Court Opinion

ID: 3002355
Source: CourtListenerOpinion
Date Created: 2015-09-24 20:28:04.477128+00
Date Added: 2024-06-11T15:02:33.303424
License: Public Domain

In the

 United States Court of Appeals
                 For the Seventh Circuit

No. 06-3881

IN R E:

    B ARRY B. K REISLER and M ARSHA D. E RENBERG ,

                                                                     Debtors.
A PPEAL OF:

    G ARLIN M ORTGAGE C ORPORATION

               Appeal from the United States District Court
          for the Northern District of Illinois, Eastern Division.
               No. 05 C 6593—Robert W. Gettleman, Judge.

    A RGUED N OVEMBER 5, 2007—D ECIDED O CTOBER 20, 2008

  Before P OSNER, E VANS, and S YKES, Circuit Judges.
  S YKES, 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 ex-
change for cash or something else of value. See F ED. R.
B ANKR. 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 debt-
ors’ 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 appro-
priate only if a creditor is guilty of misconduct that
causes injury to the interests of other creditors. The debt-
ors’ 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 Ravens-
wood. In 2002 Kreisler and Erenberg filed for bankruptcy,
and a bankruptcy trustee was appointed to jointly ad-
minister 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 fore-
close on the other property. The trustee and the bank
never reached an agreement, however, and in the mean-
time Kreisler and Erenberg decided to try to purchase
the claim for themselves. They formed Garlin Mortgage
Corporation for that purpose. Kreisler, an attorney, negoti-
ated 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 contrib-
uted 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 judge-
made doctrine now incorporated into the bankruptcy
code at 11 U.S.C. § 510(c). See 4 C OLLIER ON B ANKRUPTCY
§ 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 satisfac-
tion 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 ad-
vantage 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, equita-
ble 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 consid-
ered 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

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,1 those
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

1
   “Courts subject the dealings of an insider to ‘rigorous scru-
tiny’ ” for inequitable conduct. Lifschultz, 132 F.3d at 344
(quoting Pepper v. Litton, 308 U.S. 295, 306 (1939)). The bank-
ruptcy court applied this standard to Garlin’s claim.
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 acknowl-
edged 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 share-
holders. But that misconduct did not harm other creditors;
any abuse of the corporation hurt only Garlin’s independ-
ent 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 evi-
dence 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 irrevoca-
bly 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 com-
plained 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 Com-
munity Bank’s claim did not harm other creditors. Equita-
ble subordination was therefore improper.
                               R EVERSED AND R EMANDED.

                         10-20-08