Equitable subordination, as permitted under section 510(c)(1) of the Bankruptcy Code, provides the court the ability to reorganize creditor’s debt in the light of any inequitable conduct. The code gives courts the ability to subordinate the level of priority of a creditor’s claim in light of any inequitable conduct committed by that creditor. This remedy is applied in cases where the creditor has acted in an inequitable manner, causing injury or creating unjust positions for other creditors. This remedy is remedial, not punitive, and limited only to the extent necessary to remedy the damage caused by the wrongdoing creditor. Traditionally, equitable subordination was only applied in cases where the wrongdoing creditor was an insider, however, recently this remedy has been applied to all creditors. In addition, equitable subordination was only applied in instances of fraud, but in recent years has been expanded to remedy all unfair and unjust conduct by creditors.
Recently a creditor who breached the implied contract of good faith was found to have risen to the level of equitable subordination. Specifically, in In re LightSquared, Inc., a bankruptcy court equitably subordinated the claim of an entity that the founder, chairman of the board, and controlling shareholder of a competitor of the debtor created in order to circumvent a credit agreement’s restrictions on transferring the debt to certain parties. In particular, the court determined that the entity acted in bad conduct by breaching the implied covenant of good faith by (1) circumventing the credit agreement’s restrictions and (2) delaying the closing of the entity’s purchases of debt from other creditors. Further, the court concluded that this conduct resulted in damage to the other creditors. Accordingly, the court decided to equitably subordinate the entity’s claim to the extent necessary to place the other creditors in the position they would have been in if not for the wrongdoing.