## Facts

- Pepper, a creditor of Dixie Splint Coal Company, obtained a state-court judgment for unpaid royalties under a lease.
- Scott Litton was Dixie Splint’s dominant and controlling shareholder and effectively its sole owner.
- While Pepper’s royalty suit was pending and anticipating Pepper’s recovery, Litton caused Dixie Splint to confess judgment in Litton’s favor for a large alleged back-salary claim.
- Litton used a corporate officer subservient to him to procure the confessed judgment and later caused execution to issue on that judgment while Pepper’s execution was stayed.
- Litton purchased substantial corporate property at the sheriff’s sale for far less than its value, then transferred the property to another corporation he controlled at a much higher price payable in stock.
- Litton caused Dixie Splint to file a voluntary bankruptcy petition largely to avoid paying Pepper’s judgment.
- The bankruptcy trustee unsuccessfully sought in state court to set aside Litton’s judgment and the execution sale on limited procedural and agency-authority grounds.
- In the bankruptcy case, Litton filed a proof of claim for the unpaid balance of his judgment; the bankruptcy court looked behind the judgment, disallowed Litton’s claim, and ordered recovery of assets for the estate.
- The Fourth Circuit reversed, treating the state-court ruling as barring further challenge and limiting the bankruptcy court’s power over the insider claim.

## Issues

1. Whether the state court’s denial of the trustee’s limited motion to set aside the confessed judgment precluded the trustee from challenging the underlying claim’s validity and priority in bankruptcy.
2. Whether a bankruptcy court may look behind a state-court judgment and disallow or subordinate a dominant shareholder’s claim when inequitable conduct taints the claim.
3. What fiduciary standard applies when a controlling shareholder asserts a claim against the corporation’s bankruptcy estate.

## Decision

- The Supreme Court reversed the Fourth Circuit.
- The prior state-court ruling did not bar bankruptcy review of the underlying claim’s validity and priority because the broader equitable issues were not litigated and could not have been determined on the limited grounds presented.
- The bankruptcy court had both power and duty to examine the substance of Litton’s claim, notwithstanding its reduction to judgment, and to disallow or subordinate it where equity required.
- The Court upheld the bankruptcy court’s disallowance of Litton’s claim and its order to recover the assets transferred through the execution process for the benefit of the estate.

## Legal Principles

- Bankruptcy courts act in equity and must examine claims to prevent unfairness in administration of the estate.
- A bankruptcy court may look behind a judgment to the substance of the liability; merger of a claim into a judgment does not insulate it from scrutiny in bankruptcy.
- Bankruptcy courts may disallow or subordinate claims, including perfected or judgment claims, when equity and fairness require, especially where the claimant is an officer, director, or shareholder.
- A dominant and controlling shareholder is a fiduciary; when insider transactions are challenged, the insider bears the burden to prove good faith and inherent fairness comparable to an arm’s-length transaction.
- Insider use of corporate control to obtain preferential treatment or hinder other creditors warrants denial of equal distribution through disallowance or subordination and related equitable relief.

## Conclusion

The Court held that bankruptcy courts may disregard the formal finality of an insider’s judgment, examine the real character of the claim, and disallow or subordinate it when a controlling shareholder uses corporate control to obtain an unfair advantage over other creditors.


Pepper v. Litton, 308 U.S. 295 (1939)