The 7th Circuit Court of Appeals decided In re Kreisler, a bankruptcy case with some interesting facts. Apparently a couple of real estate developers named Kreisler and Erenberg filed bankruptcy and had interest in some properties mortgaged to Community Bank of Ravenswood. In bankruptcy, claims trading is permitted — in other words, a third party can buy a bankruptcy claim from the claim holder. The third party is betting that it can get more money out of the bankruptcy on the claim than it spends to buy the claim. The claim holder might want to sell because it needs money immediately or has a lesser view of the likely return.
In this case, however, Kreisler and Erenberg created a company, Garlin Mortgage Corporation. They then engineered a loan from another corporation they controlled to Garlin. Garlin then used that money to buy Community Bank’s bankruptcy claim against them.
The bankruptcy court was not amused. It used the doctrine of equitable subordination to set “Garlin’s” claim behind unsecured creditors in order of priority. In effect, this meant that the claim was now worthless and didn’t get paid. The Seventh Circuit, however, reversed the bankruptcy court, specifying that for equitable subordination to be appropriate, there must be wrongdoing *and* the wrongdoing must negatively affect other claim holders. In this case, however, the debtors’ shenanigans didn’t negatively affect the other claim holders. They were in exactly the same position as if Community Bank had held on to the claim. Since Community Bank had been paid and wasn’t complaining, the bankruptcy court did not have authority to demoted the claim on the basis of equitable subordination.
I wouldn’t be surprised, however, if the bankruptcy court found a different way to skin this particular cat. I don’t do much bankruptcy law, but I get the sense that this sort of cleverness might really get a bankruptcy judge angry. I wonder if, for example, the judge or the trustee might take a closer look at what sorts of corporations the debtors’ have an interest in and trying to assess the real value of those interests to include in the bankruptcy estate.
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