Title 11 of the United States Code (the “Bankruptcy Code”) implements a basic priority system under section 507 to determine the order a bankruptcy court will distribute the assets of an estate. The classic hierarchy begins with secured creditors, then “[s]pecial classes of creditors, such as those [holding] certain claims for taxes or wages . . . [then] low-priority creditors, including general unsecured creditors . . . [followed by] equity holders . . . [who] receive nothing until all previously listed creditors have been paid in full.” Section 510(c) of the Bankruptcy Code authorizes disturbing the fundamental distribution scheme for secured and unsecured claims through the common law doctrine of equitable subordination. Equitable subordination grants a bankruptcy court discretion to subordinate all or part of an allowed claim to all or part of another allowed claim where justice so requires.
Many circuits, including the Third Circuit, require a plaintiff to satisfy the following three conditions before determining whether to grant equitable subordination: (1) a higher-priority creditor engaged in inequitable conduct; (2) such conduct unfairly advantaged them or injured a lower-priority creditor; and (3) subordination is consistent with the Bankruptcy Code. There is much debate within the circuits on whether satisfying the first factor is a formal requirement. The Third Circuit formally requires sufficiently pleading inequitable conduct.
This article examines whether a lower-priority creditor in the Third Circuit must establish inequitable conduct by a higher-priority creditor whose debt is sought to be equitably subordinated. Part I explores the circuit split on formally requiring a plaintiff to establish inequitable conduct for an equitable subordination claim and discusses the factors a court may consider when determining whether a plaintiff sufficiently pleads inequitable conduct. Part II discusses the current formal requirement of establishing inequitable conduct of the Third Circuit for equitable subordination claims and examines how the Third Circuit determines sufficient proof of inequitable conduct.