On March 25, 2022, the United States Bankruptcy Court for the District of Delaware dismissed a complaint filed against a lender and other entities. An individual (and others) formerly in control of the bankrupt companies sued the creditor to seek equitable subordination of the lender’s claims under 11 U.S.C. § 510(c). The plaintiffs asserted that the claims of the lender (and others acting in concert with the lender) should be subordinated to the payment of the plaintiffs’ claims as a result of the lender’s inequitable “scheme.” The court’s decision provides a guide for lenders engaged in workout discussions or, if litigation is filed by a borrower, seeking to dismiss this type of litigation before the costly discovery process begins.

Facts Underlying the Complaint for Equitable Subordination

In In re Zohar III, Corp., 2022 WL 883325, – B.R. – (Bankr. D.Del. March 25, 2022), the Debtors (the “Zohar Funds”) were a type of investment vehicle referred to as a “collateralized loan obligation.” The Debtors obtained funds from several classes of noteholders and used the funds to purchase a portfolio of distressed senior secured loans at a discount and to originate high-interest rate loans to distressed companies (the “Portfolio Companies”) in exchange for repayment promises and equity positions in the Portfolio Companies. The investment strategy was developed by the Debtors’ principal, Lynn Tilton, and she — either personally or through other controlled entities — owned the equity in the Portfolio Companies. Ms. Tilton’s affiliated entities, the Patriarch Entities, served as collateral managers for the Zohar Funds. Ms. Tilton also installed herself as director and manager or CEO of each of the Portfolio Companies. The investment plan contemplated that some loans would underperform, but that the collective portfolio would generate enough cash flow to repay the noteholders their promised principal and interest.

The primary target of the equitable subordination lawsuit was MBIA Insurance. MBIA provided financial guaranty insurance to classes of notes issued by Debtors Zohar I and Zohar II. When those Zohar Funds defaulted, MBIA paid a total of $919 million to the insured Class A noteholders. In 2019, Zohar III also defaulted on its obligations.

Years of negotiations and litigation preceded the bankruptcy filings by the Zohar Funds. After the bankruptcy petitions were filed, Plaintiffs (Ms. Tilton, the Patriarch Entities, and others related entities) sued MBIA and others to have the Defendants’ claims in the bankruptcy cases subordinated to the claims held by the Plaintiffs. As summarized by the bankruptcy court in its decision, the Plaintiffs’ claims alleged that “MBIA devised a plan to quickly take control of and sell the Portfolio Companies, disregarding Ms. Tilton’s equity interests and ignoring the resulting value depression. The Amended Complaint alleges that the scheme orchestrated by MBIA amounted to years of inequitable conduct….” Zohar,  at *4.

Elements of Claim for Equitable Subordination

In dismissing the complaint, the bankruptcy court first addressed the elements of a cause of action for equitable subordination and the differing standards applicable to insiders as opposed to non-insiders. The bankruptcy court first recognized that equitable subordination is a “drastic” and “unusual” remedy that should only be applied in limited circumstances. It then determined that in order to survive the motion to dismiss, the complaint needed to sufficiently allege three conditions:

  1. the creditor whose claim is sought to be subordinated must have engaged in some type of inequitable conduct;
  2. the misconduct must have resulted in injury to the creditors of the bankrupt company or conferred an unfair advantage on the claimant; and
  3. equitable subordination of the claim must not be inconsistent with the provisions of the Bankruptcy

The Importance of Insider vs. Non-Insider Status

The bankruptcy court noted that there are key differences in considering the sufficiency of causes of action against an insider as opposed to causes of action against a non-insider. In addition to the statutory definition of an insider (including officers and directors), an “insider” under the Bankruptcy Code also includes an entity or person in control of the bankrupt entity. Outside of the statutory definition, insider status is inferred when a creditor has a close relationship with the debtor and something other than the close relationship suggests that their transactions were not conducted at arms’ length. If a creditor (such as a lender) is an insider, a plaintiff can support its claim with evidence of merely unfair or inequitable conduct, because dealings between a debtor and an insider are subject to more rigorous scrutiny. If the creditor is a non-insider, however, evidence of more egregious conduct, such as fraud, is required.

Arguments Raised

The key arguments raised by MBIA (and its co-defendants) included that:

  1. the complaint’s allegations did not support a conclusion that they were insiders;
  2. certain issues had been previously litigated in pre-petition litigation;
  3. factually inconsistent allegations were raised in the complaint; and
  4. there were contractual provisions that expressly permitted them to take the actions that constituted the alleged inequitable conduct.

Insider Status

One named defendant in the Zohar III  case was US Bank, which merely served as indenture trustee for the noteholders of the Zohar Funds. The bankruptcy court determined that the complaint failed to “explain how US Bank possessed the necessary day-to-day control over the Zohar Funds, let alone a relationship with them beyond that of its role as indenture trustee….” Id.  at *11.

As to MBIA and the “Controlling Class” of the Zohar III Fund that allegedly wanted to displace Ms. Tilton’s control of the Zohar Funds, the bankruptcy court found that those defendants were “insiders” (and thus subject to a higher level of scrutiny) only after control was wrested from Ms. Tilton – i.e., after Ms. Tilton and her Patriarch Entities agreed, after litigation in other courts, to resign as collateral manager of the Zohar Funds and be replaced by turnaround experts (Alvarez & Marsal and Zohar Management “AMZM”), and therefore, the stricter insider standard only applied at that time.

Factually Inconsistent Allegations That Negotiations Were For An “Improper Purpose”

Another category of allegations in the complaint related to MBIA’s negotiations to extend the maturity date of the Zohar I notes. The bankruptcy court rejected Plaintiff’s allegations to the effect that the negotiations were merely an effort to “string” Ms. Tilton along.

The bankruptcy court stated:

Plaintiffs admit that MBIA represented to Ms. Tilton and her advisors over and over again that they supported a maturity date extension and global restructuring. Plaintiffs further tell a detailed story of the significant efforts made by all parties to reach agreement that spanned three years and ended one month before Zohar I’s maturity date. There is no dispute that final terms for an extension and restructuring were never agreed upon. From these facts the Plaintiffs ask this Court to infer that MBIA, when faced with serious financial distress, was intentionally ‘stringing [Ms. Tilton] along’ for three years with the false promise of a maturity extension and global restructuring in order to cause the Zohar I default and allow it to implement a plan to steal and sell her assets. Reaching such a conclusion from the facts presented would be unreasonable.

Id. at *22 (emphasis added).

Contractual Provisions That Allowed the Creditor to Take the Actions It Took

The complaint also included allegations that “MBIA had the right under the Indenture to direct that the [Zohar Fund’s] collateral be liquidated.” Id.  at *11. Furthermore, the bankruptcy court noted,: “MBIA and the Zohar III Controlling Class do not dispute that they selected AMZM and were able to direct it but argue that they were merely exercising post-default rights given to them under the Indentures to recover on their claims.” Id.  at *18. The bankruptcy court reiterated, “The Zohar III Controlling Class argues, and the Plaintiffs do not dispute, that their prepetition actions were, in fact, authorized by the plain language of the Indenture.” Id.  at *19.

The bankruptcy court concluded:

The Plaintiffs ask the Court to ignore the objective realities (including the parties’ contractual rights and successful litigation of those rights), arguing that the Zohar III Controlling Class and MBIA (as well as AMZM) acted with an improper purpose – to take and sell Ms. Tilton’s equity for their benefit and to harm her…. But as a general matter, the pursuit of one’s legal rights, including the exercise of contractual rights, may not be grounds for equitable subordination even if the rights are exercised harshly and cause harm to other creditors.

Id.  at *24.

The bankruptcy court found that “history has shown that MBIA and the Zohar III Controlling Class have diligently and successfully enforced (and caused the Zohar Funds to enforce) their rights under the governing transaction documents.” Id.  at * 25.


The Zohar  decision provides a number of suggested and potentially successful arguments to creditors defending against equitable subordination claim and potentially defeat such a claim at motion to dismiss stage of litigation. First, and to the greatest extent supported by the facts, creditors should rigorously oppose any effort to characterize them as insider and subject their alleged inequitable conduct to stricter level of scrutiny. The decision also demonstrates that if a creditor has negotiated in good faith, but failed to reach an agreement, any argument that the negotiations give rise to an allegation of improper conduct should be vigorously contested. A defendant-creditor should also argue that matters previously addressed in pre-bankruptcy litigation need not be re-litigated. Finally, and perhaps most importantly, the Zohar decision stands for the proposition that a lender may be able to summarily negate an allegation of inequitable conduct if it can demonstrate that it consistently exercised its rights within the four corners of the existing contracts between the parties, because as the bankruptcy court recognized, an allegation to the contrary may be construed as an attempt to re-write the terms of the subject agreements, and “[p]arties have a right to enter into good and bad contracts, the law enforces both.” Id.  (quoting Nemec v. Shrader, 991 A.2d 1120, 1126 (Del. 2010)).