Opinion ID: 490185
Heading Depth: 2
Heading Rank: 3

Heading: subordination of indemnity claims

Text: 12 Even if not entitled to assert an administrative expense claim, LDC contends that it can assert claims for indemnification for defending Argue and the other officers in the adversary proceeding under section 317 of the California Corporations Code 4 and that the district court erred in subordinating those claims to general creditors' claims.
13 Section 317 provides for corporate indemnity of officers who incur litigation expenses as a result of their corporate activities. 5 Defendant-officers who prevail on the merits in litigation have a mandatory right to indemnity of litigation expenses. Cal.Corp.Code Sec. 317(d). Even if they do not prevail, they may still be indemnified in nonderivative actions if the corporation or the court hearing the litigation finds they acted in good faith and in a manner [they] believed to be in the best interests of the corporation. Id. Sec. 317(b), (e). Either prevailing on the merits or a finding of good faith is a prerequisite to the indemnity award. 14 The officers' right to indemnity under California law is contingent. The appeal of Argue's favorable judgment of the fraud claim is pending, as is trial of the state securities claims against him and the remaining officer-defendants. Until they prevail or are determined to have acted in good faith, their right to indemnity for litigation expenses under state law is uncertain. 15 This does not necessarily mean, however, that the district court prematurely subordinated the indemnity claims. By subordinating all of the officers' indemnity claims to other unsecured claims, the court allowed other creditors to participate in the distribution of the estate first, whether or not the officers ultimately prevail on the merits. The Code contemplates that the bankruptcy court will subordinate classes of contingent claims in order to hasten distribution of the estate. A contingent claim for indemnity falls within the Code's definition of a claim as a right to payment, whether or not such right is ... contingent. 11 U.S.C. Sec. 101(4)(A). Congress intended section 101(4)(A) to provide the broadest possible definition of claims so that all legal obligations of the debtor, no matter how remote or contingent, will be able to be dealt with in the bankruptcy case. S.Rep. No. 989, 95th Cong., 2d Sess. 21, 22, reprinted in 1978 U.S.Code Cong. & Admin.News 5787, 5807, 5808. As a contingent claim is defined as a claim it can be subordinated to other claims under principles of equitable subordination. 11 U.S.C. Sec. 510(c). Thus under the Code contingent indemnity claims can be allowed and subordinated. See In re Johns-Manville Corp., 57 B.R. 680, 687 (Bankr.S.D.N.Y.1986) (allowance of contingent claims permissible under the Code). Our inquiry is thus whether the court properly subordinated all indemnity claims to general unsecured claims under subordination principles. 16
17 The Creditors argue that all of the officers' indemnity claims must be subordinated under 11 U.S.C. Sec. 510(b). We review de novo the interpretation of the statute. In re Global W. Dev. Corp., 759 F.2d at 726. Section 510(b) provided at the time of the filing of the bankruptcy petition as follows: 18 Any claim for recission [sic] of a purchase or sale of a security of the debtor ... or for damages arising from the purchase or sale of such a security shall be subordinated for purposes of distribution to all claims and interests that are senior or equal to the claim or interest represented by such security. 19 Bankruptcy Act of 1978, Pub.L. No. 95-598, Sec. 510(b), 92 Stat. 2549, 2586 (amended 1984). 6 The law in effect at the time of filing of the petition governs the case. Marxen, 307 U.S. at 207, 59 S.Ct. at 815. Section 510(b) prevents equity stockholders or holders of other subordinated securities from converting their interests into higher priority general creditors' claims by asserting damages or rescission claims. H.R.Rep. No. 595, 95th Cong., 1st Sess. 194-96, reprinted in 1978 U.S.Code Cong. & Admin.News 5963, 6154-57. Congress requires subordination of such claims because failure to subordinate the interests of shareholders to those of unsecured creditors would defeat the reasonable expectations of both. Id. General creditors rely on the equity cushion created by the investment of shareholders and expect priority in bankruptcy. Id. Shareholders in turn bargain for potential profit in exchange for expected subordination of their interests in bankruptcy. Id.; Kira v. Holiday Mart, Inc. (In re Holiday Mart, Inc.), 715 F.2d 430, 433-34 (9th Cir.1983) (proper to subordinate rescission claims of holders of subordinated debentures). 20 The Creditors argue that the same considerations require subordination of indemnity claims arising out of securities rescission or fraud litigation. Section 510(b) bars shareholders from elevating their interests to the level of unsecured creditors. The Creditors maintain that if shareholders recover damages from an officer of the debtor for securities violations, and the officer in turn recovers indemnity from the estate of the debtor as an unsecured claimant, the shareholders will achieve indirectly that which section 510(b) bars them from obtaining directly. By this circuitous means, the Creditors contend, shareholders could avoid the subordination of their equity interests and defeat the expectations of unsecured creditors. 21 Even were we to accept this argument, section 510(b) would not apply here. The officers' indemnity claims are for litigation costs, not for reimbursement of liability owed to the holders of the securities. The argument that the security holder may circuitously elevate his claim to a general unsecured claim through indemnity is relevant only to indemnity of liability. The security holder recovers nothing from the officers when the latter are merely indemnified for defense costs. Thus section 510(b)--at least prior to the 1984 amendment--does not require subordination of indemnity claims for defense costs. The blanket order subordinating all indemnity claims to general unsecured claims, even those for defense costs, is not proper under that section. 22
23 The Creditors alternatively argue that the district court properly subordinated the contingent indemnity claims under 11 U.S.C. Sec. 510(c)(1) which grants the bankruptcy court discretion under principles of equitable subordination, [to] 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. Section 510(c)(1) codifies existing case law. H.R.Rep. No. 595, 95th Cong., 1st Sess. 359, reprinted in 1978 U.S.Code Cong. & Admin.News 5963, 6315. The bankruptcy court may subordinate a claim if it finds the claimant engaged in fraud, unfairness or inequity, In re Poole, 796 F.2d at 322, and the claimant's conduct harmed the debtor or its other creditors, Trone v. Smith (In re Westgate-California Corp.), 642 F.2d 1174, 1177-78 (9th Cir.1981). As the court exercises broad equitable power to subordinate claims, we review for an abuse of discretion. In re Poole, 796 F.2d at 321. 24 The district court subordinated all the officers' indemnity claims, even though the officers may ultimately prevail in their defense in the adversary litigation. It is beyond cavil that the court could subordinate indemnity claims of officers found liable of securities violations or fraud. Bankruptcy policy prohibits the debtor from indemnifying unsuccessful securities defendants to the prejudice of innocent creditors, at least when liability is predicated on fraud or negligence. In re Investors Funding Corp., 8 B.R. 260, 262, 264 (S.D.N.Y.1980); In re Baldwin-United Corp., 55 B.R. 885, 902-03 (Bankr.S.D.Ohio 1985) (no indemnity from debtor for securities violations based on fraud or negligence); In re Equity Funding Corp., 416 F.Supp. 132, 156 (C.D.Cal.1975) (same). Here, the officers have been sued for fraud and for violations of a California securities law, which requires that the defendant knew or should have known of the failure to register the security, Cal.Corp.Code Sec. 25504; see Christian Life, 45 B.R. at 910-11; Tomei v. Fairline Feeding Corp., 67 Cal.App.3d 394, 400-01, 137 Cal.Rptr. 656, 659 (1977). If the officers are ultimately found liable for negligence or fraud under either of these theories, innocent creditors should not have to reimburse them for liability or defense expenses. 25 The more difficult question is whether the district court properly subordinated indemnity claims for defense expenses of officers who ultimately may prevail in their defense. The Creditors contend that the court properly exercised its discretion to subordinate all claims of indemnity of former officers of the church, even of those who ultimately may prevail, in light of the officers' inequitable conduct in establishing and maintaining the trust fund. The court, however, failed to make any findings of improper or wrongful conduct by the officers and cited no equitable reasons to justify the subordination order. The court did not find that Argue or the remaining officers knew or should have known that the trust fund was required to be registered or that the trust fund had insufficient assets to cover liabilities. When a creditor seeks equitable subordination of a claim, the record must objectively disclose a threshold demonstration that the claimant has behaved inequitably and to the detriment of the debtor or its other creditors. Westgate-California Corp. v. First Nat. Finance Corp., 650 F.2d 1040, 1044 n. 1 (9th Cir.1981). Absent findings of the requisite inequitable and harmful conduct by the officers or of a sufficiently developed record, subordination of all indemnity claims of officers based on equitable subordination is premature. See id. at 1044 (premature to subordinate claim absent findings or a sufficient record).