## Facts

- A corporation formed to acquire Envirodyne completed a 1989 Delaware short-form merger under Del. Gen. Corp. L. § 253 after purchasing a majority of shares via a $40-per-share tender offer.
- Upon the merger’s effective date, the pre-merger stock was canceled; shareholders who did not tender ceased to be equity holders and became entitled to a fixed payment of $40 per share (or to pursue appraisal) without interest.
- Several former shareholders did not tender and were not paid their merger consideration before the surviving company later filed for Chapter 11.
- In 1993, the surviving company filed Chapter 11 in the Northern District of Illinois and owed more than $2 million to the former shareholders on account of the unpaid merger consideration.
- The debtor filed an adversary proceeding seeking equitable subordination of the former shareholders’ claims under 11 U.S.C. § 510(c), asserting that the claims were effectively old-equity interests arising from a leveraged acquisition.
- The bankruptcy court subordinated the claims below other general unsecured creditors; the district court affirmed, and the former shareholders appealed.

## Issues

1. Whether claims for unpaid merger consideration held by former shareholders may be equitably subordinated under 11 U.S.C. § 510(c) absent a finding of inequitable conduct by those claimants.
2. Whether, for bankruptcy distribution purposes, merger-consideration claims originating from a leveraged short-form merger may be treated as equity-like and placed below general unsecured creditor claims despite their state-law characterization as debt.

## Decision

- The Seventh Circuit affirmed the judgment subordinating the former shareholders’ claims.
- The court held that § 510(c) permits subordination of these claims based on their equity-like substance in the leveraged transaction, even without individualized findings of claimant misconduct.
- The court concluded that federal bankruptcy distribution principles allow looking past state-law form to preserve creditor priority over equity and equity substitutes.

## Legal Principles

- Under 11 U.S.C. § 510(c), a bankruptcy court may subordinate all or part of an allowed claim to another allowed claim for purposes of distribution when equitable subordination principles warrant it.
- Although traditional equitable subordination doctrine often focuses on creditor misconduct, subordination may be appropriate where the claim functions as an equity substitute and parity with true creditor claims would be inequitable.
- State-law characterization of an interest as “debt” is not dispositive of bankruptcy priority; federal bankruptcy law may treat a claim according to its economic substance.
- In a leveraged acquisition context, unpaid merger-consideration claims derived from canceled equity may be subordinated to claims of creditors whose capital financed or supported the debtor’s post-transaction operations.

## Conclusion

The Seventh Circuit upheld equitable subordination of former shareholders’ unpaid merger-consideration claims, ruling that § 510(c) can subordinate equity-derived, securities-like claims below general unsecured creditors to reflect economic reality and maintain the creditor-before-equity distribution scheme, even without proof of claimant wrongdoing.


In re Envirodyne Indus., Inc., 79 F.3d 579 (7th Cir. 1996)