Welcome to the 125th Pari Passu Newsletter, 

After a very successful retail bankruptcy deep dive last week, today we are looking at a more technical topic: equitable subordination.

In almost every bankruptcy, one party tends to blame another for some issue. Whether it relates to predatory lending practices or poor management, stakeholders strive to remedy their own claims by asserting the wrongdoing of the other party. Today, we are covering a less well-known aspect of the Bankruptcy Code: Equitable subordination, which allows the courts to reorder claims in the event of a bankruptcy if wrongdoing is present. While this is a powerful legal tool, implementing it effectively is tricky, and much discretion is left to the courts. 

This report details equitable subordination, what’s required to subordinate a claim, and some key limitations. We’ll also cover the fascinating case of LightSquared, where two billionaire investors fought over the hottest telecom assets at the time, and even after one party had its claim subordinated, the results may still surprise you. Let’s get into it.

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Equitable Subordination Overview

As we’ve outlined before, Chapter 11 of the Bankruptcy Code allows distressed companies to reorganize their operations instead of liquidating in order to capture more value for creditors and continue to operate as a going concern. A foundational principle of bankruptcy is the absolute priority rule, which dictates the order in which claims are paid out, ensuring senior creditors are paid out first. Almost all of the time, the absolute priority rule governs the remedies outlined in a restructuring solution. Unfortunately, there are times when creditor misconduct occurs, and the court must intervene to ensure an equitable distribution of claims for every creditor involved. In certain situations, the bankruptcy court may need to alter the order in which claims are paid out, which leads us to equitable subordination.

Equitable subordination is a powerful remedy within the U.S. Bankruptcy Code, outlined in section 510(c)(1), that allows the court to effectively reorder the priority of specific claims among creditors. The primary purpose of equitable subordination is to ensure fairness in the bankruptcy process when wrongdoing is present. Suppose a creditor acts in a way that is inequitable, resulting in injury to other creditors or giving themselves an unfair advantage. In that case, the court may subordinate all or part of the creditor’s claim to remedy the situation. The ultimate goal of section 510(c) is to provide a result that returns creditors to the position they would have been in had misconduct not occurred [1]. Equitable subordination is not meant as a punishment for wrongdoing; instead, it is simply in place to protect creditors who acted in good faith.

History

The concept of equitable subordination has been around long before it became part of the Bankruptcy Code in 1978. Prior to this, the courts simply relied on the interpretation of equitable principles outlined in the common law. In Pepper v. Litton (1939), the Supreme Court ruled that bankruptcy courts have the power to disallow or subordinate claims if equity and fairness require doing so, especially when the claim being subordinated is an officer, director, or stockholder [2]. This ruling set the stage for what we currently see in section 510(c) of the Bankruptcy Code.

Legal Standard for Subordination

Today’s bankruptcy courts rely on the case In re Mobile Steel Co. (1977) to determine whether Equitable Subordination is appropriate and warranted. This case establishes the three-part test [1]. Under the three-part test, the following three conditions must be satisfied for the court to subordinate a claim:

1. Inequitable Conduct: The claimant (insider creditor) engaged in some form of misconduct or wrongdoing. This can include fraud, breach of fiduciary duty, or simply unfair behavior. An example might be a predatory loan issued by a company officer.

2. Injury or Unfair Advantage: Second, the conduct must harm other creditors or leave the claimant with an unfair advantage. Most often, this involves unfairly skewing the distribution of claims to the claimant’s benefit. If the insider loan above strains liquidity and forces the company to file, it would clearly harm other creditors, especially those below it in the capital structure.

3. Consistency with the Bankruptcy Code: Lastly, the subordination of claims must not interfere with any other aspects of the Bankruptcy Code, ensuring fairness for all creditors. This means that even if misconduct was present, creditors still have protections. Specifically, claims that the Bankruptcy Code elevates explicitly, such as administrative expenses, wage claims, or tax claims, can not be pushed below general unsecured claims. For example, it would be much more challenging to subordinate a DIP claim because post-petition DIP financing is treated as an administrative expense under Section 364. 

As you can see, the three-part test leaves a lot on the table regarding a court decision, and the bankruptcy court has much discretion when determining whether conduct is inequitable and worthy of reorganizing claims. 

Insiders vs. non-insiders

When it comes to the discretion left to the courts, a significant consideration is whether the claimant is an insider creditor (majority shareholder, affiliated entity, sponsor, corporate officer, etc.). Insiders are subject to higher levels of scrutiny when considering misconduct. Insiders’ lower threshold for Equitable Subordination arises from insiders having a fiduciary duty, which is the legal obligation to act in the best interest of their shareholders. Because of this, misconduct by insiders is often viewed by the courts as more egregious due to it being a breach of fiduciary duty [1]. Additionally, because insider creditors control a company, there is much more room for misconduct and asset manipulation to skew recoveries in a distressed situation.

However, the Bankruptcy Code does not explicitly state that Equitable Subordination may not be applied to outside creditors. Still, due to their removal from the company's operations, the threshold for a ruling against them is often higher. For an outside creditor to be subordinated, there must be egregious conduct, such as fraud or gross overreach, as outside creditors also do not bear the fiduciary duty that insiders do. Our case study will outline a situation in which an outside creditor’s claim was subordinated. 

Hypothetical Examples of Creditor Misconduct

Now that we’ve established the criteria for subordination and who it often applies to, let’s look at some common scenarios that may be grounds for equitable subordination. 

Predatory Lending: A creditor imposes exploitative terms upon the debtor. These terms can include unreasonably high interest rates or strict repayment terms, typically done with the intent to cause the debtor to default and give the creditor access to assets or control of the company. Because the creditor isn’t technically deceiving the debtor, these predatory lending practices would have to cause extraordinary harm to other creditors to be grounds for equitable subordination.  While in theory, a distressed debtor could walk away and refuse unreasonable terms, it may be so desperate for liquidity that it accepts predatory financing as an alternative to running out of money. Moreover, if the lender holds a coercive position over the debtor, the threshold for misconduct becomes even lower. 

Fraud: A creditor deliberately deceives the debtor and/or other creditors by providing false information, misrepresenting terms, etc., tricking stakeholders into an unfavorable transaction. For fraud to be considered fraud, it must be intentional deceit. Fraud is typically considered more egregious and thus more likely grounds for equitable subordination. 

Insider Abuse: An insider creditor breaches fiduciary duty by putting its needs above the company's interests. This may include self-dealing practices, where the insider forces the debtor into loans at unfavorable terms. It might also include abuse of confidential information or any other insider activity deemed a breach of fiduciary duty in bad faith.

An important emphasis is that these examples aren’t guarantees of equitable subordination. The right conditions - and the right judge - must be present for a claim to be subordinated, and the solution must not interfere with any other principles of the Bankruptcy Code.

Simple Subordination Example

Before we continue with the post, let’s go over a simple example of what recoveries would look like under a few different scenarios:

Scenario 1: Company ABC files for bankruptcy with $500mm of total assets. The capital structure contains Creditor A with a $400mm secured claim and Creditor B with a $200mm unsecured claim. In this scenario, there is no misconduct from insider creditors. Some simple waterfall math would leave Creditor A with a 100% recovery and Creditor B with a 50% recovery. Remember that secured creditors must always be paid out first, so Creditor A would receive its full $400mm claim, leaving only $100mm left for Creditor B’s $200mm claim.

Scenario 2: Company ABC files for bankruptcy with $500mm of total assets. However, the capital structure now includes an additional $100mm unsecured claim from Creditor C, an insider creditor. The court eventually found that Creditor C, a majority shareholder, forced Company ABC into taking the $100mm loan at an unreasonably high interest rate (self-dealing), forcing the company into distress and breaching fiduciary duty. Despite the misconduct, the bankruptcy court did not deem the misconduct severe enough to subordinate Creditor C’s claim. In this case, Creditor A still receives its entire $400mm, but Creditors B and C must share the remaining $100mm because they are both unsecured. Therefore, Creditor A receives a 100% recovery on its secured claim, and Creditors B and C each receive 33%. As you can see, Creditor B, an innocent creditor, is worse off following Creditor C’s misconduct. 

Scenario 3: Assume the same capital structure and misconduct as scenario 2. However, this time, the court decided that Creditor C’s wrongdoing passed the three-part Mobile Steel test. The court chooses to subordinate all of Creditor C’s claims. Under this scenario, Creditor A recovers 100%, and Creditor B recovers 50%, which are the same recoveries had Creditor C not engaged in predatory self-dealing. In this case, Creditor C receives zero recovery.

Equitable subordination is not punitive, meaning it isn’t meant to punish the creditors at fault. Courts carefully calculate the minimum amount to be subordinated to remedy injury. For example, if there were distributable assets of $650mm, the courts would only need to subordinate 50% of Creditor C’s claim for Creditor B to recover 100%. In that case, Creditor C would recover 50% instead of zero. There are no fines or damages part of equitable subordination. While it may seem like it’s meant to punish wrongdoing, courts only subordinate the extent necessary to provide other, innocent creditors with their original recoveries.. Figure 1 below outlines this scenario. 

Let’s apply the three-part test to this scenario:

1. Inequitable Conduct: Creditor C engaged in inequitable conduct by breaching fiduciary duty by self-lending and abusing its control position. 

2. Injury: Creditor C’s claim forced the debtor into bankruptcy and reduced the value of Creditor B’s claim, so Creditor B was worse off than had Creditor C not engaged in misconduct.

3. Consistency with Bankruptcy Code: In this case, the subordinated claim now becomes inferior to the other two. Because Creditor C’s claim did not have any other special protections under the Bankruptcy Code, subordinating it would likely not violate other statutory principles, and it would remedy Creditor B’s claim to its hypothetical entitled claim. 

Looking at these results, a natural question arises: what if Creditor C issued secured debt? If this were the case, the outcome could be slightly different. The major consideration here is that even if a secured claim is subordinated, it still retains its lien and is treated as a secured claim. Because of this, the claim may receive more protections than an unsecured subordinated claim. For example, if secured creditors hold a blocking position (over one-third of the debt by amount or half by the number of claims), they are entitled to additional protections under Section 1129(b) (the cramdown provision) if they vote to reject the plan of reorganization (POR). Because a subordinated claim often becomes its own class, it often holds a blocking position when voting on the plan. The upcoming case study provides a great example of this at play. 

LightSquared Case Study

LightSquared Introduction

LightSquared Inc. was a telecommunications company incorporated in 1985. Over the years, LightSquared accumulated valuable satellite and spectrum assets. In 2010, after a series of mergers and name changes, the debtor, which operated as SkyTerra Communications, was acquired by Philip Falcone’s hedge fund, Harbinger Capital Partners. (You may recognize Falcone’s name after his big win shorting subprime mortgages ahead of the 2008 crash, earning his fund a lofty $10bn profit.) Harbinger renamed SkyTerra to LightSquared Inc. [3]. 

LightSquared was the first company to offer mobile satellite services throughout North America using its satellite spectrum network, specifically within the L-band, which refers to a specific frequency range within the radio spectrum. LightSquared offered data, fax, voice, and dispatch services to various business customers, growing the satellite segment to $30mm annual revenue by 2012 [3]. 

However, Falcone had bold plans for LightSquared. Falcone and Harbinger Capital sought to turn LightSquared’s satellite network into a nationwide wireless network by combining it with a terrestrial one. As a brief aside, a satellite network uses satellites in space for communication, while a terrestrial network uses ground-based communication, such as cell towers and cables. Falcone planned to differentiate this new 4G LTE network by operating as a wholesale network and leasing it to smaller carriers and businesses. Harbinger Capital pumped over $2bn of capital into LightSquared to support this idea. This idea took off, and LightSquared quickly entered into over 30 wholesale agreements with smaller carriers and retailers [3]. 

LightSquared’s Regulatory Nightmare

There was one significant roadblock to Falcone’s plan – LightSquared’s satellite network operated in the L-band, which is reserved for GPS systems and navigation. After early testing, GPS systems picked up interference from LightSquared, meaning that if the company continued to grow its network, other GPS L-Band operators would face troubling – and expensive – signal issues. Because of this, an array of government agencies, airlines, and GPS companies opposed LightSquared’s network. The primary objector was the Federal Communications Commission (FCC), as it would have the ultimate say over whether or not LightSquared could proceed [3]. 

In 2011, the FCC granted the company a conditional waiver with one requirement - LightSquared must fix the issue of GPS interference. Over the following months, the company would work to remedy this issue. Still, in 2012, after pressure from Congress, the FCC eventually reversed its decision and revoked LightSquared’s ability to operate its new network [3]. Clearly, this was a disaster for Falcone, as he had made a massive bet on the company’s success in creating a new network. 

Chapter 11 Bankruptcy

Shortly after the FCC’s decision, LightSquared was forced to file for Chapter 11 protection. The company was not allowed to operate and could not generate revenue to meet its $2bn+ debt obligations, so it filed immediately on May 12, 2012, in the Southern District of New York. 

LightSquared’s major debt claims in the liquidation analysis were detailed as follows [3]: 

1. A $66mm DIP facility issued at the LightSquared Inc. level

2. LightSquared Inc. Facility of $322mm plus accrued interest for a total claim of $397mm

3. LightSquared LP Facility of $1,700mm plus accrued post-petition default rate interest at 15% (the credit agreement outlined a higher rate that began accruing at the petition date) for a total claim of $2,199mm. 

Both the LP and Inc. debt facilities were senior secured, sitting at different parts of the organizational structure presented below.

While the organizational structure may appear overwhelming, we only need to focus on two entities - LightSquared Inc., the parent company, and LightSquared LP, the primary operating subsidiary. 

The LightSquared Inc. Facility (“Inc. Debt”) of $322mm was issued at the Inc. level. The only real recovery for the Inc. Debt would come from the secured guarantee from One Dot Six Corp., which held a valuable spectrum lease worth $310mm in the initial liquidation analysis [3]. 

The LightSquared LP Facility (“LP Debt”) was secured on all the assets of LightSquared LP and its subsidiaries. These were the valuable, coveted assets consisting of two satellites worth roughly $300mm (one in orbit and one under construction) and spectrum assets worth nearly $1,700mm.

Without getting into the weeds of this 3-year long bankruptcy, there are a couple of things we can gather from the details above. First, because there was no guarantee from the LP level to the Inc. level, Inc. debt would be structurally subordinated to the LP debt and receive a much lower recovery (see our double dip article for a good explanation on guarantees). Some rough math gives us the following recoveries from a liquidation:

1. DIP Facility (Inc. Level): 100%

2. LP Debt: ~90% (with no extra recovery flowing to the Inc. Debt)

3. Inc. Debt: ~50% (after paying out the DIP claim)

Importantly, this tells us that in the event of a sale, holders of LP Debt recover most, if not all, of their claim, and those who bought it at a discount would be pretty well off. This leads us to Mr. Ergen.

Enter Charles Ergen

Charlie Ergen was the billionaire founder and chairman of Dish Network, a key competitor to LightSquared, and his actions were among the most significant developments in the LightSquared bankruptcy. It was revealed that Ergen was anonymously buying the LP Debt through a special-purpose vehicle known as SP Special Opportunities (“SPSO”). In total, Ergen had bought a whopping $844mm of the secured LP Debt at prices ranging from 48 to 96 cents on the dollar and was in the position to receive a nice recovery [4].

This is significant for a couple of reasons. First, because the LP Debt was secured on LightSquared’s most valuable satellite and spectrum assets, Ergen’s company Dish Networks, a direct competitor, would have cheap access to the assets. Secondly, the LP credit agreement strictly prohibited a competitor to LightSquared from buying the debt. Once LightSquared’s filing became inevitable, Ergan began using SPSO to circumvent the restrictions in the credit docs [4]. After this information was revealed, LightSquared sued for Ergen’s claim to be equitably subordinated. LightSquared alleged that Ergen acted in an inequitable manner (abusing his position as a creditor resulting in harm of the estate) by using SPSO to deceive LightSquared, circumventing restrictions in the credit docs. Additionally, LightSquared argued Ergen’s conduct harmed the estate by prolonging the bankruptcy process without justification, increasing costs for all involved. 

First Plan of Reorganization and Equitable Subordination of Ergen’s Claim

After Ergen’s intentions were revealed, the debtor drafted its first amended plan of reorganization (POR), which detailed its plans for the estate and how it would pay back creditors. The plan detailed a sale of LightSquared along with a new money exit facility that would be used to pay back secured creditors in full. Specifically, the debtor split the LP Debt claims into Non-SPSO (Class 7A) and SPSO claims (Class 7B). The initial plan had the Non-SPSO claims being paid in full in cash, while Ergen would be paid in full with a 7-year PIK note. (Importantly, this is considered a worse option due to the uncertainty surrounding LightSquared’s future.) Ergen’s class would vote to reject this proposal [5].

A couple of essential developments followed. First, in May of 2014, after two years of back-and-forth litigation, Judge Shelley C. Chapman voted in favor of equitably subordinating Ergen’s claim below other secured creditors. This was a monumental case as it was the first time a claim from an outside creditor would be equitably subordinated [1]. Let’s apply the three-part test to Ergen’s claim:

1. Inequitable Conduct: Ergen clearly acted in bad faith by deliberately circumventing the anti-competitor clause of the LP Debt credit docs. Additionally, Ergen’s entity, SPSO, significantly delayed the finalizing of debt transactions, prolonging the bankruptcy process.

2. Injury: Ergen’s prolonging of the bankruptcy process threatened the already uncertain value of the debtor’s estate, potentially harming creditor recoveries. Additionally, legal costs reached an astonishing $300mm for this case. 

3. Compliance with the Bankruptcy Code: The subordination of Ergen’s claim below secured creditors would technically not violate any statutory principles of the Bankruptcy Code as, given the value of LightSquared’s assets, it would still provide Ergen the potential to receive a fair recovery. 

What came next may surprise you. While Judge Chapman subordinated Ergen’s claim, that same day, she also rejected the debtor's proposed POR on the grounds that it treated Mr. Ergen’s claim unfairly [6].

If you’re questioning this result, you are not alone. This ruling appears to go against much of what we’ve just covered. Let’s dive into what’s going on with this ruling.

While this may seem confusing, the answer lies in the Bankruptcy Code. More specifically, because Ergen rejected the plan where he’d be paid back via a 7-year PIK note, for the plan to be approved, it would require a cramdown. Section 1129 (b) of the Bankruptcy Code, which details the requirements for a cramdown, states cramdown may only occur if “the plan does not discriminate unfairly, and is fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.” [5]. Despite Ergen’s claim now being subordinated, due to the uncertainty surrounding the legitimate present value of the 7-year note, Judge Chapman deemed the POR as unfair treatment of Ergen’s claim under section 1129(b). 

This example highlights the limitations of equitable subordination and how, where applicable, claims must still be treated fairly under the Bankruptcy Code, despite being subordinated. Clearly, Ergen’s conduct was inequitable and caused harm to other creditors, and the subordination itself wouldn’t violate any other statutory principles. However, even though Ergen’s claim was subordinated, it was still a valid secured claim in the capital structure, and it would be treated as such. Section 1129(b) of the Bankruptcy Code outlines two options for a POR to be confirmed over the objections of secured creditors. First, the creditor may retain its liens and receive deferred cash payments in the total amount of the claim. The other option is payment in full, which is how Ergen’s claim was treated. In addition to the limitations of equitable subordination, this case also highlights the intricacies of the Bankruptcy Code. Even though Ergen’s claim was subordinated below other secured claims, it was still secured and thus received special protections under the cramdown provision of the Bankruptcy Code. 

Approved Plan of Reorganization

After the initial plan was denied, the debtors now had to develop a new one that treated Ergen’s subordinated claim fairly so that it would either pass the requirements for cramdown or be reasonable enough for Ergen to simply accept the new POR. Throughout the bankruptcy process, once Ergen realized Dish would not be able to gain control of LightSquared, he began demanding cash repayment in full [7]. For LightSquared to exit bankruptcy, it’d have to pay Ergen’s claim in full, and that’s what happened. 

On December 7, 2015, over three and a half years after LightSquared filed, Judge Chaplan approved the debtor’s 8th restructuring proposal. Ergen’s entire claim, now worth $1.4bn after the accrual of interest, was paid off at par value in cash via a $1.5bn debt raise facilitated by Jefferies. Let’s do some math on Ergen’s recovery. It was reported that he bought up the LP debt at prices between 48 and 96 cents, so let's assume an average price of 72 cents, or just over $600mm, for the $844mm worth of debt he bought. Ergen began buying the debt roughly a year before LightSquared filed and would wait the entire 3+ year bankruptcy before being paid in full. Even though Ergen could not secure LightSquared’s valuable spectrum assets, he still earned an approximate 2.33x return in 4 years, recovering $1.4bn on a $600mm investment. 

The other secured non-SPSO claims would receive new secured notes. While it may seem counterintuitive that the innocent creditors received new debt while Ergen was paid in full, it once again comes down to the details of approval under a cramdown. Because the non-SPSO lenders (Class 7A) voted to accept the plan, the debtors were free to issue new notes rather than making cash payments. On the other hand, Ergen’s claim, the objecting class, was required to be treated in one of the two options we outlined above

One of the biggest losers of LightSquared’s restructuring was Philip Falcone, who had his 96% equity stake nearly halved to 44% of post-reorg equity in the new LightSquared. Harbinger Capital also lost its control over the company’s operations [7]. 

LightSquared, now called Ligado Networks, would receive a $1.25bn equity investment from Fortress, Centerbridge, and JPMorgan Chase, who would gain board seats and control the company. Unfortunately for Ligado Networks, the company recently filed for bankruptcy again in January 2025, amidst continued uncertainty around its wireless business and intense competition from competitors [8]. 

Key Takeaways

Equitable subordination is a fascinating aspect of the Bankruptcy Code, granting courts the authority to reorder claims when creditors exceed their boundaries. As seen in the LightSquared case, it’s even possible to apply it to non-insider creditors. However, equitable subordination is not without its limitations. Claims may only be subordinated if the court deems the conduct passes the three-part test, not interfering with any other protections, such as administrative status. Additionally, the courts will only subordinate a claim to the extent that it remedies other creditors’ recoveries, rather than using it as a punishment for misconduct

LightSquared showed us that subordinated claims must still be treated according to the principles of the Bankruptcy Code. As a secured claim, Ergen’s was only subordinated below the other secured claims and received special protections under the cramdown provision, which he leveraged to receive a full par, cash recovery. As it turns out, subordinated creditors, like Ergen, may still have the last laugh. 

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