Pepper v. Litton
308 U.S. 295, 60 S. Ct. 238, 1939 U.S. LEXIS 971 (1939)
Rule of Law:
A bankruptcy court, exercising its broad equitable jurisdiction, may disallow or subordinate the claim of a controlling stockholder against the bankrupt corporation if the stockholder has breached their fiduciary duty by using their position to gain an unfair advantage over other creditors.
Facts:
- Pepper sued Dixie Splint Coal Company for unpaid royalties.
- While Pepper's suit was pending, Litton, the dominant and controlling stockholder of Dixie Splint, caused the company to confess a judgment in his favor for $33,468.89 in alleged back salary.
- After Pepper obtained a judgment for $9,000 against Dixie Splint, Litton waited until execution on Pepper's judgment was suspended before causing an execution to be issued on his own confessed judgment.
- Litton purchased all of Dixie Splint's property at the execution sale for a small sum of $3,200.
- Litton then transferred this property to a new corporation he created, Dixie Beaver Coal Company, in exchange for stock in the new company.
- Shortly thereafter, Litton caused Dixie Splint Coal Company, now stripped of its assets, to file for voluntary bankruptcy for the sole purpose of defeating Pepper's claim.
Procedural Posture:
- Pepper sued Litton and Dixie Splint Coal Company in a Virginia state court for an accounting of royalties.
- Pepper obtained a judgment against Dixie Splint Coal Company in the state court.
- Dixie Splint Coal Company filed a voluntary petition for bankruptcy in the United States District Court.
- The bankruptcy trustee moved in state court to set aside Litton's judgment, but the motion was denied on grounds of estoppel, and this denial was affirmed by Virginia's highest court.
- In the federal bankruptcy proceeding, the District Court disallowed Litton's claim as fraudulent and ordered him to return the property he purchased.
- Litton appealed to the U.S. Circuit Court of Appeals, which reversed the District Court, holding that the state court's decision was res judicata.
- The bankruptcy trustee, representing Pepper's interests, petitioned the U.S. Supreme Court for a writ of certiorari, which was granted.
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Issue:
Does a bankruptcy court, in exercising its equitable powers, have the authority to disallow or subordinate the salary claim of a dominant and controlling stockholder of a bankrupt corporation, which has been reduced to a state court judgment, where the stockholder has used his position to manipulate the corporation's affairs to the detriment of other creditors?
Opinions:
Majority - Mr. Justice Douglas
Yes. A bankruptcy court has the equitable power to disallow or subordinate a claim from a corporate fiduciary, like a controlling stockholder, even if that claim has been reduced to a state court judgment. The principle of res judicata does not prevent the bankruptcy court from inquiring into the validity and fairness of a claim, as the state court proceeding only addressed the technical regularity of the judgment, not the equitable considerations of its priority among creditors. Corporate directors and dominant stockholders are fiduciaries who owe a duty of fair dealing to the corporation and its creditors. When a claimant has breached this duty, as Litton did through a 'planned and fraudulent scheme' to benefit himself at the expense of another creditor, the bankruptcy court must use its equitable powers to undo the wrong. It will scrutinize the insider's dealings and may subordinate their claim to ensure that substance prevails over form and that justice is done.
Analysis:
This landmark decision firmly established the doctrine of equitable subordination, which has become a fundamental principle of bankruptcy law. It empowers bankruptcy courts to look beyond formal legal rights and state court judgments to prevent injustice, particularly by corporate insiders. The ruling reinforces the high fiduciary standards imposed on directors and controlling shareholders, clarifying that these duties extend to creditors, especially when a corporation is insolvent. The precedent gives bankruptcy trustees a powerful tool to challenge the claims of insiders who have engaged in self-dealing or other inequitable conduct, ensuring a more fair distribution of assets to legitimate, arms-length creditors.
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