UNITED STATES BANKRUPTCY COURT
EASTERN DISTRICT OF KENTUCKY
RUSSELL CAVE COMPANY, INC.
DEBTOR CASE NO. 99-50142
THE OFFICIAL COMMITTEE OF
UNSECURED CREDITORS PLAINTIFF
VS. ADV. NO. 01-5035
BMO NESBITT BURNS EQUITY
INVESTMENTS (U.S.), INC., et al. DEFENDANTS
Defendants General Electric Capital Corporation (AGECC@) and GE Capital Equity Capital Group, Inc. (together Athe GE defendants@) have moved to dismiss the plaintiff=s Amended Complaint to Equitably Subordinate Certain Claims (Doc. #56) filed herein on May 11, 2001. The motion to dismiss and the plaintiff=s response were heard on August 17, 2001, and submitted for decision. This court has jurisdiction of this matter pursuant to 28 U.S.C. ' 1334(b); it is a core proceeding pursuant to 28 U.S.C. ' 157(b)(2)(O).
The plaintiff=s current amended complaint was filed pursuant to the order of this court entered on April 20, 2001 (Doc. #52). It had originally filed its Amended Complaint to Equitably Subordinate Certain Claims on March 2, 2001 (Doc. #7). The GE defendants filed their motion to dismiss this amended complaint on March 12, 2001 (Doc. #22). The court=s April 20, 2001 order dismissed Counts I and II; Counts III and IV sought equitable subordination of claims arising from certain debentures and a subordinated note. The order directed the plaintiff to file an amended complaint Asetting forth with particularity the alleged inequitable conduct of the GE Defendants and the original debenture holders, and the specific injury resulting from such alleged inequitable conduct.@ After the filing of the current amended complaint, the GE defendants renewed their motion to dismiss on June 26, 2001 (Doc. #61).
A motion to dismiss made pursuant to F.R.Civ.P. 12(b)(6), made applicable in bankruptcy by F.R.Bankr.P. 7012(b), is for failure to state a claim upon which relief can be granted. As set out in Perniciaro v. Natale (In re Natale), 136 B.R. 344, 348 (Bankr. E.D.N.Y. 1992), the court, in determining such a motion
must presume that the factual allegations of the complaint are true and all reasonable inferences are to be made in favor of the nonmoving party. Jenkins v. McKeithen, 395 U.S. 411, 421-22, 89 S.Ct. 1843, 1848-49, 23 L.Ed.2d 404 (1969). The purpose of a motion to dismiss is to assess the legal sufficiency of a complaint, not to judge the weight of evidence which might be offered in its support. Geisler v. Petrocelli, 616 F.2d 636, 639 (2nd Cir. 1980).
However, on a motion to dismiss, it is clear that the court does not have to accept every allegation in the complaint as true in assessing its sufficiency. 5A Charles A. Wright & Arthur R. Miller, Federal Practice and Procedure '1357, at 311-18 (2d ed. 1990). The allegations of a complaint must be "well-pleaded" and thus the court need not accept "sweeping and unwarranted averments of fact." Haynesworth v. Miller, 820 F.2d 1245, 1254 (D.C.Cir. 1987). Legal conclusions, deductions or opinions couched as factual allegations in a complaint are not given a presumption of truthfulness. 2A James Wm. Moore et al., Moore's Federal Practice &12.07[2.-5], at 12-63 to 12-64 (2d ed. 1991). A complaint is subject to dismissal if it fails to allege a required element which is necessary to obtain relief sought. Moore, supra, at 12-68; (cite omitted). A motion under Fed.R.Civ.P. 12(b)(6) should also be granted if a bar to relief is apparent from the face of the complaint. Moore, supra, at 12-68 to 12-69.
The court's task under Rule 12(b)(6) is then to determine the sufficiency, and not the merits, of the amended complaint. See also Pereira v. Binet, et al. (In re Harvard Knitwear, Inc.), 153 B.R. 617 (Bankr. E.D.N.Y. 1993), and Allard v. Weitzman (In re DeLorean Motor Co.), 991 F.2d 1236 (6th Cir. 1993).
The court=s power to equitably subordinate creditors= claims is codified at 11 U.S.C. ' 510(c) which provides in pertinent part:
Notwithstanding subsections (a) and (b) of this section, ... , the court mayB
(1) 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 or part of an allowed interest to all or part of another allowed interest[.]
The conditions that must be satisfied before equitable subordination is applied have been organized as a three-part test first articulated in Benjamin v. Diamond (In re Mobile Steel Co.), 563 F.2d 692, 700 (5th Cir. 1977):
(i) The claimant must have engaged in some type of inequitable conduct. ... (ii) The misconduct must have resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant. ... (iii) Equitable subordination of the claim must not be inconsistent with the provisions of the Bankruptcy Act. (Citations omitted.)
This test has been recognized and adopted by many courts, including the Sixth Circuit. See First Nat=l Bank of Barnesville v. Rafoth (In re Baker & Getty Fin. Servs., Inc.), 974 F.2d 712 (6th Cir. 1992).
The Sixth Circuit has, however, gone on to Afurther develop@ the principles of equitable subordination, and has held that a showing of creditor misconduct is not necessary for the court to make a determination that a claim should be equitably subordinated. United States v. Noland (In re First Truck Lines, Inc.), 48 F.3d 210, 218 (6th Cir. 1995), rev=d, United States v. Noland, 517 U.S. 535, 541, 116 S.Ct. 1524, 1527 (1996). Since the Supreme Court=s reversal in First Truck did not address the question of whether creditor misconduct is a necessary element of equitable subordination, the Sixth Circuit=s pronouncement on the subject remains the law in this circuit.
So-called Ano-fault@ subordination looks to the Anature and origin@ of the claim. See SPC Plastics Corp. et al. v. Griffith (In re Structurlite Plastics Corp.), 224 B.R. 27, 35 (B.A.P. 6th Cir. 1998). So far the only types of claims that have been subordinated in the absence of creditor misconduct are tax penalty and stock redemption claims. In re First Truck Lines, Inc., 48 F.3d at 219; In re Structurlite Plastics Corp., 224 B.R. at 36. Barring a demonstration that the Anature and origin@ of the claim justifies equitable subordination, however, it would appear that inequitable conduct must be proven. In Official Unsecured Creditors Comm. v. Ampco-Pittsburgh Corp. (In re Valley-Vulcan Mold Co.), 237 B.R. 322, 334 (B.A.P. 6th Cir. 1999), the panel cited Structurlite and agreed with its holding concerning Ano-fault@ equitable subordination, but then went on to state:
In holding the Committee was not entitled to equitable subordination, the bankruptcy court again noted the Committee=s failure to prove any facts warranting the relief sought. The court pointed out there was nothing in the evidence to support the Committee=s allegation of undercapitalization or asset-stripping and that the Committee had already failed in its attempts to prove that any transfer at issue was fraudulent under Ohio law.
. . .
Accordingly, the bankruptcy court did not abuse its discretion in denying the Committee=s request for equitable subordination ... See, e.g., Paulman v. Gateway Venture Partners III, L.P. (In re Filtercorp, Inc.), 163 F.3d 570, 583 (9th Cir. 1998) (stating A>subordination requires some showing of suspicious, inequitable conduct=@ even beyond initial undercapitalization of an enterprise).
As concerns the level of proof required to demonstrate that claims should be subordinated, the dealings of fiduciaries with their corporations are subject to Arigorous scrutiny,@ and when challenged by an objection with a substantial factual basis, the burden is on them to prove the good faith and fairness of a transaction. In re Mobile Steel Co., 563 F.2d at 701. Creditors who are not insiders (and therefore not fiduciaries) are subject to a higher standard. As stated by the court in Carter-Waters Oklahoma, Inc. et al. v. Bank One Trust Co., N.A., et al. (In re Eufaula Indus. Auth.), 266 B.R. 483, 489 (B.A.P. 10th Cir. 2001):
If the claimant is an insider or a fiduciary, the party seeking equitable subordination need only show Aunfair@ conduct. Estes v. N & D Props., Inc. (In re N & D Props., Inc.), 799 F.2d 726, 731 (11th Cir. 1986). However, where non-insider claims are involved, the level of pleading and proof is significantly higher. Id. at 731-32. Although courts now agree that equitable subordination can apply to a non-insider creditor, the circumstances are Afew and far between.@ Kham & Nate=s Shoes No. 2, Inc. v. First Bank, 908 F.2d 1351, 1356 (7th Cir. 1990); accord Waslow v. MNC Commercial Corp. (In re M. Paolella & Sons, Inc.), 161 B.R. 107, 119 (E.D.Pa. 1993) (AEquitable subordination has seldom been invoked, much less successfully so, in cases involving non-insiders and/or non-fiduciaries.@), aff=d, 37 F.3d 1487 (3d Cir. 1994). Importantly, a non-insider creditor Agenerally owes no fiduciary or contractual duty to the other creditors of a debtor [and therefore] must be found to have engaged in some specific conduct that gave rise to a fiduciary, contractual, or other legally recognized duty to the other creditors before its claim will be equitably subordinated.@ Andrew DeNatale and Prudence B. Abram, The Doctrine of Equitable Subordination as Applied to Nonmanagement Creditors, 40 Bus.Law. 417, 430 (1985) (footnote omitted).
The GE defendants contend that they are not insiders, and therefore not fiduciaries, and that they are subject to this higher level of proof. The plaintiff responds that insider status cannot be resolved on a motion to dismiss.
As set out above, the court=s task on a motion to dismiss is to determine the sufficiency of the complaint, that it alleges each required element to obtain the relief sought. For purposes of a complaint seeking equitable subordination, the elements that must be alleged are inequitable conduct on the part of the claimant, damage to the debtor=s creditors or an unfair advantage to the claimant, and consistency with the provisions of the Bankruptcy Code.
The plaintiff contends first of all that the amended complaint alleges specific facts concerning the GE defendants= insider status. Regarding the debentures, these include in Count I, & 80, the acquisition of a controlling block of the debtor=s common stock by BMO Nesbitt Burns Equity Partners, Inc. and Brand Equity Ventures I-A, L.P. (referred to collectively in the amended complaint as Athe Investors@), the Investors= power to select two members of the debtor=s board of directors and to veto outside directors unacceptable to them, the active participation of the Investors= personnel in board activities and strategic decisions of debtor=s management, the Investors= preparation of business plans and financial projections used by the debtor, and the Investors= direct negotiations with Heller Financial, Inc. concerning modification of the terms of the debtor=s $15 million revolving credit facility with Heller. The Investors assigned their interests in the debentures to the GE defendants in July 1999.
Inequitable conduct on the part of the Investors is alleged in Count I at && 81-82. The plaintiff contends that the GE defendants= transactions with the debtor were purposely structured to give them and their assignors the rewards of an equity investment in the debtor while forcing the other creditors to subsidize the risk. In order to pursue their equity return, the amended complaint alleges, the Investors accelerated the debtor=s shift from a traditional mail order business to retail stores, thereby increasing the debtor=s expenses and debt. The amended complaint alleges that the Investors kept the debtor in operation and incurring new debt long after it made business sense to do so. The amended complaint at Count I, & 83 further alleges that the Investors= inequitable conduct resulted in injury to the debtor=s creditors by impairing the debtor=s ability to pay its creditors, impairing the liquidation value of the debtor=s assets and causing the debtor to incur additional debt after it was no longer reasonable to do so. Finally, Count I alleges at & 84 that equitable subordination of all claims arising from the Debentures is not inconsistent with any provision of the Bankruptcy Code.
In Count II, in regard to equitable subordination of the subordinated note, the plaintiff made allegations of insider status for defendant GECC at & 87. The plaintiff alleged there that GECC, while formally having only observer status, participated actively in the meetings and decision-making of the debtor=s board of directors, and gave directions to and exercised veto power over debtor=s management. The plaintiff further alleged that GECC participated in the debtor=s negotiations with other financing entities, and took an active role in formulating plans and projections for use by the debtor=s management.
Allegations of inequitable conduct are found in && 88-89. These include GECC=s delaying agreement on a credit facility to be extended to the debtor while its financial condition continued to deteriorate so that the debtor was unable to obtain the credit facility; abandoning its involvement in managing the debtor=s business and developing plans to address its deteriorating financial condition; failure to exercise control over the debtor to cause it to cease operations and cease incurring debt; and keeping the debtor in operation and continuing to incur debt after it was no longer reasonable to do so in an effort to enhance GECC=s equity interest in the debtor.
Injury to the debtor=s creditors is alleged at & 89: impairment of the debtor=s ability to pay its creditors, impairment of the liquidation value of the debtor=s assets, and the debtor=s incurring additional debt after it was no longer reasonable for the debtor to do so. Finally, Count II alleges at & 90 that equitable subordination of any and all claims arising from the Subordinated Note is not inconsistent with any provision of the Bankruptcy Code.
It appears to the court that the plaintiff has amended its complaint with sufficient facts to survive a Rule 12(b)(6) motion to dismiss. The plaintiff has alleged facts to support its position that the GE defendants and their assignors, the Investors, were insiders, and that it is therefore unnecessary to demonstrate inequitable conduct on their part. Such allegations nothwithstanding, the plaintiff has also alleged inequitable conduct as set out above. It has further alleged specific instances of harm to the debtor=s other creditors, or unfair advantage to the GE defendants and/or the Investors.
As stated in Bower v. Federal Express Corp., 96 F.3d 200, 203 (6th Cir. 1996), AIn order for a dismissal to be proper, it must appear beyond doubt that the plaintiff would not be able to recover under any set of facts that could be presented consistent with the allegations of the complaint.@ The court concludes that the plaintiff is not precluded from recovery under some set of facts consistent with its allegations, and that the plaintiff=s motion to dismiss for failure to state a claim should therefore be overruled. An order in conformity with this opinion will be entered separately.
By the Court -
Judge William S. Howard
Raymond J. Lembke, Esq.
Frank T. Becker, Esq.