ESOP Promissory Notes Subject to Equitable Subordination during Bankruptcy, Court Rules

December 6, 2004 ( - Two former employees of now-bankrupt Merrimac Paper Co. who accepted promissory notes when cashing out their Employee Stock Ownership Plans (ESOP) are not entitled to priority in their claims, a US District Court has ruled.

>In affirming a lower court’s decision, US District Judge Nathaniel Gorton of the US District Court for the District of Massachusetts ruled that the two employees’ bid for payment in the amount stated in their promissory notes must get in line behind claims from other creditors. Gorton also ruled that the contention of the two employees – that the claims were not subject to being pushed further back in the line because they arose out of the Employee Retirement Income Security Act (ERISA) – held no sway.

>Ralph Harrison and Alan Eggert, two former employees of the bankrupt company, were issued promissory notes worth $916,300 and $1.5 million respectively after they cashed out their ESOP shares. Harrison was paid approximately one-third of the note, while Eggert was not reimbursed at all.

>Both former employees filed suit, claiming that Merrimac and its administrators violated their ERISA fiduciary duties, and asserted that they were entitled to priority for the unpaid notes.

>In the adversary proceedings brought before the US Bankruptcy Court for the District of Massachusetts, the court ruled that the employees’ claims were not special and should be equitably subordinated to the claims of other competitors. It also found that ERISA did not prevent this action from occurring. The decision was then appealed to the District Court.

>In his ruling affirming the lower court’s decision, Gorton noted that under Bankruptcy Code Section 510(C), the court can subordinate the claims of one group to another if the debtor had engaged in some type of inequitable conduct, the misconduct resulted in injury to the creditors, and equitable subordination of the claim is not inconsistent with the Bankruptcy Code. Gorton noted that other courts have, in the past, carved out an exception for the requirement of inequitable conduct in cases involving payments in stock redemption agreements, and therefore found that the claims at hand could be subordinated even if there was no inequitable conduct on the part of Merrimac.

“A stockholder who accepts a promissory note in payment for his stock assumes the risk that the corporation may be insolvent when the note becomes due,” Gorton wrote, reasoning that the subordination was appropriate because shareholders of a corporation who become creditors are not equal to other creditors.

>Gorton also rejected Harrison and Eggert’s claim that ERISA prevented them from being subordinated, citing the fact that bankruptcy law applies to such promissory notes. “Appellants’ conclusory statements about the equities of this particular case do not extend to ERISA the authority to trump the bankruptcy laws,” Gorton wrote in his ruling.

>The ruling in the case, Harrison v. Merrimac Paper Co., is available here .