In the

United States Court of Appeals

For the Seventh Circuit

No. 06-3881

IN RE:

BARRY B. KREISLER and MARSHA D. ERENBERG,

Debtors.

APPEAL OF:

GARLIN MORTGAGE CORPORATION

Appeal from the United States District Court

for the Northern District of Illinois, Eastern Division.

No. 05 C 6593—Robert W. Gettleman, Judge.

ARGUED NOVEMBER 5, 2007—DECIDED OCTOBER 20, 2008

Before POSNER, EVANS, and SYKES, Circuit Judges.

SYKES, Circuit Judge. The bankruptcy rules authorize

claims trading, a practice in which a creditor sells its

claim against a bankrupt debtor to a third party in exchange for cash or something else of value. See FED. R.

BANKR. P. 3001(e). Claims trading allows creditors to

opt out of the bankruptcy system, trading an uncertain

future payment for an immediate one, so long as they can

find a purchaser. The purchaser essentially becomes an
2 No. 06-3881

investor in the bankruptcy estate, betting that the

future payout will eventually be more than the claim’s

purchase price.

This case involves claims trading with a twist: two

bankrupt individuals in Chapter 7 proceedings under

joint administration in the bankruptcy court formed a

corporation to purchase a secured claim against their

own estates. Claims trading by debtors in their own

estates is unusual; debtors in bankruptcy presumably

lack assets outside their estates that might be used to

purchase a claim. The bankruptcy court viewed the debtors’ actions as misconduct and invoked the doctrine

of equitable subordination. The result was that their

corporation’s claim was given last priority, meaning it

could be paid only after the claims of every unsecured

creditor. Not surprisingly, there wasn’t enough money to

pay all the unsecured claims, so the corporation ended up

with nothing. An appeal was taken to the district court,

which affirmed, and the corporation appealed to this court.

We reverse. Equitable subordination is generally appropriate only if a creditor is guilty of misconduct that

causes injury to the interests of other creditors. The debtors’ formation of a corporation to purchase a secured

claim against their own estates may have amounted to

misconduct, but it did not harm the other creditors, who

were in the same position whether the original creditor

or the debtors’ corporation owned the secured claim.
No. 06-3881 3

I. Background

Real-estate developers Barry Kreisler and Marsha

Erenberg each owned an interest in two properties located

on Western Avenue in Chicago, both of which were

fully encumbered by several mortgages, including a

junior mortgage held by the Community Bank of Ravenswood. In 2002 Kreisler and Erenberg filed for bankruptcy,

and a bankruptcy trustee was appointed to jointly administer their estates. Community Bank filed secured

claims for nearly $900,000 in each case.

The bankruptcy proceedings threatened to drag out,

and the bank decided that it wanted out of the case.

According to the trustee, Community Bank approached

her about making a deal and proposed reducing its

claim against one of the properties to $15,000 in return

for the trustee’s help obtaining court approval to foreclose on the other property. The trustee and the bank

never reached an agreement, however, and in the meantime Kreisler and Erenberg decided to try to purchase

the claim for themselves. They formed Garlin Mortgage

Corporation for that purpose. Kreisler, an attorney, negotiated on Garlin’s behalf to purchase Community Bank’s

claim for $16,500 and financed the transaction through a

loan from another corporation that he and Erenberg

controlled. In exchange for his efforts, Kreisler was to

receive a $35,000 fee from Garlin, payable when Garlin

settled its claim against the bankruptcy estate.

Garlin and Community Bank eventually consummated

this transaction, and the bank assigned its note and

secured claim on the Western Avenue properties to
4 No. 06-3881

Garlin. But when Garlin moved to have the secured

claim paid, it ran into trouble in the bankruptcy court.

Kreisler and Erenberg had not disclosed their relationship

with Garlin to either the bankruptcy court or the trustee.

Although the two were clearly the driving force behind

the company—they had formed it and funded it through a

loan, and Kreisler stood to gain most or all the profits

through his $35,000 fee—they were not the owners or

directors of the company. On paper, the owners and

directors were Kreisler’s sister and a close friend of

Erenberg’s; the two later testified that they had not contributed any capital or participated in any of the operations of

the company.

When the bankruptcy judge discovered Kreisler’s and

Erenberg’s involvement with Garlin, he threw the book at

them. Invoking the doctrine of equitable subordination,

the judge held that Garlin—whose secured claim

ordinarily would have been one of the first paid—would

be paid last. Because there wasn’t enough money to pay

the unsecured creditors, Garlin came away with nothing.

Garlin appealed to the district court, which affirmed.

This appeal followed.

II. Discussion

The only issue in this case is whether the bankruptcy

judge properly applied equitable subordination, a judgemade doctrine now incorporated into the bankruptcy

code at 11 U.S.C. § 510(c). See 4 COLLIER ON BANKRUPTCY

§ 510.05 (Alan N. Resnick & Henry J. Sommer eds., 15th ed.

rev. 2007). Equitable subordination allows the bankruptcy
No. 06-3881 5

court to reprioritize a claim if it determines that the

claimant is guilty of misconduct that injures other

creditors or confers an unfair advantage on the claimant.

In re Lifschultz Fast Freight, 132 F.3d 339, 344 (7th Cir. 1997)

(citing Benjamin v. Diamond (In re Mobile Steel Co.), 563

F.2d 692, 700 (5th Cir. 1977)). The result is usually that

the claimant receives less money than it otherwise

would (or none at all), but that is not the goal. Equitable

subordination is remedial, not punitive, and is meant to

minimize the effect that the misconduct has on other

creditors. Mobile Steel, 563 F.2d at 700-01.

Equitable subordination generally requires the satisfaction of three conditions: (1) the claimant must have

“engaged in ‘some type of inequitable conduct’ ”; (2) the

misconduct must have “ ‘resulted in injury to the

creditors of the bankrupt or conferred an unfair advantage on the claimant’ ”; and (3) subordination must

“ ‘not be inconsistent with the provisions of the Bankruptcy

Act.’ ” United States v. Noland, 517 U.S. 535, 538-39 (1996)

(quoting the Fifth Circuit’s “influential opinion” in Mobile

Steel, 563 F.2d at 700)). If these conditions are met, equitable subordination is applied only to the extent necessary

to undo the effect of the misconduct on other creditors.

Mobile Steel, 563 F.2d at 701.

We noted in Lifschultz that “[i]n the context of equitable

subordination, the type of conduct that has been considered inequitable generally falls within the following

categories: (1) fraud, illegality, breach of fiduciary duties;

(2) undercapitalization; and (3) [the] claimant’s use of

the debtor as a mere instrumentality or alter ego.” 132
6 No. 06-3881

“Courts subject the dealings of an insider to ‘rigorous scru1

tiny’ ” for inequitable conduct. Lifschultz, 132 F.3d at 344

(quoting Pepper v. Litton, 308 U.S. 295, 306 (1939)). The bankruptcy court applied this standard to Garlin’s claim.

F.3d at 344-45 (citations and internal quotation marks

omitted). The conduct at issue here does not fit

neatly into any of these categories; the bankruptcy court

acknowledged as much. Nonetheless, the court equitably

subordinated Garlin’s claim after characterizing Garlin’s

purchase of Community Bank’s junior mortgage as “an

elaborate scheme” by Kreisler and Erenberg to receive

proceeds from the sale of their property “to the

exclusion of their unsecured creditors.”

We can put to one side whether the court’s finding of

inequitable conduct was correct. Although Garlin asks

us to reexamine both the finding of misconduct and the

level of scrutiny the court applied in reaching it, those 1

aspects of the bankruptcy court’s analysis ultimately do

not affect our conclusion. Even accepting that Garlin

(Kreisler and Erenberg) committed misconduct within

the contemplation of this equitable doctrine, misconduct

alone doesn’t justify subordination of this claim. Only

misconduct that harms other creditors will suffice, and

there is no evidence that Kreisler and Erenberg’s scheme

harmed any of their creditors.

The only creditor that was affected by Kreisler and

Erenberg’s purchase of Community Bank’s claim was

Community Bank. But the bank isn’t complaining; it

voluntarily sold its claim at a deep discount. And
No. 06-3881 7

although the bankruptcy court thought it significant that

Kreisler and Erenberg initially hid their connection to

Garlin, there is no evidence that Community Bank cared

about the affiliation. On the contrary, the bank negotiated

the sale of its claim directly with Kreisler. As for the

other creditors, they were not affected at all and would

be in the same position regardless of whether it was

Community Bank or Garlin asserting the junior lien

against the Western Avenue properties.

Our conclusion requires one minor qualification: Garlin’s

decision to purchase Community Bank’s claim might

have disadvantaged the other creditors if it interfered with

the trustee’s own settlement with Community Bank.

According to the trustee, that’s what happened here: she

claims to have been negotiating a deal with Community

Bank under which the bank would reduce one of its claims

in return for the trustee’s help foreclosing on the other

property. But the trustee presented no evidence that any

deal with Community Bank was imminent or even likely.

Indeed, at oral argument the trustee’s counsel acknowledged that the trustee had only “had discussions” with

Community Bank. No deal had been reached, and whether

such a deal could have been reached is speculation.

Moreover, even if the trustee was close to an agreement

with Community Bank, it is far from clear that Garlin’s

usurpation of that deal would amount to misconduct.

Debtors generally do not owe fiduciary duties to their

creditors. Lifschultz, 132 F.3d at 346. Kreisler and Erenberg

were not required to offer their deal with Community

Bank to the trustee before accepting it.
8 No. 06-3881

The bankruptcy court cited several other aspects of

Garlin’s transaction with Community Bank that might

support a finding of misconduct, but none caused injury

to Kreisler or Erenberg’s creditors. For example, the court

faulted Kreisler and Erenberg for improperly “dominating”

Garlin, for treating it essentially as their own even though

it was owned—at least on paper—by independent shareholders. But that misconduct did not harm other creditors;

any abuse of the corporation hurt only Garlin’s independent shareholders, and the trustee has not suggested that

these shareholders were also creditors of Kreisler or

Erenberg’s estates.

The bankruptcy court also found that Garlin had failed

to properly notify the court when it acquired Community

Bank’s claim, as required by Rule 3001(e)(2) of the Federal

Rules of Bankruptcy Procedure. But again, there is no evidence that the Rule 3001(e)(2) violation harmed other

creditors. Rule 3001(e)(2) requires the purchaser of a

claim to notify the bankruptcy court after the purchase

so that the bankruptcy court can allow the purported

seller the opportunity to object before the claim is irrevocably deemed to be transferred. The point of the rule is to

prevent fraudulent transfers. But Community Bank, the

creditor protected by the rule, has not claimed the

transfer was fraudulent and has not otherwise complained about the transaction.

The trustee suggests that the other creditors were

harmed by the Rule 3001(e)(2) violation because if she had

known Garlin had a deal with Community Bank, she

would have proposed an alternative that would have
No. 06-3881 9

been more favorable to the other creditors than Garlin’s.

But that would have been impossible. Rule 3001(e)(2)

required Garlin to notify the bankruptcy court only after

it had purchased Community Bank’s claim—too late for

the trustee to negotiate a better deal with Community

Bank.

There is, no doubt, a certain underhanded quality to

Kreisler and Erenberg’s conduct; their effort to hide

their involvement suggests that they thought they were

doing something wrong. But the bankruptcy rules allow

claims trading, and their use of Garlin to purchase Community Bank’s claim did not harm other creditors. Equitable subordination was therefore improper.

REVERSED AND REMANDED.

10-20-08