By: Nicholas Smargiassi
St. John’s University School of Law
American Bankruptcy Institute Law Review Staff
In general, under principles of equitable subordination, a court may subordinate the claims of a creditor for conduct that is unfair to the other creditors of a bankruptcy estate. The pertinent misconduct must benefit the creditor that engaged in misconduct or harm the other creditors’ position in the bankruptcy estate. In In re John Varvatos Enters., the United States District Court for the District of Delaware held that the Bankruptcy Court did not abuse its discretion in dismissing Knox’s equitable subordination claim with prejudice for failure to state a claim.[1] Knox, the class representative of former John Varvatos Enterprises “JVE” saleswomen, successfully won a class action suit against JVE for violation of the Federal Equal Protection Act and other related claims in New York.[2] That judgment was on appeal when JVE and certain affiliates filed voluntary petitions for relief under Chapter 11 of title 11 of the United States Code (the “Bankruptcy Code”) with the Delaware bankruptcy court. During the bankruptcy case, JVE sold substantially all of its assets to their parent company Lion/Hendrix Cayman Limited (“LHCL”) via a secured credit bid. However, Knox attacked LHCL’s status as a secured creditor by filing a complaint against LHCL asserting that LHCL “encouraged” or “facilitated” the discriminatory policy by allowing JVE to offer a discount for women at other stores owned by LHCL that was not equivalent to the benefits given to men.[3] According to Knox, LHCL’s secured debt should be subordinated below Knox’s judgment.[4] The Bankruptcy Court dismissed Knox’s equitable subordination claim, and Knox appealed that decision to the United States District Court of Delaware.[5] On appeal, The United States District Court agreed with the Bankruptcy Court’s decision that Knox failed to plead enough facts to show that LHCL actually facilitated the alleged inequitable conduct, and Knox failed to plead a connection between LHCL's alleged inequitable conduct and a harm to Knox in terms of their position as a creditor and the bankruptcy results.[6]
The doctrine of equitable subordination allows a court to subordinate all or part of an allowed claim to all or part of another allowed claim.[7] The Delaware District Court stated that the purpose of equitable distribution is to allow a court to “sift the circumstances surrounding any claim to see that injustice or unfairness is not done in administration of the bankrupt estate.”[8] It is well established that there are three conditions that must be present in order to grant an equitable subordination claim.[9] First, the claimant must have engaged in some type of inequitable conduct.[10] The Delaware District Court affirmed the Bankruptcy Court’s reasoning that Knox failed to show that JVE would not have continued the clothing policy had LHCL not allowed JVE to offer a discount.[11] Second, the misconduct must have resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant.[12] Here, the court also concluded that Knox failed to allege that LHCL benefitted in the bankruptcy case from JVE’s Equal Protection Act violations, and no creditor, including Knox, was injured in the bankruptcy case as a result of the Equal Protection Act violations. Third, equitable subordination must not be inconsistent with the provisions of the Bankruptcy Code.[13] The court determined that Knox failed to plead sufficient facts to the first two requirements of an equitable distribution claim, and thus did not address the third element. In granting the defendant's motion to dismiss,[14] the district court emphasized the purpose of an equitable distribution claim, which is to eliminate injustice or unfairness to innocent creditors in the administration of the bankruptcy estate and noted that this was an unusual basis for an equitable subordination claim because the conduct had no impact on the subsequent bankruptcy.[15]
Equitable subordination is not appropriate when the inequitable conduct had no impact on the recovery by, or priority of, creditors in the bankruptcy case. Here, Knox’s equitable subordination claim was dismissed because, among other things, the purported misconduct did not injure creditors or confer an unfair advantage on the claimant. Moreover, even if the misconduct had injured other creditors, the equitable subordination claim would have been dismissed because there was no misconduct and equitable subordination would have been inconsistent with the provisions of the Bankruptcy Code.[16]
[1] In re John Varvatos Enters., No. 20-11043(MFW), 2021 U.S. District LEXIS 171924, at *25 (D. Del. Sep. 10, 2021).
[2] Id. at *3–4.
[3] Id. at *5.
[4] Id.
[5] Id.
[6] Id. at *20–22.
[7] Id. at *7-8.
[8] Id. at *8. (quoting Pepper v. Litton, 308 U.S. 295, 307-08, 60 S. Ct. 238 (1939); Burden v. U.S., 917 F.2d 115, 117 (3d Cir. 1990).
[9] Id. at *8.
[10] Id.
[11] Id. at *10–11.
[12] Id.
[13] Id.
[14] Id. at *20–22.
[15] Id. at *8-16 (“equitable subordination is remedial, and the goal is to undo or to offset any inequality in the claim position of a creditor that will produce injustice or unfairness to other creditors in terms of the bankruptcy results” quoting Citicorp Venture Capital, Ltd. v. Comm. of Creditors Holding Unsecured Claims, 323 F.3d 228, 233-34 (3d Cir. 2003)).
[16] Id. at *8.