F I L E D
United States Court of Appeals
Tenth Circuit
PUBLISH
AUG 26 2004
UNITED STATES COURT OF APPEALS
PATRICK FISHER
Clerk
TENTH CIRCUIT
In re: HEDGED-INVESTMENTS
ASSOCIATES, INC.; HEDGED-
SECURITIES ASSOCIATES, LP;
HEDGED-INVESTMENTS
ASSOCIATES, LP; HEDGED-
INVESTMENTS ASSOCIATES II,
LP,
Debtors,
HARVEY SENDER, Trustee,
Plaintiff - Appellee,
v.
THE BRONZE GROUP, LTD.,
No. 02-1191, 02-1192
Defendant - Appellee,
v.
J. DANIEL BRINKER, DONALD
SHWAYDER, ALFRED WEISNER
and LAURENCE DEMUTH, JR.,
individually and as Class
Representatives of Class III;
CLASS III,
Defendants - Appellants,
and
FRED HANNAHS and MARY
ESTILL BUCHANAN, individually
and as Class Representatives of
Classes I and II; CLASSES I and II,
Defendants - Appellants.
Appeal from the United States District Court
for the District of Colorado
(D.C. Civil Action No. 98-B-1507)
Bruce E. Rohde, Davis & Ceriani, P.C., Denver, Colorado (M. Frances Cetrulo
and Edwin G. Perlmutter, Berenbaum, Weinshienk & Eason, P.C., Denver,
Colorado, with him on the briefs), for Appellants.
Phillip D. Barber, Phillip D. Barber, P.C., Denver, Colorado (Randall J.
Feuerstein, Dufford & Brown, P.C., Denver, Colorado), for Appellees.
Before EBEL, BALDOCK and KELLY, Circuit Judges.
EBEL, Circuit Judge.
This case is the latest to arise from the bankruptcy of Hedged Investments
Associates, Inc. (HIA), a stock investment Ponzi scheme which was run for
thirteen years by James Donahue until it finally collapsed in the fall of 1990.
This long-running dispute again before us concerns the proper distribution of the
assets in the bankruptcy estate.
In this appeal, certain equity investors in HIA and its affiliated entities
(Appellants) ask us to reverse the district court’s decision refusing to
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recharacterize as an equity investment a loan advanced to HIA by Defendant-
Appellee The Bronze Group, Ltd. (Bronze Group). Appellants also ask us to
reverse the district court and equitably subordinate the Bronze Group’s claim on
the assets of HIA’s bankruptcy estate so that the Bronze Group would be treated
on par with the Appellant equity investors. We exercise jurisdiction to review the
district court’s order under 28 U.S.C. § 158(d) and AFFIRM, holding that the
Bronze Group loan does not meet either our criteria for recharacterization or for
equitable subordination.
I. Background
Plaintiff Harvey Sender serves as the bankruptcy trustee for HIA. The
individually named Defendants-Appellants were investors and limited partners in
the various HIA sub-partnerships of Donahue’s Ponzi scheme, and they represent
three Classes of similarly situated investors who also joined as limited partners of
HIA’s affiliated partnerships. Classes I and II include HIA limited partners who
were forced in prior litigation to return preferential and fraudulent transfers and
partnership distributions they had previously received from HIA, totaling $6.7
million, back to the bankruptcy estate. Class III includes HIA limited partners
who lost money on their investment, withdrawing less than they contributed to the
partnerships. Their claims total $193.3 million. Defendant/Appellee The Bronze
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Group, Ltd. is a limited partnership, constituted by several private corporations’
pension trusts, that advanced funds to HIA under a loan agreement concluded in
June of 1986.
The Bronze Group’s initial advance was for $900,000, and with subsequent
repayments and new advances the total outstanding principal on its loans to HIA
comes to $1.83 million. HIA faces claims from trade creditors for $18,000 and
other loan claims similar to that of the Bronze Group’s claim for approximately
$1 million. The HIA bankruptcy estate has assets of approximately $11 million to
divide among HIA’s creditors and limited partners.
The Bronze Group’s loan agreement with HIA was memorialized in a
promissory note and accompanied by a security agreement and UCC-1 financing
statements identifying the assets in one of HIA’s trading accounts at Kidder
Peabody as collateral. The agreement set a flexible interest rate, with a minimum
rate of 15% per annum for the life of the loan, plus additional interest to match
the rate of any greater HIA earnings, minus a fee of 4% per annum.
In this, the Bronze Group loan’s payment terms were nearly identical to the
profit payments Donahue had promised to HIA’s limited partners/equity investors
in the mid-80's. Under the limited partnership agreements, Donahue sent letters
to the limited partners setting a guaranteed minimum return for the coming year,
with additional profits distributed from HIA’s overall gains minus a management
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fee that calculated out to approximately 4%. The minimum return promised to
limited partners fluctuated over the course of HIA’s existence from 8% to 12% to
15%, and in the mid-1980's the promised return was at 15%.
The Bronze Group loan transaction had some peculiar origins. Prior to the
formation of the Bronze Group, a substantially similar group of individuals and
trust funds had formed a partnership called BGL Associates (BGL), which had
contracted with Broker Services, an asset-trading company managed by Mr.
Donahue, to set up a stock trading account separate from the HIA partnerships.
BGL never became a limited partner of HIA. Upon discovering that Mr. Donahue
had not segregated BGL’s funds but had commingled them with the pooled HIA
accounts, the BGL partners cancelled their arrangement with Broker Services and
asked to withdraw their funds totaling $900,000. The members of the now-
dissolved BGL partnership then formed the Bronze Group and contributed
$900,000, which was then loaned back to HIA under the Bronze Group
promissory note.
Mr. Donahue’s final disbursement of BGL funds took place on the same
day as the contribution of the former BGL partners into Bronze Group and the
Bronze Group’s advance of $900,000 to HIA under the HIA-Bronze Group loan
agreement. At the time of the three transactions, the bank account against which
Mr. Donahue’s checks to the BGL partners had been written contained $124,000
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— far less than the $900,000 paid out to BGL’s partners. Those checks did not
bounce, however, since the former BGL partners simultaneously deposited
$900,000 with the newly-formed Bronze Group, which in turn wrote a check for
$900,000 to HIA as the initial advance on the Bronze Group loan. The
bankruptcy court below aptly characterized this transaction as a “financial
somersault.”
During the next four years, HIA sent the Bronze Group 1099 tax forms
detailing interest earned on the loan principal, and the Bronze Group asked HIA
to fill out “audit letters” that certified to the Bronze Group’s auditors that HIA
owed the Bronze Group principal and interest on the funds it had borrowed. The
Bronze Group made occasional withdrawals from the loan account, which were
characterized as HIA’s repayment of loan principal and accrued interest, and the
Bronze Group also made periodic advances to HIA under the 1986 agreement.
The current case began when Mr. Sender filed for declaratory judgment in
the bankruptcy court for the District of Colorado, requesting that the court
approve the distribution of the bankruptcy estate to all of HIA’s creditors and
investors under a “cash-in, cash-out” system, in which each claimant or interest
holder would receive a pro-rata share of the estate based upon the principal he or
she had loaned or entrusted to HIA. The Bronze Group objected, asserting that its
status as a lender to HIA gave it priority over the equity investors and demanding
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full payment of the principal and interest due under its loan agreement with HIA.
The bankruptcy court held that the Bronze Group’s advances to HIA did, in fact,
constitute a loan, but the court equitably subordinated the Bronze Group’s claim
to equal priority with HIA’s limited partners/equity investors, and ordered that the
HIA estate be distributed on a pro-rata “cash-in, cash-out” basis.
The Bronze Group appealed the equitable subordination order to the district
court, and the limited partner Classes cross-appealed the bankruptcy court’s
decision not to recharacterize the Bronze Group transaction as an equity
investment rather than a loan. The District of Colorado affirmed the lower
court’s decision not to recharacterize the Bronze Group loan but reversed the
bankruptcy court’s equitable subordination order, entering a judgment in favor of
the Bronze Group for the loan principal as well as all interest that accrued prior to
HIA’s filing for bankruptcy.
The limited partner Classes now appeal the district court’s order. They first
request that we reverse both lower courts’ refusal to recharacterize the Bronze
Group loan as an equity investment. They also urge us to reverse the district
court on equitable subordination, thereby re-instating the bankruptcy court’s order
that the Bronze Group’s claim be equitably subordinated to equal priority with the
interests of HIA’s limited partners and satisfied on the same “cash-in, cash-out”
basis.
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II. Recharacterization
A. Distinguishing Recharacterization from Equitable Subordination
We begin our analysis by reiterating the important distinction between the
two remedies of recharacterization and equitable subordination.
When a putative loan to a corporation is recharacterized, the courts
effectively ignore the label attached to the transaction at issue and instead
recognize its true substance. The funds advanced are no longer considered a loan
which must be repaid in bankruptcy proceedings as corporate debt, but are instead
treated as a capital contribution.
The doctrine of equitable subordination, by contrast, looks not to the
substance of the transaction but to the behavior of the parties involved. The
funds in question are still considered outstanding corporate debt, but the courts
seek to remedy some inequity or unfairness perpetrated against the bankrupt
entity’s other creditors or investors by postponing the subordinated creditor’s
right to repayment until others’ claims have been satisfied. See Sinclair v. Barr
(In re Mid-Town Produce Terminal, Inc.), 599 F.2d 389, 393-94 (10th Cir. 1979)
(describing the discrete analytical steps as “first determin[ing] whether the
transaction was a contribution to capital rather than a loan” and “next ... whether
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there was any fraud or sharp dealing requiring subordination under the ‘inherent
fairness’ doctrine”).
The Sixth Circuit drew a clear distinction between these remedies in Beyer
Corp. v. MascoTech, Inc. (In re AutoStyle Plastics, Inc.):
Not only do recharacterization and equitable subordination serve different
functions, but the extent to which a claim is subordinated under each
process may be different.... Recharacterization cases turn on whether a
debt actually exists, not on whether the claim should be equitably
subordinated. In a recharacterization analysis, if the court determines that
the advance of money is equity and not debt, the claim is recharacterized
and the effect is subordination of the claim as a proprietary interest because
the corporation repays capital contributions only after satisfying all other
obligations of the corporation. In an equitable subordination analysis, the
court is reviewing whether a legitimate creditor engaged in inequitable
conduct, in which case the remedy is subordination of the creditor's claim
to that of another creditor only to the extent necessary to offset injury or
damage suffered by the creditor in whose favor the equitable doctrine may
be effective.
269 F.3d 726, 748-49 (6th Cir. 2001) (emphasis in original) (internal quotations
and citations omitted). Our first task, therefore, is to examine the nature of the
Bronze Group’s advances to HIA to consider whether they can properly be
considered “loans.”
B. Standard of Review
Whether a transaction labeled as a loan should be recharacterized as an
equity investment is a mixed question of fact and law. We defer to the
bankruptcy court’s findings regarding the fundamental facts of the transaction,
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reviewing them under a clearly erroneous standard. Phillips v. White (In re
White), 25 F.3d 931, 933 (10th Cir. 1994). The application of our legal test for
recharacterization to those underlying facts, however, is a question of law which
we review de novo. Gullickson v. Brown (In re Brown), 108 F.3d 1290, 1292
(10th Cir. 1997).
C. Governing Legal Standard for Recharacterization
The legal test for recharacterization in this Circuit was laid out in broad
terms in In re Mid-Town. In that case we reviewed the Utah district court’s
decision to equitably subordinate a loan made to a family-owned produce store by
its dominant shareholder and president, on the grounds that the loan was made by
an “insider” at a time when the borrower corporation was badly undercapitalized.
Were the courts to permit such a loan from dominant shareholders, the district
court feared, controlling equity owners of a troubled corporation could jump the
line of the bankruptcy process and thwart the company’s outside creditors’ and
investors’ priority rights. In re Mid-Town, 599 F.2d at 391-92.
This court reversed, rejecting the district court’s automatic subordination of
insider loans on the grounds that such a fixed rule would discourage owners’
efforts to salvage a troubled business. Id. at 392. We then remanded the case,
instructing the lower courts to analyze the recharacterization issue separately from
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the equitable subordination question, and to do so by looking at three factors:
(1) the initial operating capital of Mid-Town, (2) the length of time the business
was in operation at the time of the loan, and (3) whether the parties treated the
transaction as a loan or as a capital investment. Id. at 393.
Recent tax law cases in other circuits have used a more extensive set of
criteria to judge whether funds advanced to a now-bankrupt entity were true loans
or camouflaged equity investments. However, these expanded criteria are fully
consistent with our more generally phrased test in Mid-Town, and the tax cases
seek to vindicate government interests similar to the interests of competing
creditors and investors in the bankruptcy context. The Sixth Circuit recently
applied such a multi-factor test from the tax cases to a bankruptcy
recharacterization inquiry like the one now before us. In re AutoStyle Plastics,
269 F.3d at 750. We now do the same, and while not exclusive, we consider the
following factors to distinguish true debt from camouflaged equity:
(1) the names given to the certificates evidencing the indebtedness;
(2) the presence or absence of a fixed maturity date;
(3) the source of payments;
(4) the right to enforce payment of principal and interest;
(5) participation in management flowing as a result;
(6) the status of the contribution in relation to regular corporate creditors;
(7) the intent of the parties;
(8) “thin” or adequate capitalization;
(9) identity of interest between the creditor and stockholder;
(10) source of interest payments;
(11) the ability of the corporation to obtain loans from outside lending
institutions;
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(12) the extent to which the advance was used to acquire capital assets; and
(13) the failure of the debtor to repay on the due date or to seek a
postponement.
Stinnett’s Pontiac Serv., Inc. v. Comm’r of Internal Revenue, 730 F.2d 634, 638
(11th Cir. 1984). 1 None of these factors is dispositive and their significance may
vary depending upon circumstances. But it is useful to begin with a fairly
detailed list to aid in our analysis.
D. Application of the Recharacterization Standard
While the lower courts’ discussions of recharacterization failed to identify
the standard they applied in reaching their decisions, the bankruptcy court’s
findings of fact are sufficiently detailed to allow us to apply the test set forth
above and to affirm the bankruptcy court’s conclusion that the Bronze Group’s
funds are properly treated as a loan. Six factors cut in favor of viewing the
Bronze Group transaction as a loan: (1) the transaction documents drafted by the
1
Use of a more comprehensive set of criteria also serves one of our main
concerns identified in Mid-Town—that excessive suspicion about loans made by
owners and insiders of struggling enterprises would discourage legitimate efforts
to keep a flagging business afloat. Mid-Town, 599 F.2d at 392. Too heavy an
emphasis on undercapitalization produces just such an unhealthy deterrent effect.
Undercapitalization certainly remains an important factor to consider, but under
the multi-factor approach we adopt today business owners need not fear, should
their rescue efforts fail, that the bankruptcy court would give disproportionate
weight to the poor capital condition of their failing companies and thus too
quickly refuse to treat their cash infusions as loans.
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parties treat the funds as a loan and fulfill the proper formalities for a commercial
loan; (2) Bronze Group had the right to enforce payment of principal and interest;
(3) Bronze Group acquired no management control in exchange for its funds;
(4) Bronze Group’s loan agreement did not subordinate it to HIA’s other
commercial creditors; 2 (5) the parties intended the transaction to be a loan; and
(6) HIA was able to secure loans from other lenders around the time, and in one
case after, it signed for the Bronze Group loan.
Factors weighing in favor of recharacterization include (1) the absence of a
fixed loan maturity date, (2) HIA’s “thin” capitalization, and (3) HIA’s payment
of Bronze Group’s interest out of a pooled investment account. On balance, we
agree with the lower courts that the Bronze Group loan to HIA did not merit
recharacterization, and we AFFIRM the district court’s judgment on that ground. 3
2
In contrast, the limited partnership agreements signed by equity investors
such as the Appellants explicitly subordinate the investors’ interests to the claims
of HIA’s creditors.
3
Appellants also cite to four prior rulings from this court, in which we
refused to enforce the limited partnership agreements between HIA and its
individual investors, and argue that the Bronze Group’s loan agreement with HIA
should be similarly unenforceable.
In three of the cases referenced by Appellants, the partnership agreements
had been invoked by Mr. Sender, acting as HIA’s bankruptcy trustee, seeking to
recover monies paid out to early investors in Mr. Donahue’s ponzi scheme who
were fortunate enough to have received “profits” from their venture. See Sender
v. Simon, 84 F.3d 1299 (10th Cir. 1996); Sender v. Hannahs (In re Hedged-
Investments Assocs., Inc.), 86 F.3d 1166 (10th Cir. May 23, 1996) (unpublished);
Sender v. Buchanan (In re Hedged-Investments Assocs., Inc.), 84 F.3d 1281 (10th
(continued...)
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III. Equitable Subordination
A. Standard of Review
Equitable subordination, like recharacterization, presents a mixed question
of fact and law. As with our recharacterization analysis above, we review the
bankruptcy court’s findings of fact for clear error and review the lower courts’
application of the legal test for equitable subordination de novo.
3
(...continued)
Cir. 1996). We refused to permit Mr. Sender to invoke the partnership
agreements against the individual investors, stating that we would not “aid the
effort of a fraudulent entity that used the trappings of legal formality to lure its
victims to turn around and try to hold its victims accountable under those same
legal formalities.” Sender v. Simon, 84 F.3d at 1308. These cases do not address
the situation now before us, in which a creditor of HIA seeks to enforce its claim
against the bankruptcy estate.
In the fourth case, Sender v. Buchanan (In re Hedged-Investments Assoc.,
Inc.), 84 F.3d 1286 (10th Cir. 1996) (hereafter, Buchanan II), an individual
investor in HIA sought to invoke her partnership agreement with HIA to defend
against Mr. Sender’s claims for recovery under the fraudulent transfer provision
of the bankruptcy statute, 11 U.S.C. § 548. We rejected this defense on public
policy grounds, since the defendant investor’s ill-gotten profits came directly
from the pockets of the ponzi scheme’s less “fortunate” victims, and allowing her
to retain those funds would penalize others who belonged to the same class of
equity investors as did the defendant. Id. at 1290.
Appellants have advanced no argument for extending this public policy
principle to apply across different classes of bankruptcy claimants, and we decline
to do so. The bankruptcy statutes give clear priority to a bankrupt entity’s
creditors over its equity investors, and, having refused to recharacterize the
Bronze Group’s loan as an equity investment, we will not now circumvent the
statutory priority scheme by holding the Bronze Group’s loan agreement
unenforceable.
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B. Governing Standard for Equitable Subordination
Equitable subordination in bankruptcy is governed by § 510(c) of the
Bankruptcy Code, but the statute is phrased broadly:
(c) Notwithstanding subsections (a) and (b) of this section, after notice and
a hearing, the court may –
(1) under principles of equitable subordination, subordinate for
purposes of distribution all or part of an allowed claim to all or part
of another allowed claim or all or part of an allowed interest to all or
part of another allowed interest; or
(2) order that any lien securing such a subordinated claim be
transferred to the estate.
11 U.S.C. § 510(c).
In United States v. Noland, the Supreme Court held that Congress’s failure
to include specific criteria for equitable subordination in the language of the
statute, and the provision’s reference to “principles of equitable subordination,”
“clearly indicates congressional intent at least to start with existing doctrine” that
had developed prior to the statute’s revision in 1978. 517 U.S. 535, 539 (1996).
In a case decided in 1977, the Fifth Circuit announced what has now become the
standard formulation of the common law of equitable subordination. Benjamin v.
Diamond (In re Mobile Steel), recognized by the Noland Court as the leading
Circuit case on the subject, listed three requirements that must be met for a court
to exercise its equitable subordination power: (1) “inequitable conduct” on the
part of the claimant sought to be subordinated; (2) injury to the other creditors of
the bankrupt or unfair advantage for the claimant resulting from the claimant’s
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conduct; and (3) consistency with the provisions of the Bankruptcy Code. 563
F.2d 692, 699-700 (5th Cir. 1977).
Our Circuit adopted the Mobile Steel standard in Sloan v. Zions First Nat’l
Bank (In re Castletons, Inc.), placing special emphasis on the inequitable conduct
prong: “The critical inquiry is whether there has been inequitable conduct on the
part of the party whose debt is sought to be subordinated.” 990 F.2d 551, 559
(10th Cir. 1993) (emphasis added) (internal quotation marks omitted).
1. The Necessity of the Inequitable Conduct Element
Notwithstanding our statement in In re Castletons that identifying
inequitable conduct is “[t]he critical inquiry” in equitable subordination cases,
Appellants’ argue that inequitable conduct is not always a prerequisite for
ordering equitable subordination. It is true that this general rule is not without
exceptions. In United States v. Reorganized CF&I Fabricators of Utah (In re
CF&I Fabricators of Utah, Inc.), we held that “section 510(c)(1) does not require
a finding of claimant misconduct to subordinate nonpecuniary loss tax penalty
claims.” 53 F.3d 1155, 1159 (10th Cir. 1995). However, as the district court
correctly pointed out below, this is a narrow exception that has been applied
solely to tax penalty claims brought by the government, on the theory that giving
priority in bankruptcy to punitive fines owed to the government does not serve the
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purpose of the punitive fine—which is to punish the company and its owners for
their wrongdoing—but rather unfairly punishes the debtor’s innocent creditors.
We have never extended the exception to the general bankruptcy context.
The Supreme Court subsequently narrowed the exception further when it
vacated this court’s decision on appeal. See United States v. Reorganized CF&I
Fabricators of Utah, Inc., 518 U.S. 213 (1996). A unanimous Court found our
holding — that the “no-fault” exception was at least potentially available for all
tax penalty claims — was too much like a “categorical reordering of priorities”
that the Court had previously found unacceptable in Noland. Id. at 229. The
Supreme Court did not, however, prohibit the lower courts from approving an
equitable subordination judgment on a case-by-case basis in the absence of any
evidence of inequitable conduct.
We decline to extend the “no-fault” equitable subordination exception
applied in CF&I Fabricators beyond the tax penalty context. Appellants have
presented no persuasive argument that would justify such an extension, nor have
they presented any argument that would support granting the severe remedy they
seek in the absence of any finding that the Bronze Group acted inequitably. We
adhere to the general rule, therefore, that equitable subordination is not justified
absent a finding that the party sought to be subordinated engaged in inequitable
conduct.
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2. The Test for Inequitable Conduct
“Inequitable conduct” for subordination purposes encompasses three
categories of misconduct: “(1) fraud, illegality, and breach of fiduciary duties; (2)
undercapitalization; or (3) claimant’s use of the debtor as a mere instrumentality
or alter ego.” Fabricators, Inc. v. Technical Fabricators, Inc. (In re Fabricators),
926 F.2d 1458, 1467 (5th Cir. 1991) (interpreting the Mobile Steel standard and
finding the claimant had committed fraud amounting to inequitable conduct by
inducing other creditors to continue extending new credit to the troubled debtor
company). See also CTS Truss, Inc. v. FDIC (In re CTS Truss, Inc.), 868 F.2d
146, 148-49 (5th Cir. 1989) (formulating the categories as cases “in which a
fiduciary of the debtor misuses his position to the disadvantage of other creditors;
those in which a third party, in effect, controls the debtor to the disadvantage of
others; and those in which a third-party defrauds other creditors”).
When examining a transaction for evidence of inequitable conduct, this
Circuit has joined other Courts of Appeals in applying different levels of scrutiny
to “insiders” and “non-insiders” of the debtor corporation. See In re Castletons,
990 F.2d at 559. Where the claimant is an insider or a fiduciary, the party seeking
subordination need only show some unfair conduct, and a degree of culpability,
on the part of the insider. See Estes v. N & D Properties, Inc. (In re N & D
Properties, Inc.), 799 F.2d 726, 731 (11th Cir. 1986); United States v. Colorado
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Invesco, Inc., 902 F. Supp. 1339, 1344 (D. Colo. 1995). If the claimant is not an
insider or a fiduciary, however, the party seeking subordination must
“demonstrate even more egregious conduct such as gross misconduct tantamount
to fraud, misrepresentation, overreaching or spoilation.” In re Castletons, 990
F.2d at 559 (internal quotations omitted).
The bankruptcy court did not explicitly discuss whether or not the Bronze
Group should be considered an insider of HIA. Related facts found by the
bankruptcy court as well as other evidence in the record strongly suggest the
Bronze Group was not an insider of HIA. Nevertheless, regardless of which
standard is used, we conclude that Bronze Group’s actions do not constitute
“inequitable conduct” applicable to either insiders or non-insiders.
C. Application of the Equitable Subordination Standard
Appellants have not shown the Bronze Group engaged in inequitable
conduct as defined above, and we therefore conclude that the Bronze Group loan
may not be equitably subordinated.
The Bronze Group’s conduct mentioned in the bankruptcy court’s Order
and detailed in the record before us does not qualify as “gross misconduct
tantamount to fraud, misrepresentation, overreaching or spoilation.” See id. The
bankruptcy court rested its equitable subordination ruling primarily on the Bronze
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Group’s failure to conduct reasonable due diligence before advancing the loan to
HIA and on the similarities between the Bronze Group loan’s earnings structure
and the promised returns for the limited partnerships. Failure to conduct due
diligence was certainly bad business practice, and the loan’s terms might indeed
be questionable, but these facts do not amount to blatant fraud or other illegality
at the expense of HIA’s other creditors. 4 While HIA was most assuredly
“undercapitalized” at the time of the Bronze Group loan, mere undercapitalization
also falls short of the “gross misconduct” standard, especially where, as the
bankruptcy court concluded, the Bronze Group’s managers were unaware of
HIA’s financial straits until the entire scheme collapsed in 1990. There are,
moreover, no allegations that the Bronze Group controlled HIA as an
instrumentality or an alter ego.
Even if we were to consider the Bronze Group an insider of HIA,
Appellants have not shown Bronze Group engaged in sufficiently culpable
conduct to qualify for equitable subordination. In order to make a prima facie
showing of inequitable conduct, Appellants must “present material evidence of
4
Cf. Carter-Waters Oklahoma, Inc. v. Bank One Trust Co., N.A. (In re
Eufaula Industrial Authority), 266 B.R. 483, 490-91 (B.A.P. 10th Cir. 2001)
(finding no gross misconduct and refusing equitable subordination where a bank
that served as the indenture trustee for bonds issued to fund a construction project
failed to inform contractors of the financial difficulties faced by the project, thus
allowing the work to continue in spite of the risk that the contractors would not
receive full payment).
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unfair conduct,” and demonstrate some culpability on Bronze Group’s part. See
In re N & D Properties, 799 F.2d at 731; In re Eufaula, 266 B.R. at 489; Invesco,
902 F. Supp. at 1345.
As the Seventh Circuit concluded while analyzing the hazards of insider
loans to undercapitalized debtors, “while undercapitalization may indicate
inequitable conduct, undercapitalization is not in itself inequitable conduct.” In
re Lifschultz Fast Freight, 132 F.3d 339, 345 (7th Cir. 1997). The Lifschultz
court reasoned that low capital resources increases the risk of loss for a lender or
investor, but in a transparent market with good information flows, prices (and
interest rates) will fluctuate accordingly, putting the lender or investor on notice
about his risk. “Trickery upsets this logic,” however, and so an insider lender’s
exploitation of secret information or misrepresentation of the borrower’s financial
health is punishable by equitable subordination. Id. at 346.
In the case at bar, Appellants do not claim that the Bronze Group extended
a loan with the intention of deceiving or harming the limited partnership investors
in HIA. It is certainly true that the interest terms on the Bronze Group loan are
similar to the returns promised annually to HIA’s equity investors. Since loans do
not generally pay as well as equity investments, Appellants can argue that the
Bronze Group loan deal does not seem “fair.” But the Appellants themselves
seem to negate any inference of the Bronze Group’s “culpability” by offering a
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legitimate explanation for Appellee’s preference for structuring the funds given to
HIA as a loan: the Bronze Group trustees, Appellants observe, desired a loan in
order better to comply with their prudent fund management obligations under
ERISA. Lending money to a hedge fund may not be exactly prudent, but there is
no evidence in the record that suggests the Bronze Group’s trustees had any
culpable knowledge about the fraudulent nature of HIA or that the trustees had
reason to believe the Bronze Group’s loan would harm HIA’s limited partners.
The record shows, and the bankruptcy court concluded, quite the opposite. In any
event, there is nothing inherently inequitable about negotiating a creditor
relationship with a debtor as a condition of providing funds to the debtor.
Because we hold that a finding of inequitable conduct is a necessary
prerequisite to ordering equitable subordination, and because we conclude the
Bronze Group’s actions do not meet our definition of inequitable conduct, 5 we
AFFIRM the district court’s judgment that Appellants were not entitled to have
5
Appellants urge us to remand to the bankruptcy court for an explicit
statement of whether the Bronze Group was guilty of inequitable conduct. The
bankruptcy court did not address this question, but that court’s findings of fact
provide sufficient basis for us to apply the legal standard for inequitable conduct
in the course of deciding this appeal. See Fowler Bros. v. Young (In re Young),
91 F.3d 1367, 1373 (10th Cir. 1996). The dispute between the parties at this
stage is not over the facts of the Bronze Group transaction but over how those
facts ought to be characterized as a legal matter. We therefore deny Appellants’
request for a remand.
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the Bronze Group loan subordinated to equal “cash-in cash-out” treatment with
HIA’s equity investors.
IV. Conclusion
Because we conclude that the Bronze Group loan with HIA satisfies neither
the criteria for recharacterization as an equity investment nor the standard for
equitable subordination, we AFFIRM the judgment of the district court granting
the Bronze Group recovery of its remaining principal balance and accrued pre-
petition interest.
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