Sometimes when the Supreme Court decides an issue in the bankruptcy arena, it causes immediate changes in the way that cases are resolved. Other times, the Court's decisions barely cause a ripple in the flow of the way plans are drafted. The Court's two 1996 decisions on subordination of claims are, perhaps, an example of the latter. Despite their apparent rejection of a shotgun approach to subordinating certain types of claims (such as penalty claims that governmental entities often have cause to impose), plan drafters seem to go on routinely including such subordination provisions. Do those decisions really still leave the issue open? Or is this just another example of "let's put it in and see if anyone objects?" The United States believes the latter is more likely—and that plan drafters should think carefully before trying to subordinate penalties if they are interested in avoiding objections from the government.

Section 510 of the Bankruptcy Code allows involuntary subordination of claims in two circumstances—where the claim arises from rescission of a contract for purchase or sale of a security, and under principles of "equitable subordination." The subordination of claims arising from the purchase and sale of securities is based on the notion that such claims are more akin to equity interests than a true creditor. Creditors have the right to be repaid the amount of their debt—nothing more and nothing less. A person holding an equity interest, on the other hand, has the hope of receiving much more than the original investment and, conversely, the possibility of losing that same amount. The risk and benefits are two sides of the same coin. The absolute-priority rule reflects that reality and bars equity interests from taking until true creditors have been satisfied. A claim relating to the purchase or sale of stock does not necessarily involve the same possibility of unlimited loss or gain, but still comes out of a situation where the party had or will have those possibilities. The Code, accordingly, gives those claims a position essentially equal to the underlying rights of equity interests that merely held their shares. In re Telegroup Inc., 281 F.3d 133, 138 (3rd Cir. 2002) (subordination not limited to claims involving fraud in purchase or sale but to any claims arising out of a transfer, where there is causal role between sale and damages).

Equitable subordination, on the other hand, is based on the notion that some claims are unworthy of being paid along with other, more virtuous claims. Classically, such subordination involves a creditor that engaged in some sort of unlawful or inequitable conduct in obtaining the claim, or in situations where an insider demands the right to be treated equally with outside creditors. See In re Mobile Steel Co., 563 F.2d 692, 700 (5th Cir.1977) (claimant must be found to have engaged in inequitable conduct; the misconduct must have either resulted in injury to creditors or given the claimant an unfair advantage, and subordination must not be in conflict with other bankruptcy provisions). The issues as to insiders, who have greater knowledge and greater abilities to benefit from the debtor's business prospects, are, in many ways, akin to the issues relating to stock interests. An alternative analysis may focus on whether the "claim" should be recharacterized as an equity interest (which has the same effect of subordinating the demand for payment). In addition to these scenarios, however, there are other types of claims that have frequently been subject to equitable subordination, including penalty claims and debts under stock redemption agreements where the claim does not meet the literal terms of §510(b). It is those issues that trigger the questions about categorical subordination that the Supreme Court might have thought it had resolved in 1996.

In chapter 7 cases, penalty claims that would otherwise be general unsecured claims are subordinated pursuant to §726(a)(4), without reliance on §510(c). Prior to 1996, courts routinely subordinated penalty claims in chapter 11 and 13 cases as well, using two basic rationales. The first was that it was inequitable to pay punitive claims before compensatory claims were paid in full (i.e., "punitive damages don't punish the debtor, only the creditors"). See In re First Truck Lines (United States v. Noland), 48 F.3d 210, 214-18 (6th Cir. 1995), and discussion therein; In re Apex Oil Co., 118 B.R. 683, 697-98 (Bankr. E.D. Mo. 1990); In re Johns-Manville Corp., 68 B.R. 618 (Bankr. S.D.N.Y. 1986). The second was that such subordination was required by the "best-interest-of-creditors" test. Since such claims were subordinated in chapter 7, and since creditors must receive at least as much as in a chapter 7 case, then—so goes the argument—such claims must also, ipso facto, be subordinated in chapter 11. See discussion in In re New York Medical Group PC, 265 B.R. 408, 416, n. 5 (S.D.N.Y. 2001).

The first line of argument in particular reached its apogee in Noland. In that chapter 7 case, the Sixth Circuit concluded that post-petition tax penalties, which were given administrative expense status under §503(b)(1)(C), could still be equitably subordinated to other general unsecured claims because they were penalties. It assumed that penalty claims were generally disfavored and relied on ambiguous statements in the legislative history to justify denying the claims the priority status prescribed by Congress. When the case arrived at the Supreme Court, it quickly reversed in U.S. v. Noland, 517 U.S. 535 (1996).

The Court held that while subordination could apply to any claim, even including one given administrative status, the decision to do so must be based on some characteristic of the specific claim that justified denying it the presumptive status given by Congress. If an issue was one that would result in a "categorical" restructuring of the status of specific types of claims, that decision was one that must be made by Congress, not the courts. Since in Noland nothing in the lower court's decision turned on any facts unique to the case, or any misconduct of the claimant, the result would apply to any penalty claim. In other words, the Sixth Circuit was assuming, categorically, that it would be inequitable to allow penalties to be paid pari passu with other unsecured claims and that all such claims would be subordinated. But such a decision, the Supreme Court held, was one for Congress, not the courts.

The Court followed up with U.S. v. Reorganized CF & I Fabricators of Utah Inc., 518 U.S. 213 (1996). The Tenth Circuit had upheld a plan that placed pre-petition tax penalties into a subordinated class, again based on the equitable subordination principles in §510(c), without any showing of misconduct by the government, based solely on the nature of the claim. The Court again firmly rejected the notion that some types of claim could be subordinated based on a "categorical" view of their merits, without regard to any specific reason, for treating those claims differently than any others. If Congress meant to subordinate all claims of a particular type, it was quite capable, the Court held, of doing that; when it chose not to do so, courts could not create their own automatic downgrades. While not explicitly ruling that creditor misconduct must always be shown in all cases, the Court did not cite any other bases for such subordination. The most likely such reason might, as noted above, be the claims of insiders, which may be subject to greater scrutiny. The Court also did not decide two other issues: whether the claims could be separately classified and the effect of the best-interest-of-creditors test.

After these two cases, it would seem that the treatment of penalty claims in particular should change markedly in chapter 11 cases. The holders of such claims have likely not engaged in misconduct; to the contrary, they are more likely to be among the most sinned against. As a result, equitable subordination would appear to be inappropriate, leaving only the application of the "best interests" as a basis for denying penalty claims equal treatment. At first glance, the syllogism above—if penalties are subordinated in chapter 7, they must also be subordinated in chapter 11 to give creditors the same recovery—may seem logical, but it often falls apart if one actually does the math.

The reason is simple—the "bigger pie" that chapter 11 is assumed to create for creditors can readily make it possible to accommodate penalty claims while still satisfying the best-interests test. Thus, to be confirmed, a chapter 11 plan must show that it will produce at least as much as the liquidation alternative and debtors usually manage to "prove" that it will produce much more for unsecured creditors. One may be cynical about those depressing liquidation analyses, but the debtor cannot just disclaim them when it comes time for the penalty analysis. In short, reorganizations always promise to create a larger estate, and it is from that added recovery that penalties can be paid. The best-interest test requires only that other creditors receive more "absolute" dollars, not that they receive the same percent of the overall estate as in chapter 7. With a larger estate, even if more claims share in the pie, it is easily possible that the nonpenalty claims will still receive as much or more in absolute dollars. For instance, if $5 million in claims divide up a $1 million estate in a "fire sale" liquidation, a $10,000 claim will receive $2,000. If a $1 million penalty claim is added in chapter 11 increasing the claims pool to $6 million, but if the asset pool increases even more—i.e., to $2.4 million—then that same claimant will receive $4,000. Thus, it is quite possible to add penalty claims and still not violate the best-interest test.

So with those principles, have plans stopped proposing to automatically subordinate penalty claims? Hardly. It is a rare plan that does not include a provision subordinating penalty claims, at least for creditors other than tax claimants. Interestingly, though, there have been few reported decisions in this area, suggesting either that the plans have not been objected to, or conversely, that the debtors have retreated from the position when challenged. Some decisions suggest, generally without much real analysis, that the best-interest-of-creditors test can decide the issue. See Owens Corning v. Credit Suisse First Boston, 322 B.R. 719 (D. Del. 2005) (large value of punitive damage claims in asbestos case indicates that they should be subordinated under best-interest test, but no actual calculations done). Cf. In re Cassis Bistro Inc., 188 B.R. 472 (Bankr. S.D. Fla. 1995) (pre-Noland case that used equitable subordination, but at least made some attempt to actually apply best-interest test to support the subordination decision).

In both the Enron and Worldcom cases—two bad actors on a colossal scale—the plans initially provided for such automatic subordination of penalty claims and for claims relating to the securities fraud issues arising out of the debtors' misconduct. The treatment of those latter claims has been much affected by the provisions of the Sarbanes-Oxley Act (see the discussion in the "A Collision of Fairness: Sarbanes-Oxley and §510(b) of the Bankruptcy Code," ABI Journal, October 2005, p. 8.) Governmental entities challenged the proposed treatment of penalty provisions and, in both cases, forced the debtor to back off the attempt to decide the issue in the plan by fiat. The debtors agreed that if they sought to subordinate such claims they would have to do so by way of a specific action brought against those claims with the government able to challenge whether the debtor had shown both inequitable conduct and a best-interest issue.

Other courts suggest that they can simply disallow punitive claims even if such claims could plainly be found to have merit outside the bankruptcy arena. This typically occurs in mass tort cases where the plans routinely disallow all punitive damage claims, even where a judgment has already been entered. See, e.g., the plan language in In re Asbestos Claims Management Corp., 294 B.R. 663, 685 (N.D. Tex. 2003) and In re G-I Holdings Inc., 323 B.R. 583, 594 (Bankr. D. N.J. 2005). The Seventh Circuit rejected that notion in In re A.G. Financial Services Inc., 395 F.3d 410, 413-15 (7th Cir. 2005), although on the merits it found that the creditors had not asserted a credible claim for such damages. It noted that there was nothing in the Code that allows for disqualification simply because of the punitive nature of the claims; if courts do not have the power to categorically subordinate claims, it can hardly be thought that they have the power to categorically disallow them.

Other courts have taken a very broad view of the disqualification for securities claims. Starting with the provision actually contained in the Code, those courts have used the policy justifications about the profit and loss potential for equity claims to extend to any matters that relate in any way to a stock holding. In particular, a number of cases had broadly made any claims arising out of stock-redemption candidates for equitable subordination by extending the same principles used in §510(b) into the §510(c) context.

The most recent case on this issue is In re Merrimac Paper, 420 F.3d 53 (1st Cir. 2005). It comes down squarely against automatic subordination of such claims. That case involved an ERISA plan participant who had received a stock distribution from his plan on retirement, exercised an option to have the stock repurchased and was being paid overtime on a simple promissory note. When the debtor filed bankruptcy, the debtor argued that the payments on the note should be subordinated because they were related to a stock transfer. The lower courts concluded that the claim did not arise under §510(b) but nevertheless considered it under §510(c) and equitably subordinated it, essentially relying on reasoning in older cases that had held that any sort of matter related to a stock transfer warranted subordination for the same reasons as in §510(b). The First Circuit reversed. It noted that after Noland and CF & I, general principles about the types of claims that deserved to be subordinated were no longer valid. "Taken together, the principles enunciated in Noland and Reorganized CF & I vividly demonstrate why the bankruptcy court erred in equitably subordinating the appellant's claim based on nothing more than its classification as a stock redemption claim." Merrimac, 420 F.3d at 62. Perhaps the ringing reaffirmation of the principles in Noland and Merrimac may signal a renewed devotion in the courts to the principle that "categorical subordination" is not a power that courts may exercise.

That leaves, of course, the question of whether the Code should allow such subordination, particularly for penalties. There is certainly an intuitive sympathy to the notion—after all, if those who have been truly "harmed" by the debtor are not being paid in full, should someone else have their compensatory claim and a punitive claim as well? Or should the government be able to extract at least a partial pound of flesh when trade creditors may go unsatisfied? Perhaps so, and perhaps Congress should do something to create an unequivocal rule to that effect.

But before it does, at least a couple of countervailing considerations should be included in the analysis. First, the notion that only the creditors are being punished ignores completely the rather large category of chapter 11 cases filed for closely held corporations. In such cases, with an often-rather-modest "new value" infusion, it may be quite possible for the owners to launder their stock holdings through bankruptcy, pay a limited portion of their debts and, if penalties are subordinated, rid themselves of those costs altogether without paying anything for their misconduct. Barring such a maneuver surely results in some punishment for the owners. At a minimum, the amount of money necessary to constitute adequate "new value" will surely be larger if penalties are included in the mix of claims that must be accounted for.

Second, governmental penalties in particular are imposed on a business for a reason—because it has been operating in a fashion that victimizes the state's citizens. Such operations often tend to make a business more prosperous or to allow it to operate a scheme that otherwise could not continue for nearly as long. The trade creditors dealing with such bad actor businesses typically are paid until nearly the end, and have reaped the benefits of doing business for an extended period. While a trade creditor might miss payment of the last invoice or two, victims may have lost everything they paid to the debtor. In the overall context of their relative dealings, is it really clear that trade creditors should be paid everything and that the state should be barred from collecting anything for the victims or for its own use in enforcing the statute?

Third, penalties are meant to serve a deterrent factor—perhaps not only as to the entity engaging in the misconduct, but those choosing to do business with it—and facilitate its actions. Let's return to the example of Enron, for instance—it did not engage in all of its hidden ventures, its off-the-books financing and its manipulation of the energy markets without business partners who have their own sins to answer for. Where many of the largest creditors in the case—those sitting on the creditors' committee—had their own potential liabilities to answer for in terms of aiding, abetting, and facilitating Enron's bad act (whether or not the actions of those third parties rose to the level of specific civil or criminal culpability), is there not some justice in forcing those parties to suffer in some part along with Enron itself? In short, the question of what the rule should be for treatment of penalties in chapter 11 cases is one that can engender lively debate. The question of what the Code actually provides is far simpler: Penalties may not be automatically subordinated, and the government will challenge plans that propose to do so.