrine of equitable subordination to reform contracts by prioritizing the claims of innocent creditors over those of creditors who engage in malicious misconduct. In recent decades, though, equitable subordination has devolved into a standardless doctrine under which judges sometimes subordinate claims in a no-fault manner according to their personal views of equity. The resulting uncertainty distorts commercial expectations and raises the cost of credit. Bold action is needed to correct this distortion. To that end, this Article reconceptualizes equitable subordination by analyzing how the doctrine should be reformulated to protect innocent creditors, while penalizing misconduct and preserving commercial expectations. Among other requirements, it argues that courts should adhere to a fault-based doctrine and that they should assess misconduct by a business judgment rule, similar to how courts assess corporate governance. Accordingly, courts should only find non-insider creditors, who are not otherwise conflicted, to have engaged in misconduct—making their claims subject to equitable subordination—if there is no rational business purpose for their alleged misconduct. To give lenders sufficient clarity and ex ante guidance, the Article explains why the reformulated doctrine should be legislatively implemented. Congress could accomplish that by amending 11 U.S.C. § 510 along the lines proposed in the Appendix to the Article. Finally, the Article compares the related doctrines of recharacterization and equitable disallowance. Often conflated with equitable subordination, those doctrines are shown to be confusing and irrelevant. The Article argues for their elimination.