Does an Insider Lender Have a Fiduciary Duty to Preserve Litigation Rights Against Itself?

When a borrower has deleveraged its balance sheet, distressed investors that received both new loans and enough shares to designate a director of, or otherwise exercise control over, the borrower can find themselves in the uncomfortable role of fiduciary to the borrower’s other creditors if the borrower subsequently becomes insolvent.  A recent bankruptcy court decision suggests that such insider lenders’ fiduciary duties may actually require them to preserve litigation rights against themselves simply to avoid having the right to repayment of their loans equitably subordinated.

In re Northstar Development Corp. 465 B.R. 6 (Bankr. W.D.N.Y. 2012), involved a Chapter 7 case commenced by the former owner of the landmark Statler Towers in Buffalo, New York.  Northstar filed the case 18 months after selling off the hotel property to another developer and repaying mortgage loans that had been advanced by Northstar’s sole principal, Gerald Buchheit, but apparently not repaying amounts owed to another creditor, the hotel’s janitorial service.  After obtaining a judgment against Northstar in state court, the creditor commenced an action against Northstar and Buchheit (later removed by the Chapter 7 trustee to the Bankruptcy Court) seeking to avoid Northstar’s repayment of Buchheit’s mortgage loans, and also to avoid a series of additional payments Northstar had made to Buchheit in the months following the sale.  The last of these payments occurred a year and five days before Buccheit filed Northstar’s Chapter 7 petition, just outside the one-year insider preference avoidance period.1

With a preference action no longer an option, and fraudulent conveyance and Section 5482 remedies unavailable, because Buchheit’s mortgage satisfactions constituted, respectively, fair consideration3 and reasonably equivalent value4 for the mortgage loan repayments Buchheit received, the Court considered whether Buchheit’s conduct was sufficiently “inequitable” to other company creditors to justify the subordination of his claim.5  Noting that, as a director and sole shareholder of Northstar, Buchheit owed a fiduciary duty to all of its creditors, the Court held that Buchheit’s failure to put Northstar into Chapter 7 during the one-year preference avoidance period constituted a breach of Buchheit’s fiduciary duty to the company’s other creditors, because it denied them the right to share in payments that Buchheit effectively kept for himself. To right this perceived wrong, the Court ordered Buchheit’s claims to be equitably subordinated.6

Northstar’s holding, that an insider lender’s failure to preserve avoidance claims against itself may subject the lender’s claims to equitable subordination, raises more questions than it answers.  Would it still have been a breach of fiduciary duty if Buchheit never put Northstar into Chapter 7?  Do insider lenders have an affirmative obligation to timely notify creditors of the existence of adverse claims against themselves?  Are all actions that strengthen insider lender defenses to adverse claims contrary to the lenders’ fiduciary duty?  Such uncertainties aside, Northstar is a useful reminder to insider lenders to reconsider divestiture of their debt or equity positions if their deleveraged borrower appears headed for renewed financial distress.

 

  1. 11 USC §547(i) (2006).
  2. 11 USC §548 (2006).
  3. 11 USC §544(b) (2006); N.Y. Debt. & Cred. Law §272 (McKinney 2012).
  4. 11 USC §548(a)(1)(B)(i) (2006); Northstar, 465 B.R. 6 at 12-13.
  5. See 11 USC §510(c) (2006); Northstar 465 B.R. at 15-16, citing United States v. Noland, 517 U.S. 535, 116 S.Ct. 1524 (1996).
  6. The Court did except from subordination any further interest Buchheit might have in any distribution in the trustee’s adversary proceeding against him, not an insignificant amount considering that Buchheit also held approximately 95% of the general unsecured creditor class. Northstar, 465 B.R. at 17.
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