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Delaware District Court Holds Subordination Agreements Enforceable to Subordinate Junior Secured Creditor’s Timely Filed Claim to Those Tardily Filed by a Senior Secured Creditor

Bank of New York Mellon Trust Co. v. Miller (In re Franklin Bank Corp.), No. 13-1713-RGA, 2014 WL 3611596 (D. Del. July 21, 2014)

In this Memorandum Opinion, Judge Andrews of Delaware’s District Court vacated an order of the Bankruptcy Court and held that a secured creditor who tardily filed its claims years after the applicable bar date did not waive its ability to enforce subordination agreements to subordinate a junior secured creditor’s timely filed claims.  The District Court further held that, despite the Bankruptcy Court’s contrary ruling, the senior creditor’s failure to act more quickly did not support equitable subordination of its claims under Bankruptcy Code section 510(c).

Prior to commencing its chapter 7 bankruptcy proceeding in 2008, Franklin Bank Corporation (“FBC”) created four capital trusts (“Trusts I-IV”), issued four classes of junior subordinated debt securities (“Debt Securities I-IV”), and issued contingent convertible senior notes (the “Senior Notes”).  Bank of New York Mellon Trust Company (“BNYM”) serves as the indenture trustee for the Senior Notes and Trusts I-III, while Wilmington Trust serves as the indenture trustee for Trust IV.  The debt was subject to subordination agreements that established a priority scheme, placing the Senior Notes in the most senior position, followed by the Debt Securities held by BNYM as indentured trustee for Trust I, then those for Trusts II and III, and finally, the Debt Securities held by Wilmington Trust as indentured trustee for Trust IV.

During the bankruptcy proceeding, Wilmington Trust timely filed a proof of claim on behalf of Trust IV; however, BNYM did not file a proof of claim on account of the Senior Notes (or Trusts I-III) until more than two and a half years after the bar date.  When the chapter 7 trustee filed his final report identifying Wilmington Trust’s timely claim as allowed and paid in a reduced amount, BNYM objected, arguing that Wilmington Trust’s claim was contractually subordinated to its untimely filed claims under Bankruptcy Code section 510(a).  Despite the subordination agreements, the Bankruptcy Court held that BNYM waived the right to enforce the subordination agreements “by sitting on its hands for 2 ½ years.”  According to the Bankruptcy Court, this was prejudicial conduct amounting to gross negligence that would materially and adversely affect FBC’s estate.  Moreover, the Bankruptcy Court alternatively held that BNYM’s claims were equitably subordinated under section 510(c) due to its behavior.  This appeal followed.

In support of its vacatur, the District Court found that BNYM did not waive the right to enforce the subordination agreements by its mere failure to timely file claims.  Under governing New York law, contractual rights may be waived if they are “knowingly, voluntarily and intentionally abandoned.”  Fundamental Portfolio Advisors, Inc. v. Tocqueville Asset Mgmt., L.P., 850 N.E.2d 653, 658 (N.Y. 2006).  While Judge Andrews conceded that a failure to act can establish abandonment under New York law, he found that BNYM’s failure to timely file its claims did not rise to the level of a “clear manifestation of intent” to abandon its subordination agreement rights.  Moreover, the Court stated that prejudice does not factor into a waiver analysis under New York law, but even if it did, no prejudice existed.  Among other things, BNYM’s enforcement of its rights was consistent with agreements knowingly entered into by Wilmington Trust and would have no effect on the administration of the estate save for causing the Trustee to modify the recipient of the distribution from Wilmington Trust to BNYM.

The District Court also disagreed with the Bankruptcy Court that BNYM’s claims should be equitably subordinated under section 510(c).  To equitably subordinate a claim, the Third Circuit requires a finding that a claimant engaged in inequitable conduct that resulted in injury, and that subordination would not be inconsistent with the Bankruptcy Code.  Schubert v. Lucent Techs. Inc. (In re Winstar Commc’ns, Inc.), 554 F.3d 382, 411 (3d Cir. 2009).  According to Judge Andrews, BNYM did not inequitably act when untimely filing its claims and making a late attempt to enforce the subordination agreements.  While the Bankruptcy Court attributed this conduct to gross negligence and subordinated the claims, the District Court ruled that gross negligence does not rise to the level of inequitable conduct required for equitable subordination (i.e. fraud, spoliation, or overreaching).  Moreover, the Court noted that equitably subordinating BNYM’s claims based solely on their lateness would be inconsistent with Bankruptcy Code sections 726(a) and 510, which expressly contemplate payment of allowed late-filed claims and permit the use of subordination agreements enforceable under applicable nonbankruptcy law, respectively.