Appeal from the United States District Court
for the Northern District of Illinois, Eastern Division. No. 95 C 3528 William T. Hart, Judge.
Before Cudahy, Manion, and Rovner, Circuit Judges.
Decided December 10, 1997
In a case under chapter 7 of the Bankruptcy Code, the trustee requested the bankruptcy court to equitably subordinate a creditor's secured claim that was based on the creditor's loan to the debtor. Equitable subordination of a claim moves the creditor down in the order of payment out of the assets in the bankruptcy estate, generally reducing (or eliminating) the amount the creditor can recover. In this case, the trustee argued that the loan should be treated as a capital contribution (i.e., as equity) because it was made by insiders of the debtor, the debtor was undercapitalized and the debtor and its principals engaged in inequitable conduct. The bankruptcy court denied the trustee's request, finding that the trustee failed to establish either undercapitalization or sufficient inequitable conduct. The trustee appealed to the district court, which reversed and remanded to the bankruptcy court, ordering the subordination of the claim. The district court concluded that the bankruptcy court committed clear error when it determined that the debtor was adequately capitalized. As for inequitable conduct, the district court stated, "creditor misconduct is not a necessary prerequisite for application of equitable subordination," citing In re Virtual Network Services Corp., 902 F.2d 1246, 1249-50 (7th Cir. 1990). This appeal followed. We clarify the relationship between undercapitalization and equitable subordination: the general rule is still that undercapitalization alone is insufficient for equitable subordination--here of a secured claim. We also conclude that the bankruptcy court's finding of adequate capitalization is not clearly erroneous. But we are more concerned than the bankruptcy court about certain raises to the insiders cited by the trustee. On that issue, we remand to the bankruptcy court for further consideration of the trustee's equitable subordination request.
A business is ailing. Revenues are down, profits gone. Rather than let it die, the owners decide to try reviving it. Doing so will require an infusion of new funds. The owners drum up the needed funds but face a choice: which legal form should the owners use, equity or debt?
If the business is closely held, the advantage will be to debt, preferably secured. Equity classically carries the right to the firm's residual earnings. But in a closely-held company, this advantage means little, for the owners already have it through their pre-existing equity stakes. A loan, on the other hand, will provide the firm with needed funds while limiting the owners' risk that the company will go bankrupt and the new funds will end up in the wallets of the unsecured creditors. Tax advantages might also accrue. *fn1 Of course, in opting for debt, the owners also accept a trade-off: outside lenders will or ought to be more reluctant to extend credit to what is now a more heavily-leveraged firm.
An unfair advantage to the owners, allowing them to reap the benefits of both debt and equity? Maybe. Will a bankruptcy court respect this choice of form? Not always. The power of equitable subordination, codified at 11 U.S.C. sec. 510(c), allows a bankruptcy court to relegate even a secured claim to a lower tier, even to the lowest-- the equity tier. This appeal centers on when a bankruptcy court may exercise this power based on the debtor's undercapitalization.
The debtor is Lifschultz Fast Freight Corporation. Its owners ran a shipping business dating from the turn of the century. Their company was Lifschultz Fast Freight, Inc. ("LFFI"). Its chief enterprise was freight forwarding: consolidating freight from customers and arranging for a shipper to haul it by road or rail. Even though the Interstate Commerce Commission allowed LFFI in 1985 to join the ranks of the freight carriers, the bulk of the business nonetheless remained in freight forwarding.
The second half of the 1980s was unkind to LFFI. Deregulation had unleashed rapacious competition in trucking, but LFFI stuck to a high-price, highservice track. The company lost hefty sums of money each year, starting at $400,000 in 1985 and rising more or less steadily to $5.5 million in 1989. The insiders decided against liquidating the losing business and instead tried to revive it. The revised business strategy was to focus on running trucks from the West Coast at full capacity. In early March 1990, the insiders set up a new corporation, the future debtor, with $1,000 in cash. Eighty percent of the debtor's stock was in five pairs of hands--Theodore Cohen, Salvatore Berritto, Anthony Berritto, Sebastian DeMarco and Michael DeMarco. The remaining 20% was LFFI's. These insiders transferred to the new company all of LFFI's operations outside New York City (including the customer list), a valuable lease to a California shipping terminal and Dodgers season tickets. The debtor's only assumed liability from LFFI was $232,000 of unpaid employee vacation.
As the list of initial assets shows, one thing the debtor lacked was cash--so sorely, in fact, that the debtor was short $91,000 for meeting its first payroll. The solution was the secured loan agreement (the "Loan Agreement"), dated March 13, 1990. The agreement linked the debtor and one of the insiders' affiliated companies, Salson Express Co., Inc. ("Salson Express"). By April, Salson Express had lent the debtor $862,841.30. Most of that money the insiders had themselves borrowed from First Fidelity Bank in exchange for personal guarantees from Salvatore Berritto, Sebastian DeMarco and Theodore Cohen. The insiders then lent the money on a secured basis to Salson Express, which lent it in turn to the debtor under the Loan Agreement. On August 10, 1990, the debtor found a fresh $1 million in the form of a factoring agreement from Ambassador Factors. Ambassador Factors required that its security interest superordinate that of the insiders under the Loan Agreement, and also extracted personal guarantees from the insiders. With some of this new money, the debtor paid off all but $300,000 of the insiders' secured loan at the time of the bankruptcy petition--the $300,000 at issue in this appeal.
The insiders never succeeded in staunching the losses. Administrative expenses ate up the debtor's operating margins month after month. On revenues that fluctuated monthly between $1.7 million and $2.2 million, the debtor lost an average of $193,000 per month between March and October 1990. Its only monthly profit was in August, for $12,000. An involuntary chapter 11 petition brought the debtor into bankruptcy on November 20, 1990. Prepetition unsecured debt stood at $2.6 million. The trustee operated the business until May 1991, when the debtor proceeded to liquidation under chapter 7.
The insiders filed a claim in bankruptcy court for the remaining $300,000. (More precisely, Salson Express filed, but we refer to Salson Express and the insiders interchangeably, as the parties have stipulated.) In response, the trustee requested that the bankruptcy court equitably subordinate the insiders' secured interest and transfer the lien to the estate. The debtor had been undercapitalized, the trustee asserted, and therefore the insiders' claim should be subordinated to the general creditors'.
The bankruptcy court held that the debtor had not been undercapitalized as a matter of fact, but even if the debtor had been, undercapitalization by itself could not justify equitable subordination. To set aside Salson Express' lien would require that the insiders had been guilty of some other "inequitable conduct." Finding no other inequitable conduct, the bankruptcy court refused to subordinate the insiders' secured claim.
The district court saw the law and facts differently. Citing In re Virtual Network Services Corp., 902 F.2d 1246 (7th Cir. 1990), the district court said that equitable subordination did not require proof of a creditor's inequitable conduct (or misconduct; the terms are often used synonymously in the case law). Undercapitalization alone was enough. Also, finding clear error, the district court concluded that the debtor had been patently undercapitalized. The district court reversed and ordered equitable subordination. The insiders (Salson Express) appeal.
We review the legal conclusions of the bankruptcy court de novo and uphold the bankruptcy court's factual findings unless clearly erroneous. In re Lefkas Gen. Partners, 112 F.3d 896, 899-900 (7th Cir. 1997). If the bankruptcy court's "account of the evidence is plausible in light of the record viewed in its entirety," we will not reverse its factual findings even if we "would have weighed the evidence differently." Anderson v. City of Bessemer City, 470 U.S. 564, 573-74 (1985). This same criterion applies to each factual finding of the bankruptcy court, whether or not based on the credibility of witnesses. See id. at 575.
The crux of this case is undercapitalization-- what the term means, whether it was present in this case, and if so, what consequences would follow. Undercapitalization is a poorly-defined phrase, and especially so in the context of bankruptcy. An undercapitalized firm is one without enough capital; but that tells us little. We try to define the meaning of "undercapitalization" in this opinion. First we clarify the controlling law. If the debtor was in fact undercapitalized, could undercapitalization alone justify equitable ...