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As the fallout from the financial disasters at Enron Corp., Adelphia Communications Corp. and other former high-fliers continues, the reverberations have reached beyond the companies and their respective officers and directors and have hit the financial institutions that provided the capital to these famous flameouts. In Enron, court-appointed examiner Neal Batson has questioned (in his recently filed third interim report) the conduct of Enron’s lenders relating to the complex structured finance transactions engaged in by Enron. See In re Enron Corp., Case No. 01-16034 (Bankr. S.D.N.Y.) In Adelphia, the Official Committee of Unsecured Creditors filed a mammoth complaint charging Adelphia’s lenders and investment bankers with aiding and abetting the fraud perpetrated by the Rigas family-Adelphia’s controlling shareholders-alleging that the lenders permitted them to siphon enormous amounts of money from Adelphia for their personal use while the financial institutions earned huge fees and income from the transactions. See In re Adelphia Comm. Corp., Case No. 02-41729 (Bankr. S.D.N.Y.). The examiner in Enron and the committee in Adelphia have concluded that the fraud by these notorious Chapter 11 debtors and their principals could not have occurred without the complicity of their respective lenders and, in the case of Adelphia, its investment bankers. The financial institutions implicated in these cases are also among the largest creditors of the failed corporate-debtor entities and hold security interests in their assets. Thus, the specter of equitable subordination has appeared. In the typical bankruptcy case, secured creditors get paid first because they hold liens on the assets. If the value of the assets of a debtor are far exceeded by the liabilities secured by those assets against them, there exists a high degree of probability that the claims of unsecured creditors and the interests of shareholders will remain unpaid. The only hope for unsecured creditors and other stakeholders will be if the secured creditors’ liens are avoided or their claims are subordinated. Consequently, among the litany of claims raised or brought against the financial institutions named in Enron and Adelphia are causes of action seeking to subordinate equitably the secured claims of the lenders to the claims of other creditors pursuant to � 510(c) of the U.S. Bankruptcy Code. In fact, in Enron, Batson has asserted that sufficient evidence exists for the bankruptcy court to subordinate equitably more than $5 billion of senior secured claims held by certain financial institutions as a remedy to redress the conduct of the lenders in aiding and abetting the fraud committed by Enron, its officers and directors. The equitable powers of a bankruptcy court should “produce just and fair results ‘to the end that fraud will not prevail, that substance will not give way to form, that technical considerations will not prevent substantial justice from being done.’ ” In re Fabricators Inc., 926 F.2d 1458, 1464 (5th Cir. 1991) (quoting Pepper v. Litton, 308 U.S. 295, 305 (1939)). Equitable subordination is an extraordinary remedy that bankruptcy courts may (but are not required) to impose. Section 510(c) of the code codified the court’s ability to subordinate equitably for purposes of distribution of all or part of the claims of a creditor to those of other creditors. In Benjamin v. Diamond (In re Mobile Steel Co.), 563 F.2d 692 (5th Cir. 1977), (under the former Bankruptcy Act), the 5th U.S. Circuit Court of Appeals established a widely followed three-part test for equitable subordination. The test requires a proponent of an equitable subordination action to show that the claimant to be subordinated has engaged in some type of inequitable conduct such as fraud, illegality or breach of duty; undercapitalization; or control or use of the debtor as an alter ego. The proponent also must show that the misconduct resulted in injury to the creditors of the debtor or conferred an unfair advantage on the claimant. Finally, one must show that equitable subordination of the claim is not inconsistent with the provisions of the Bankruptcy Act (now Code). It has been difficult for courts generally to define the boundaries of inequitable conduct under the first part of the Mobile Steel test. In those cases not involving an insider or a fiduciary of a debtor, the conduct must be egregious, such as “fraud, spoliation or overreaching” to warrant subordination. Thus, courts have observed that the circumstances in which equitable subordination is invoked against noninsiders are “few and far between.” The extraordinary nature of the relief renders courts reluctant to subordinate even the claims of insiders making a secured loan to, or participating as a lender in a senior credit facility of, an undercapitalized borrower in the absence of a clear attempt by the insider-lender to use its power to control the borrower to the detriment of other creditors. What about the conduct of an investment banking firm that provided both financial advisory and underwriting services? Could the claims of a senior lender affiliated with that investment banking firm be exposed to equitable subordination? One of the claims raised in the Adelphia complaint squarely addressed that question last year. See In re Sunbeam Corp., 284 B.R. 355 (Bankr. S.D.N.Y. 2002). In Sunbeam, the official committee of unsecured creditors unsuccessfully sought to tag the senior lenders, led by Morgan Stanley Senior Funding Inc., with the alleged misdeeds of Morgan Stanley & Co. Inc., which had rendered financial advisory and investment banking services to Sunbeam. By tying the alleged claims against Morgan Stanley & Co. Inc. to Morgan Stanley Senior Funding Inc. and the other senior lenders, the committee sought, among other things, to subordinate equitably or equitably disallow the claims of the senior lenders in the hope that junior creditors, particularly the holders of approximately $500 million in notes issued by Sunbeam, could receive the distributions under Sunbeam’s plan. In 1997, Sunbeam retained Morgan Stanley & Co. Inc. as its financial advisor to pursue a sale of Sunbeam while it was in the midst of a restructuring. When it became apparent that the proposed restructuring and sale efforts were failing, Sunbeam instructed Morgan Stanley & Co. Inc. to redirect its focus toward identifying companies for Sunbeam to acquire in related durable consumer products businesses. Morgan Stanley & Co. Inc. identified and facilitated the acquisition of three such companies for an aggregate purchase price of $2.5 billion, of which $1.7 billion was cash and assumed debt. At the time, in view of the potential synergies that could be derived from the acquisitions that were identified in a report prepared by accountants and consultants at Coopers & Lybrand, Morgan Stanley & Co. Inc. issued a fairness opinion to Sunbeam’s board of directors in support of the acquisitions. With a need to raise approximately $2.3 billion to finance the purchase of these companies, Morgan Stanley & Co. Inc. indicated in March 1998 that it or one of its affiliates could raise the necessary financing. Ultimately, Morgan Stanley & Co. Inc. agreed to underwrite the note offering, which raised approximately $750 million; and Morgan Stanley Senior Funding Inc., with First Union Bank and Bank of America, agreed to lead and syndicate the senior bank financing, which raised approximately $1.6 billion. All for one, one for all? According to the committee’s pleadings, all of the financial advisory, underwriting and senior lending services that resulted in the closings of the financings and the acquisitions were handled by an integrated team directed by Morgan Stanley & Co. Inc. The committee also alleged that during its engagement as underwriter for the note offering, Morgan Stanley & Co. Inc. became aware of aggressive accounting practices and fraud at Sunbeam and, nevertheless, encouraged and approved the release of misleading material financial data regarding Sunbeam’s condition that was used to lure investors into purchasing the notes. Moreover, in the committee’s view, the note offering was intended solely to provide credit support for the senior secured bank facility led by Morgan Stanley Senior Funding Inc. and the other lenders. Finally, the committee also alleged that Sunbeam dramatically overpaid for the acquisitions, notwithstanding the fairness opinion rendered by Morgan Stanley & Co. Inc. Thus, the committee asserted that the acquisitions were a complete disaster for Sunbeam and its stakeholders and rendered Sunbeam insolvent. In the committee’s view, Morgan Stanley & Co. Inc. was culpable because it engineered the entire transaction, including the financings. However, Morgan Stanley & Co. Inc. was not a creditor of Sunbeam and, therefore, the committee sought to impute Morgan Stanley & Co. Inc.’s improper conduct to Morgan Stanley Senior Funding Inc., one of the senior lenders. Simply stated, the committee charged that Morgan Stanley & Co. Inc. was the alter ego of Morgan Stanley Senior Funding Inc. The committee further asserted that an agency relationship existed between Morgan Stanley & Co. Inc. and the other lenders in the senior credit facility and therefore, Morgan Stanley & Co. Inc.’s conduct could be imputed to them as well. Lastly, the committee urged the court to find that First Union Bank and Bank of America acted egregiously by failing to conduct due diligence in connection with the misleading information published by Sunbeam. For these reasons, the committee sought to subordinate equitably the claims of Morgan Stanley Senior Funding Inc. and the other lenders, to avoid their claims and liens as fraudulent conveyances and to recoup from the lenders any amounts otherwise payable to Morgan Stanley Senior Funding Inc. from amounts that have been owed to Sunbeam as a result of Morgan Stanley & Co. Inc.’s improper conduct. Claim was dismissed The bankruptcy court dismissed the committee’s equitable subordination claim; it refused to impute Morgan Stanley & Co. Inc.’s conduct to Morgan Stanley Senior Funding Inc. and the other lenders, holding that a claim of a creditor may not be subordinated based on the conduct of another party. The court rejected as conclusory and without basis the committee’s assertion that Morgan Stanley & Co. Inc. ran the entire process and that Morgan Stanley Senior Funding Inc. had no discretion as to whether or not to make the loans under the senior secured credit facility. The court placed great emphasis on the committee’s failure to set forth facts consistent with the factors typically associated with alter ego liability, as set forth in Fletcher v. Atex Inc., 56 F.3d 1451, 1456-58 (2d Cir. 1995). The court essentially found that the committee turned the doctrine of corporate veil piercing on its head in its effort to pin Morgan Stanley & Co. Inc.’s conduct on Morgan Stanley Senior Funding Inc. in order to subordinate the latter’s senior secured claims. That is, the alter ego doctrine and corporate veil piercing are employed “to ensure that an entity who engaged in inequitable conduct is held accountable for its actions and to prevent that wrongdoer from using another entity to shield it from liability.” The court noted in this instance that “[t]here is no evidence . . . that [Morgan Stanley & Co. Inc.] used [Morgan Stanley Senior Funding Inc.] to shield itself from potential liability.” The bankruptcy court refused to disregard the corporate structure and punish Morgan Stanley Senior Funding Inc. (by equitably subordinating or disallowing its claims and those of the other lenders) for any purported sins of Morgan Stanley & Co. Inc. No agency Similarly, the court rejected the committee’s attempt to connect Morgan Stanley Senior Funding Inc. and Morgan Stanley & Co. Inc. under an agency theory, holding that “[t]here are no allegations in the Amended Complaint that [Morgan Stanley & Co. Inc.] acted subject to [Morgan Stanley Senior Funding Inc.'s] direction and control.” Under principal-agent theory, according to the court, the committee would have had to show that Morgan Stanley Senior Funding Inc. directed and controlled Morgan Stanley & Co. Inc. in an effort to improve its position vis-�-vis other creditors. The committee had alleged the opposite. Ultimately, the bankruptcy court concluded that the committee fell far short of the threshold required to demonstrate that Morgan Stanley & Co. Inc. and Morgan Stanley Senior Funding Inc. were the same entity for the purpose of imparting the former’s conduct on the latter’s, so as to justify the equitable subordination of the latter’s claims. Failure to implicate Morgan Stanley Senior Funding meant that there was no chance that the committee would be able to associate Morgan Stanley & Co. Inc.’s conduct with the other lenders. Thus, it is clear from Sunbeam that the bankruptcy courts will not casually disregard corporate formalities even among affiliated entities in the same transactions to impose equitable subordination. To the extent that Sunbeam’s noteholders may have had claims against Morgan Stanley & Co. Inc. in connection with the note offering or the acquisition, the court was not going to permit them to use the equitable power of the bankruptcy court to punish the undersecured lenders without clear evidence of wrongdoing by the lenders themselves. Ramifications Ultimately, like many issues before a bankruptcy court, the question of equitable subordination of a creditor’s claim comes down to fundamental fairness among creditors-all of whom are presumably harmed by the insolvency of a debtor. Creditors of a debtor do not generally owe a duty to one another and thus, before the claims of one are subordinated by order of a court to those of another outside the scope of ordinary business dealings, the inequitable conduct of the creditor to be subordinated must be egregious. Also, as demonstrated in Sunbeam, parties will have to prove more than mere participation in a transaction to warrant subordination. In the Enron matter, in volumes of materials (with more forthcoming), Batson has asserted that the highly complex structured finance transactions that purportedly misled investors and third parties could not be accomplished without the full support of the lenders that engaged in these transactions with Enron. Therefore, in the view of the examiner, aiding and abetting the alleged fraud at Enron constituted inequitable conduct warranting subordination notwithstanding the absence of a duty owing from these creditors to others. The lenders are probably not helped by the massive settlements made with the government by the key lenders to Enron. Whether or not the bankruptcy court will agree, should one or more actions be commenced, remains unknown. Similarly, the creditors committee in the Adelphia case, like the committee in Sunbeam, will attempt to show in the course of an enormous set of claims that lending and investment banking arms acted as single units to profit from putting together major financings for Adelphia. In large measure these transactions benefited Adelphia’s principals and not the company and were based on misleading financial information made available to the financial institutions and therefore, the claims of these financial institutions should be subordinated. Emanuel C. Grillo is a partner in the bankruptcy and restructuring practice at the New York office of Torys.

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