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Private Equity Funds and Lenders: Equitable Doctrines May Override Contractual Protections When Senior Lenders Overreach

Senior lenders often have broad authority over financially troubled corporate borrowers by virtue of favorable loan, waiver or forbearance agreements and can act to preserve their own interests. However, courts may ultimately limit the scope of a senior lender’s power over a corporate borrower, even if its actions fall within the scope of the underlying contract. A recent decision by the Appellate Division, First Department, in the case of Tap Holdings, LLC v. Orix Finance Corporation[1] (“Orix Finance”) demonstrates that a senior lender can expose itself to successor, alter ego and fraudulent conveyance liability by unfairly prejudicing the claims of junior creditors and equity holders. The Court in Orix Finance made clear there are limits to what a senior lender can do to protect its investment and there is a point at which equity may trump the terms of an otherwise valid loan agreement. As a result, junior creditors and private equity funds with ownership stakes in troubled corporate entities may have greater recourse against a senior lender than previously believed.

Orix Finance involved transactions between Tap Operating Company, LLC (“Tap”), its holding company (“Tap Holdings”) and a group of senior lenders. Following “technical defaults” of the underlying loan agreement by Tap, the parties entered into a series of forbearance agreements.[2] When Tap and its senior lenders were unable to come to a restructuring agreement, the senior lenders foreclosed on their security interest in the membership units held by Tap Holding, thereby terminating its voting rights, and replaced all but one of the members of Tap’s board of directors.[3] The senior lenders subsequently transferred all of Tap’s assets to a new corporate entity (“New Tap”) for $66 million, which was enough to cover only the senior lenders’ outstanding loans.[4] New Tap did not assume Tap’s subordinated debt, yet it employed all of Tap’s employees and continued in the operation of the business by using the same trade name, physical assets and website.[5] These machinations rendered Tap insolvent and IPC Manager II (“IPC”), Tap’s subordinated lender, asserted a claim against New Tap for successor and fraudulent conveyance liability and against the senior lenders for alter ego liability.[6] The defendants moved to dismiss the claim, relying in part on the waiver provision in a subordination agreement which provided that IPC “waive[d] any right to . . . challenge the appropriateness of any action the [senior lenders] take with respect to [Tap].”[7]

The trial court denied the motion to dismiss and the First Department affirmed, allowing the claim to proceed.[8] Assuming all of IPC’s allegations to be true, the First Department found that IPC had adequately alleged the existence of a scheme by the senior lenders to reshape Tap’s corporate structure for the purpose of working an inequity on its subordinated lenders and its actions had no legitimate business purpose.[9] The First Department also held that three exceptions to the general rule against successor liability were applicable: (1) first, the “mere continuation doctrine” applied because New Tap had acquired Tap’s “business location, employees, management and goodwill”[10]; (2) second, the doctrine of “de facto merger” applied because Tap’s business ceased when its assets were purchased—it was dissolved as soon as possible and New Tap assumed those liabilities necessary for the “uninterrupted continuation of Tap’s business”[11]; and (3) finally, IPC had alleged a fraudulent transfer given that Tap was rendered insolvent by the actions of the senior lenders.[12] The First Department rejected the senior lenders’ argument that the claims were barred by the waiver provision, finding that “where . . . intentional misconduct is alleged, there can be no waiver.”[13]

Orix Finance allows subordinated lenders to hold senior lenders accountable for inequitable conduct. Section 510(c) of the Bankruptcy Code offers an analogous remedy to junior creditors in the bankruptcy context.[14] Equitable subordination is a “drastic” and “unusual remedy” that allows for the subordination of senior debt in bankruptcy where a senior creditor has engaged in misconduct, the junior creditors have been injured by that conduct and subordination is consistent with other relevant provisions of the Bankruptcy Code.[15] Like successor and alter ego liability, equitable subordination allows for the vindication of the rights of junior creditors unfairly prejudiced by the actions of a senior lender.[16]

Orix Finance illustrates the potential consequences for senior lenders that unfairly damage the claims of subordinated lenders or the rights of equity holders, including private equity funds. By the same token, the case demonstrates that junior lenders and equity holders have tools available to them which they may use to ameliorate an otherwise unfair outcome, even in the face of a contractual provision that would purport to preclude such liability. Senior lenders hoping to avoid such an outcome should not assume that courts will allow whatever a contract permits and instead should consider whether their actions go so far as to unfairly damage the rights of other parties.


[1] 2013 NY Slip Op 5293 (1st Dept. July 16, 2013).

[2] Id. at *3.

[3]Id. at *4.

[4] Id. at *6.

[5] Id.

[6] Id. at *7-8.

[7]Id. *8-9.

[8]Id. at *11.

[9]Id. at *13-14.

[10]Id. at *14 (quoting Schumacher v. Richards Shear Co., 59 N.Y.2d 239, 244-45 (1983)).

[11]Orix Finance, 2013 NY Slip Op 5293 at *15 (quoting Fitzgerald v. Fahnestock & Co., 286 A.D.2d 573, 574-75 (1st Dept. 2001)).

[12]Orix Finance, 2013 NY Slip Op 5293 at *16.

[13]Id.

[14] 11 U.S.C. § 510(c)(i) (2013). Section 510 does not permit the subordination of debt to equity. See Schubert v. Lucent Tech., Inc., 554 F.3d 382, 414 (3d Cir. 2009). However, it does not negate the bankruptcy court’s equitable power to disallow a claim altogether in the “extreme instances” where a creditor’s actions warrant such an outcome. See In re Washington Mut., Inc., 461 B.R. 200, 256 (Bankr. D. Del. 2011).

[15]See Official Comm. Of Unsecured Creditors v. Tennenbaum Capital Partners, LLC, 353 B.R. 820, 840 (Bankr. D. Del. 2006); see also Citicorp Venture Capital, Ltd. v. Official Comm. Of Unsecured Creditors, 160 F.3d 982, 986-87 (3d Cir. 1998).

[16] The First Department in Orix Finance remarked that successor liability is warranted “when any abuse of the corporate form is exercised for the purpose of working an inequity on another.” Orix Finance, 2013 NY Slip Op 5293 at *13.


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Business Litigation Bulletin is a newsletter of Tannenbaum Helpern Syracuse & Hirschtritt LLP’s Litigation and Dispute Resolution practice. It provides strategic perspectives on legal cases that impact the business community.

09.16.2013  |  PUBLICATION: Business Litigation Bulletin  |  TOPICS: Investment Management, Litigation  |  INDUSTRIES: Private Investment Funds

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