## Facts

- A plumbing and heating supply business operated as a partnership owned by J.A. Fazio, Lawrence C. Ambrose, and B.T. Leonard, with recorded partner capital totaling about $51,620.78 by September 1952.
- The partnership’s financial condition before incorporation was weak: current liabilities slightly exceeded current assets, cash was minimal, receivables were pledged to a bank, and operations had recently shifted from profit to loss.
- In contemplation of incorporating, Fazio and Ambrose withdrew nearly all their partnership capital on September 15, 1952, leaving only $2,000 each as capital and taking demand promissory notes (no interest) for the withdrawn amounts.
- The business was then incorporated as Leonard Plumbing and Heating Supply, Inc., issuing stock based on the reduced capital structure; the corporation assumed the partnership’s liabilities.
- Fazio and Ambrose became corporate officers and directors and remained controlling insiders.
- The corporation later entered bankruptcy, and Fazio and Ambrose filed creditor claims on the notes (treated as corporate obligations).
- The bankruptcy trustee objected and sought to subordinate those insider claims to general unsecured creditors, arguing the corporation was grossly undercapitalized and the insider debt conversion was inequitable.

## Issues

1. Whether controlling insiders’ claims on promissory notes issued when they withdrew capital in anticipation of incorporation should be equitably subordinated to general unsecured creditors’ claims.
2. Whether gross undercapitalization at inception and insiders’ conversion of equity into debt, even absent classic fraud, justifies subordination.

## Decision

- The Ninth Circuit reversed the district court’s affirmance of the bankruptcy referee.
- The court held that Fazio’s and Ambrose’s claims on the notes must be subordinated to the claims of general unsecured creditors.
- The case was remanded for further proceedings consistent with subordination.

## Legal Principles

- Bankruptcy courts may subordinate insider claims under equitable principles when necessary to protect general creditors.
- Transactions between a corporation and its controlling shareholders, officers, or directors are subject to strict scrutiny; insiders must show fairness comparable to an arm’s-length bargain.
- Converting substantial equity into purported debt while leaving a newly formed corporation grossly undercapitalized can constitute inequitable conduct warranting subordination.
- Subordination may be appropriate even without proof of technical fraud or mismanagement when insiders use control to shift business risk to outside creditors.

## Conclusion

The court required subordination of controlling insiders’ note claims because they withdrew capital just before incorporation, recast it as debt, and left the corporation grossly undercapitalized while it continued to operate and incur obligations to outside creditors.


Costello v. Fazio, 256 F.2d 903 (9th Cir. 1958)