A Debtor Must Obtain Relief from the Automatic Stay Before Seeking to Equitably Subordinate Another Debtor’s Secured Claims Against Its Estate

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Contributed by Allen S. Blaustein

Weil secured a complete victory for Lehman Commercial Paper Inc. (“LCPI”) in the Ninth Circuit in a matter that has significant implications regarding the scope of an automatic stay imposed by section 362(a) of the Bankruptcy Code.  Section 362(a) bars actions that, among other things, would diminish the estate of a debtor in bankruptcy (the first debtor).  The Ninth Circuit held that “if another (also a debtor in bankruptcy) wants to equitably subordinate the creditor claims of the first debtor, it must seek relief from stay from the first debtor’s home bankruptcy court.” In re Palmdale Hills Property, LLC, — F.3d —-, 2011 WL 3320429, at *1 (9th Cir. Aug. 3, 2011).

Background

Prior to commencing its bankruptcy case in the United States Bankruptcy Court for the Southern District of New York, LCPI made approximately $1 billion in secured loans to various Palmdale entities that are part of a land development consortium.  The Palmdale entities defaulted on those loans prior to commencing their own bankruptcy cases in the Central District of California.  The Palmdale debtors subsequently sued LCPI in the California bankruptcy court seeking equitable subordination of LCPI’s secured claims against them and requesting that, as part of such equitable subordination, LCPI’s lien rights be transferred to the Palmdale debtors’ estates.  Although the California bankruptcy court rejected LCPI’s argument that such action violated the automatic stay imposed as a result of LCPI’s own chapter 11 case, the United States Bankruptcy Appellate Panel of the Ninth Circuit reversed the bankruptcy court and held that the Palmdale debtors’ equitable subordination action is an affirmative action that violates LCPI’s automatic stay.  The Palmdale debtors then appealed to the Ninth Circuit.  In the first decision by a United States Circuit Court to address this issue, the Ninth Circuit agreed with LCPI’s position and affirmed the Ninth Circuit BAP’s decision.

Goals of the Automatic Stay

The Ninth Circuit recognized that section 362(a) imposes an automatic stay in order to protect a bankruptcy estate from being depleted by creditors’ lawsuits and seizures of property and provides the debtor breathing room to reorganize.  To accomplish these goals, section 362(a)(1) & (3) prohibits (1) commencing or continuing actions against the debtor that began or could have begun before the bankruptcy was filed, or to recover a prepetition claim against the debtor, and (2) “any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate.”  Thus, actions seeking affirmative relief against a debtor’s estate are stayed.

LCPI’s Automatic Stay Prevented LCPI’s Claims from Being Subordinated

Quoting the Ninth Circuit BAP’s 2007 decision in Capital Diversified Trust Deed Fund, LLC (In re USA Commercial Mortg. Co.),  the Ninth Circuit stated that subordination of a claim under section 510(c) of the Bankruptcy Code “presupposes that the claim is allowed but for equitable reasons must be subordinated to the other allowed claims.”  Moreover, if an allowed secured claim is equitably subordinated, section 510(c)(2) of the Bankruptcy Code permits the court to order that “any lien securing such a subordinated claim be transferred to the estate.”  Equitable subordination closely resembles a counterclaim because the result is the conveyance of an allowed claim against the estate back to the estate based on equitable grounds.  Under existing Ninth Circuit BAP precedent, a counterclaim is subject to the automatic stay.

In Palmdale, the Ninth Circuit recognized that “transferring the liens from Lehman’s estate to Palmdale’s estate would give the Palmdale estate millions of dollars worth of property, in which it formerly had no equity, at the expense of leaving Lehman unsecured.”  Consequently, it held that the Ninth Circuit BAP correctly held that equitable subordination was an affirmative action that would violate LCPI’s automatic stay and found the Ninth Circuit BAP’s decision to be “consistent with the purpose of § 362 to protect the bankruptcy estate.”

The Ninth Circuit also recognized the lack of binding contrary authority.  Although In re Metiom held that equitable subordination of an unsecured claim does not violate the automatic stay because it is a defense to a proof of claim, the Ninth Circuit did not find Metiom helpful in making its decision.  Metiom involved an unsecured claim against a debtor’s estate, and so could not involve the transfer of a lien to the estate of the debtor that is prosecuting the equitable subordination claim.  The Ninth Circuit distinguished Palmdale because “[t]he bankruptcy court’s ability, in equitably subordinating a secured claim, to transfer property from the bankruptcy estate, means that a claim for equitable subordination of a secured claim is an ‘act to . . . exercise control over property of the estate’ subject to stay.”  Accordingly, the extent to which Palmdale would apply to equitable subordination of an unsecured claim remains an open issue in the Ninth Circuit.

Notwithstanding Metiom, other courts in the Southern District of New York have made it clear that the automatic stay prohibits a party from seeking equitable subordination against a debtor, regardless of whether the debtor holds secured claims or unsecured claims.  In In re Enron Corp., Judge Gonzalez held that commencing an adversary proceeding against a debtor seeking equitable subordination of the debtor’s claims was an offensive action subject to the automatic stay.  The court held that equitable subordination is not a defense to a debtor’s liability on a proof of claim and noted that equitable subordination can only be used to reorder priorities, not disallow claims.  Its holding clearly applies to attempts to equitably subordinate secured claims and unsecured claims.  Additionally, in LCPI’s chapter 11 case, Judge Peck has unequivocally declared that “the law in the Southern District of New York, as stated by Judge Gonzalez in the Enron Case, and I choose to follow his reasoning, is that litigation brought by a party against a debtor seeking to equitably subordinate claims of that debtor constitutes a violation of the automatic stay.”  Thus, although Palmdale may rest upon the nature of LCPI’s claims as secured claims, the existing law in the Southern District of New York is broader and prohibits a party from seeking equitable subordination of any claims by a debtor – whether secured or unsecured – against another bankruptcy estate.