Equitable Subordination Alert Memo

July 1, 2008

On June 20, 2008, the United States Court of Appeals for the Fifth Circuit issued a decision in Wooley v. Faulkner (In re SI Restructuring, Inc.), overturning a decision of the United States Bankruptcy Court for the Western District of Texas, affirmed by the District Court. This important decision defines the circumstances under which a corporate insider who lends money to the corporation in a time of distress, on less than favorable terms, is subject to the equitable subordination of his or her claim in the corporation’s subsequent bankruptcy proceeding. The Fifth Circuit ruled that so long as the corporation uses the borrowed funds for legitimate corporate purposes such as paying employees, secured creditors, or vendors, such that the insider loan transaction does not cause harm to the corporation or its unsecured creditor body, the insider’s bankruptcy claim will not be equitably subordinated. Significantly, in so ruling, the court expressly rejected the debtor’s argument that the transaction did damage the corporation by worsening its financial condition. The court held that such an argument amounted to an attempt by the debtor to invoke the “deepening insolvency” doctrine, a theory of damage the viability of which the court refused to accept.

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