Herby's Foods, Inc., Matter of

• Decision Date: 20 September 1993
• Docket Number: No. 92-1703,92-1703
• Citation: 2 F.3d 128
• Parties: , Bankr. L. Rep. P 75,446 In the Matter of HERBY'S FOODS, INC., Debtor. SUMMIT COFFEE COMPANY, et al., Appellants, v. HERBY'S FOODS, INC., Appellee.
• Court: U.S. Court of Appeals — Fifth Circuit

Page 128

2 F.3d 128

24 Bankr.Ct.Dec. 1116, Bankr. L. Rep. P 75,446

In the Matter of HERBY'S FOODS, INC., Debtor SUMMIT COFFEE COMPANY, et al., Appellants, v. HERBY'S FOODS, INC., Appellee.

No. 92-1703.

United States Court of Appeals Fifth Circuit.

Sept. 20, 1993.

Dennis Olson, Robert M. Nicaud, Jr., Godwin & Carlton, Dallas, TX, for appellants.

Lynnette R. McClellan, Greg Hesse, Jenkens & Gilchrist, Dallas, TX, for appellee.

Appeal from the United States District Court for the Northern District of Texas.

Before POLITZ, Chief Judge, REYNALDO G. GARZA and JOLLY, Circuit Judges.

POLITZ, Chief Judge:

We review the propriety of a bankruptcy court's equitable subordination of certain creditors' claims to a level equivalent to that of equity stockholders. Finding no infirmity in the bankruptcy court's rulings or in the upholding thereof by the district court, we affirm.

Background

Herby's Foods, Inc. produced and distributed fast foods to convenience stores. The Summit Coffee Company, Inc., Dunnam-Snyder Company, and The Snyder Company, Inc. (collectively, the Insiders) are interrelated companies that advanced funds to Herby's and possess claims as unsecured creditors in the Herby's bankruptcy.

The corporate "food chain" was as follows: (1) Herby's was a wholly owned subsidiary of Summit; (2) all of the voting securities of Summit were owned by Dunnam; (3) Dunnam is a partnership composed of seven trusts for the benefit of William Snyder's ex-wife and children; and (4) the managing agent for Dunnam at the time of Summit's acquisition of Herby's was Snyder Co., owned by William Snyder's ex-wife and children. In addition to the commonality of ownership interests, these companies enjoyed a commonality of management. At various times, William Snyder personally held several management positions, including president of Snyder Co., managing agent of Dunnam, an officer of Summit, and president of Herby's. The Insiders stipulated that they are "insiders" of Herby's as defined in the Bankruptcy Code. ¹

Summit purchased Herby's on October 26, 1987 pursuant to a Stock Purchase Agreement. ² The purchase price was $5,500,000, $2,800,000 of which was actually a loan to Herby's to pay off an intercompany debt to its previous owner. Herby's executed a note and security agreement in favor of Summit for $2,800,000. Like the Stock Purchase Agreement, these documents were dated October 26, 1987; the security interest, however, was not perfected at that time.

In addition, Dunnam provided a working capital line of credit to Herby's in the amount of $4,000,000. The parties have stipulated that no third-party lender would make a working capital loan to Herby's on any terms. The line of credit was evidenced by Herby's promissory note and security agreement, both dated October 26, 1987. Once again, the security interest was not timely perfected. Through a series of draws, Herby's eventually borrowed the maximum amount available under this line of credit.

Summit did not file a UCC-1 to perfect its security interest under the purchase money loan until November 10, 1988, 13 months after the note and security agreement had been executed. Similarly, Dunnam did not file a UCC-1 to perfect its security interest under the working capital loan until June 9, 1989, 20 months after the date of the underlying note and security agreement. According to Snyder, both of these security agreements covered "basically everything" owned by Herby's. Snyder also admitted that, "[w]e delayed putting in the UCC's because we were hoping to get a secured lender."

Between Summit's acquisition of Herby's and the filing of its petition in bankruptcy on September 7, 1989, the amount that Herby's owed to its unsecured creditors (other than the Insiders) increased fivefold, from $929,550.23 to $4,635,675. Further, between January 6, 1989 and September 1, 1989, Snyder Co. made unsecured advances to Herby's exceeding $579,000, advances which were not evidenced by loan agreements or any other documentation and which apparently bore no interest.

After Herby's filed its voluntary Chapter 11 bankruptcy petition, the Insiders, as unsecured creditors, submitted these proofs of claims:

Summit $3,086,394.52

Dunnam $4,054,696.12

Snyder Co. $ 579,276.47

The Official Unsecured Creditors Committee (the Committee) responded with a Complaint to Subordinate Claims, Avoid Liens and Object to Claims. In its complaint the Committee sought to subordinate and object to the claims of the Insiders and to avoid the liens of Summit and Dunnam. Neither Summit nor Dunnam asserted liens, nor did they oppose their avoidance, apparently in recognition of their avoidability under 11 U.S.C. Sec. 547. The Insiders opposed the avoidance of their claims and, alternatively their subordination to a level below that of general unsecured creditors.

The bankruptcy court applied the test for equitable subordination which we detailed in In re Mobile Steel Co. ³ Under that test, equitable subordination is justified only if: (1) the claimant engaged in inequitable conduct; (2) the misconduct resulted in injury to the creditors or conferred an unfair advantage on the claimant; and (3) equitable subordination of the claim would not be inconsistent with the provisions of the Bankruptcy Act (now Bankruptcy Code). ⁴ The bankruptcy court found in the affirmative on each of the three Mobile Steel inquiries and subordinated the claims of the Insiders to the level of equity holders, finding that this ranking was necessary to offset the harm that the debtor and its non-insider creditors had suffered as a result of the inequitable conduct of the Insiders. 134 B.R. 207 (Bkrtcy.N.D.Tex.1991).

Timely appealing the affirmance by the district court, the Insiders assert five points of error: (1) the finding that Herby's was undercapitalized on the date of Summit's acquisition; (2) the finding that the late perfection by Summit and Dunnam of their security interests constituted inequitable conduct; (3) the characterization of the sums advanced to Herby's by Summit, Dunnam, and Snyder Co. as equity contributions rather than loans; (4) the finding that the Insiders' actions harmed the other creditors sufficiently to warrant subordination; and (5) the affirmance of the extent of the equitable subordination ordered by the bankruptcy court.

Analysis

A. Standard of Review

Bankruptcy Rule 8013 provides that on appeal, "[f]indings of fact ... shall not be set aside unless clearly erroneous, and due regard shall be given to the opportunity of the bankruptcy court to judge the credibility of the witnesses." ⁵ The clearly erroneous rule should be strictly applied if the district court has affirmed the bankruptcy court's findings. ⁶ The bankruptcy court's conclusions of law, however, are reviewed de novo. ⁷

B. Principles of Equitable Subordination

The Bankruptcy Code provides that the bankruptcy court may "under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all of part of an allowed interest to all or part of another allowed interest." ⁸ The legislative history of this provision reflects that Congress "intended that the term 'principles of equitable subordination' follow existing case law and leave to the courts development of this principle." ⁹ The equitable powers of a bankruptcy court, including the power to subordinate, may be "invoked to the end that fraud will not prevail, that substance will not give way to form, that technical considerations will not prevent substantial justice from being done." ¹⁰

In Mobile Steel we established the test to determine when equitable subordination is appropriate. In addition to the tripartite test noted above, we further held in Mobile Steel that three additional principles must be considered in determining whether the three prongs of the subordination test have been satisfied. First, the inequitable conduct by the claimant may be sufficient to warrant subordination whether or not the misconduct related to the acquisition or assertion of the claim. Second, a claim should be subordinated only to the extent necessary to offset the harm that the bankrupt and its creditors suffered as a result of the inequitable conduct. Third, the claims arising from the dealings between the debtor and its fiduciaries must be subjected to rigorous scrutiny, and, if sufficiently challenged, the burden shifts to the fiduciary to prove both the good faith of the transaction and its inherent fairness. ¹¹

Subsequent to Mobile Steel, we expanded the class of claims that are subject to rigorous scrutiny to include insider claims. ¹² Additionally, if the claimant is an insider, less egregious conduct may support equitable subordination. ¹³ The determination of insider status is a question of fact subject to the clearly erroneous standard of review. ¹⁴

Although the exact parameters of inequitable conduct have not been comprehensively or precisely delineated, such conduct does encompass: (1) fraud, illegality, breach of fiduciary duties; (2) undercapitalization; and (3) the claimant's use of the debtor corporation as a mere instrumentality or alter ego. ¹⁵

Undercapitalization generally refers to the insufficiency of capital contributions made to the debtor corporation. Inadequate capitalization may be established by the testimony of a skilled financial analyst that the capitalization "would definitely be insufficient to support a business of the size and nature of the bankrupt in light of the circumstances existing at the time the bankrupt was capitalized." ¹⁶ Capitalization is also inadequate "if, at the time when the advances were made, the bankrupt could not have borrowed a similar amount of money from an informed outside source." ¹⁷

Even though undercapitalization alone generally does not justify equitable subordination, evidence of additional inequitable conduct may do so. For example, if...