Waslow v. MNC Commercial Corp. (In Re M. Paolella & Sons, Inc.)

MEMORANDUM

This is an appeal from the Bankruptcy Court’s Final Judgment entered on February 3, 1992. The debtor’s secured creditor, MNC Commercial Corp. (“MNC”), filed timely notice of appeal from this final judgment; this appeal was docketed as Civil Action No. 92-1405. MNC appeals the equitable subordination of its claim and the judgments as to reclamation entered against MNC and in favor of American Cigar Company, American Tobacco Company, Lorillard, Inc., Philip Morris, Inc., and R.J. Reynolds Tobacco Company (collectively referred to as “the tobacco company plaintiffs”). The Bankruptcy Court concluded that the tobacco company plaintiffs should be entitled to recover, under equitable subordination, the following amounts: American Tobacco — $59,-387.47; Lorillard — $374,636.00; Philip Morris — $820,700.51; and R.J. Reynolds — $681,-585.70. The Bankruptcy Judge also determined, however, that to award judgments in the same amount on both equitable subordination and reclamation would be to compensate the plaintiffs twice for the same harm. Therefore, the Bankruptcy Judge concluded that the legal remedy should precede equitable relief. That is, the Bankruptcy Judge concluded that the tobacco companies were entitled to judgments on their reclamation claims and, if the equitable subordination award exceeded the judgment as to reclamation, the plaintiff could then recover the difference in equitable subordination. Thus, the Bankruptcy Court entered judgments against MNC and for the tobacco company plaintiffs on their reclamation claims as follows: American Tobacco — $59,387.47; Loril-lard — $374,636.00; Philip Morris — $619,-589.40; and R.J. Reynolds — $537,764.80. The Bankruptcy Court determined that, as to R.J. Reynolds and Philip Morris, the judgments as to equitable subordination exceeded the judgments awarded as to their reclamation claims. Therefore, the Bankruptcy Court entered judgments for these two plaintiffs as to their equitable subordination claims in excess of the reclamation claims as *111 follows: Philip Morris — $201,111.11; and R.J. Reynolds — $143,820.90.

The trustee in bankruptcy, Larry Waslow, also filed timely notice of appeal as to the Bankruptcy Court’s final judgment against MNC and in favor of the trustee in the amount of $166,103. The trustee’s appeal was docketed as Civil Action No. 92-1532. The trustee contends that the judgment in his favor should have been $2,655,488.

This Court has jurisdiction to hear these consolidated appeals, 92-1405 and 92-1532, pursuant to 28 U.S.C. § 158.

I. STANDARD OF REVIEW

The district court’s review of questions of law in a bankruptcy appeal is plenary. Universal Minerals, Inc. v. C.A. Hughes & Co., 669 F.2d 98 (3d Cir.1981). However, findings of fact of the bankruptcy court will hot be set aside unless “clearly erroneous.” Bankruptcy R. 8013; Decatur Contracting v. Belin, Belin & Naddeo, 898 F.2d 339 (3d Cir.1990). “A finding is ‘clearly erroneous’ when, although there is evidence to support it, the reviewing court is left with the definite and firm conviction that a mistake has been committed.” U.S. v. U.S. Gypsum Co., 333 U.S. 364, 393-94, 68 S.Ct. 525, 541, 92 L.Ed. 746 (1948). Upon a determination that the Bankruptcy Court’s factual findings are not clearly erroneous, the district court must examine whether the factual findings are legally sufficient to support the bankruptcy court’s conclusions of law. See Universal Minerals, 669 F.2d at 102.

II. FINDINGS OF FACT BY THE BANKRUPTCY COURT

Since this Court has determined that the findings made by the Bankruptcy Court are not “clearly erroneous,” we summarize the relevant facts as found by the Bankruptcy Judge as follows:

The debtor, M. Paolella & Sons, Inc., was the largest wholesale distributor of tobacco products in the Delaware Valley. On January 26, 1982, the debtor and MNC entered into a financing agreement that provided a line of credit secured by virtually all of the debtor’s assets, ie., receivables, inventory, and equipment. These security interests were perfected by filings pursuant to the Uniform Commercial Code (“UCC”). Initially of two-year duration, the agreement was renewed and was in effect up to January 26, 1986. The financing agreement was asset-based in that it provided the debtor with a line of credit determined by a formula whereby the debtor could borrow against 85% of eligible accounts receivable and 60% of eligible inventory.

In October 1982, the debtor requested and MNC permitted an increase in credit to enable the debtor to participate in a special buying program offered by the tobacco companies. Thereafter, the debtor’s loan was always out of formula. That is, after October 1982, the amount advanced by MNC always exceeded the sum of 85% of eligible receivables plus 60% of eligible inventory. Although MNC attempted repeatedly to bring the loan within formula, MNC agreed on several occasions to increase the amount of the overadvance to enable the debtor to participate in the tobacco companies’ special buying programs; the debtor participated in these programs regularly.

As a consequence of the loan being out of formula, MNC, pursuant to the financing agreement, exercised considerable control of the debtor’s business operations. Each business day the debtor would submit a report disclosing daily information as to receivables and weekly data as to the inventory. In addition, the debtor submitted weekly reports denoting invoices received. The financing agreement also gave MNC reasonable access to the debtor’s premises during regular business hours and at other reasonable times, in order to conduct audits of its collateral. Pursuant to the agreement, MNC conducted frequent audits of the debtor’s operations. MNC used all of this information to calculate the value of its collateral, the daily loan balance, and the additional loan sums then available to the debtor. All of these computations also included information from the debtor’s tobacco distributor subsidiaries, Jersey Coast Tobacco & Candy (“Jersey Coast”) and William B. Merrey and Sons, Inc. (“Merrey”). Typically, Michael Paolella, the debtor’s president, or another Paolella *112 employee, would phone MNC on the morning of each business day and speak with MNC’s vice-president of operations, Stephen Cromwell. The parties would discuss (1) the amount of the cheeks written by the debtor that would be presented to the MNC subsidiary, Maryland National Bank, for payment that day, and (2) the funds that MNC would make available to the debtor’s account to honor those checks. The debtor’s sole operating cash was located in Maryland National Bank whereas all receivables proceeds were placed in an account controlled by MNC and located at Continental Bank. By agreement between MNC and the debtor, funds to cover the checks were placed in the Maryland National Bank account twenty-four hours after the cheeks were presented. All monies with respect to Merrey and Jersey Coast were handled through these same accounts, and the loan and advances were all computed including the two subsidiaries. The financing agreement gave MNC the right to demand immediate repayment of the overad-vance and, if not repaid, declare the loan in default. MNC also had the right to refuse to advance additional loan funds or make available to the debtor the proceeds of its receivables.

The debtor received inventory from different tobacco companies on a daily basis and was given twelve-fifteen days to pay the invoice (except for American Cigar, which allowed thirty days for payment). Periodically, tobacco suppliers would offer special buying programs in advance of price increases and would allow the debtor to: (1) purchase at pre-increase price; (2) take additional time to pay; or (3) purchase in greater quantities than usual. The debtor usually participated in these programs and so informed MNC.

By the early part of 1984, MNC became concerned about the debtor’s ability to repay its loan. At this time, MNC classified the loan in the “watch” category and further reduced the classification to “substandard” by October 1985. In late 1985, Robert Stewart, MNC president, assumed final decision-making authority as to the loan previously overseen by Cromwell and Stewart and Cromwell consulted daily with Stewart regarding the loan. Moreover, as of August 19, 1985 the credit committee, which had previously reviewed the loan, ceased to do so and Stewart and Cromwell assumed this function.

In May 1985, the debtor and MNC discussed plans to liquidate debtor’s assets and repay all of the debtor’s creditors. Robert Stewart was aware of the liquidation plan, which was expected to be complete within three-five months with a “target date” of January 1,1986. A condition of the plan was the debtor’s reduction of the overadvance by $50,000 per week.

In September 1985, the debtor started to sell its assets. In a sale financed by MNC, Merrey was sold to Thomas J. Kline, Inc. (“Kline”) in December, and MNC credited the debtor’s account by $1,733,800. In addition, the debtor took back a note from Kline and assigned the note to MNC; MNC did not credit the face amount of the note, $350,-000, to the debtor. On December 29, 1985, the debtor’s stock in Jersey Coast was sold in a transaction financed by MNC, and the debtor’s account was credited $1,483,500. The debtor also took back two notes totaling $212,000 from the buyer and assigned these to MNC. It is unclear from the record whether MNC received any payments on these notes; the Jersey Coast notes also were not credited to the debtor’s account.

In the latter part of 1985, MNC decided to inventory the debtor’s goods and sent Mr. Baldwin, MNC executive vice-president, to physically count all tobacco products. Previous audits had been performed by MNC’s audit manager, Rick Sell, and only samples were counted. Mr. Baldwin conducted three audits in the early-morning hours of January 8, 15, and 21, 1986. The inventories were conducted while the debtor was closed for business, and there was no one in the warehouse except the audit team and the debtor’s representative. In addition, unaware of the Baldwin audits, Mr. Sell conducted a regular audit during the debtor’s business hours on or about January 28, 1986.

In expectation of an orderly liquidation, Michael Paolella began informing certain tobacco companies that he would not be renewing personal loan guarantees. He did not *113 inform these companies, however, of his liquidation plans.

American Tobacco had previously obtained a letter of credit in the amount of $120,000 from the debtor secured by Maryland National Bank. The letter allowed American Tobacco to draw upon the letter if payment from the debtor was more than thirty days overdue. The letter required that American Tobacco be given thirty days notice if the letter was to be canceled or not renewed. On January 3, 1986, twenty-two days before the deadline for notification, Maryland National Bank sent notice to American Tobacco that the letter of credit would not be renewed on its expiration date of February 24, 1986. As a result of the cancellation, the letter of credit covered invoices up to January 24,1986 since only these would be thirty days overdue on or before February 24. However, because American Tobacco’s credit terms gave the debtor twelve days to make payment on invoices, the letter of credit actually covered invoices sent up to January 12, 1986, since only these would be overdue by January 24, 1986. January 12, 1986 was a Sunday, and the debtor did not order inventory on weekends; therefore, the last invoice to be covered by the letter of credit was dated January 10, 1986.

American Tobacco was aware that the letter of credit would not be renewed by January 9, 1986, when its employee, Frank Gallagher, contacted Michael Paolella regarding the notice of non-renewal. Gallagher wanted to ascertain whether the decision not to renew had been made by the debtor or by the bank. Gallagher was not entirely satisfied with Paolella’s explanation that the non-renewal was the debtor’s decision. Accordingly, he called Maryland National Bank and was referred to Cromwell at MNC. Gallagher called Cromwell on Wednesday, January 15, 1986, and Cromwell confirmed that the decision not to renew the letter of credit was the debtor’s. It appears, however, that the decision not to renew the letter of credit was MNC’s. In the interim, American Tobacco, despite Gallagher’s dissatisfaction with Michael Paolella’s explanation regarding the letter of credit, continued to sell tobacco inventory to the debtor after January 10, 1986 and during the period when the letter of credit had expired.

In December 1985, the tobacco companies announced future price increases and special buying programs at pre-increase prices as follows: Philip Morris — 150% of average weekly purchases at pre-increase price; R.J. Reynolds — 225% of normal weekly purchases at pre-increase price; and Lorillard — 100% of two average weekly purchases at the pre-increase price. The debtor took full advantage of these programs after notifying MNC of its desire to do so. The effect of these programs was to increase the debtor’s tobacco inventory from mid-December 1985 through early January 1986 with payments due sometime .in late January. MNC knew of these transactions and inventory buildup as a result of the financial information it received from the debtor.

American Cigar and American Tobacco did not have special programs nor did they provide any additional inventory to the debtor. However, the other tobacco companies extended credit above the average weekly amount. The debtor typically purchased $70,000 daily from Philip Morris and had twelve days to repay. Philip Morris was owed $1,712,608.13 as of January 31, 1986— the day the tobacco companies filed the involuntary bankruptcy petition. As a result of the special buying program, Philip Morris provided $820,700.51 in above normal credit to the debtor. Reynolds was owed $1,181,-585.70 on January 31,1986 and typically sold $50,000 of tobacco products daily with fourteen days to pay. Therefore, the above normal credit provided by this creditor due to the special buying program was $681,585.70. The debtor normally purchased approximately $35,000 per day from Lorillard with fifteen days to pay; on January 31,1986, the debtor owed Lorillard $759,636.00. The portion of the debt attributed to the special buying program was $374,636.00.

On December 31, 1985, the debtor’s union contract expired although the parties continued to negotiate. On Friday, January 24, 1986, on the advice of labor counsel, Michael Paolella sent a letter to the union stating his plan to liquidate and cease operations as soon as possible. On that same date, Paolella *114 called Cromwell and informed him that one or more large checks issued by the debtor to pay for inventory would be presented for payment on Monday, January 27, 1986. Cromwell informed Paolella that he was unsure whether MNC would advance funds to honor the checks, and he stated that he would inform Paolella of the bank’s decision on Monday. On Monday, January 27, 1986, Paolella informed Cromwell for the first time about the letter that he had sent to the union the previous Friday; also, Paolella inquired about the bank’s decision regarding the checks.

On Tuesday, January 28, 1986, MNC decided not to advance the funds to honor the debtor’s checks presented the previous day; Paolella was informed of this decision on Wednesday, January 29, 1986. Paolella told Cromwell that MNC should take over and operate the debtor. On Thursday, January 30, 1986, MNC notified the debtor that the loan was in default and requested immediate repayment of the entire balance and possession of all collateral securing the loan. In addition, Rick Sell, MNC’s audit manager, took possession of the debtor’s assets and secured the warehouse. MNC president Stewart testified that the decision to cease funding was motivated by the union letter and fear of a violent strike.

Also on January 30, 1986, credit collection managers from several tobacco companies came to the debtor’s business in Philadelphia after their companies learned that the debt- or’s checks had been dishonored by Maryland National Bank. On Friday, January 31, 1986, despite entreaties by Paolella that the debtor be given until Monday, February 3, 1986 to liquidate its assets, the tobacco company plaintiffs filed an involuntary bankruptcy petition against the debtor. Larry Was-low was appointed Chapter 7 trustee on February 6, 1986, and an order for relief was entered on April 13, 1986.

Upon sale of the debtor’s assets, the trustee obtained $4,500,000.00 from the sale of inventory (estimated by the trustee to be 75% of the debtor’s cost) and $3,000,000.00 in receivables collection (estimated by the trustee to be approximately 90% of face value). The debtor’s equipment was liquidated for $125,277.00. On January 31, 1986, the date of the bankruptcy petition, the debtor owed MNC $11,218,252.00. As a result of the trustee’s liquidation of the estate, MNC received a distribution totaling $6,606,678.37. On November 1, 1985, ninety days pre-petition, the debtor owed MNC approximately $14,520,067.00. The debtor’s report on that date shows: receivables of $6,245,533.64 and inventory of $9,718,227.39, including receivables and inventory for Jersey Coast and Mer-rey subsidiaries. The inventory located by the Chapter 7 trustee was approximately one-third (approximately $3,000,000.00) less than the debtor’s figure reported on its daily report to MNC dated January 31, 1986. There was no evidence presented that either the debtor or trustee had improperly converted the inventory.

The five tobacco Company plaintiffs filed proofs of claim as follows: American Cigar— $23,923.40; American Tobacco — $283,671.51; Lorillard — $759,636.04; Philip Morris— $1,712,608.13; and Reynolds — $1,181,585.70. The debtor was insolvent, ie., its debts exceeded its assets, during the ninety-day period preceding the filing of the bankruptcy petition on January 31, 1986. Each of the tobacco companies filed a written demand for reclamation of goods on the debtor within ten days of the involuntary petition. Due to the perishable nature of the goods, the tobacco companies, MNC, the debtor, and the trustee all agreed (1) to permit the trustee to sell the goods, and (2) that any reclamation claim would attach to the proceeds. The tobacco companies asserted reclamation claims as follows: American Cigar — $15,565.71; American Tobacco — $194,499.40; Lorillard — $445,-659.20; Philip Morris — $619,589.40; and Reynolds — $537,764.80.

III. BANKRUPTCY COURT’S JURISDICTION

Defendant MNC argues that the Bankruptcy Court lacked jurisdiction to render final judgments as to plaintiffs’ equitable subordination and reclamation counts. As a basis for this argument, MNC contends that the Bankruptcy Court erred in holding that these were “core” proceedings under the bankruptcy code. MNC asserts that these *115 are “non-core” proceedings and that the Bankruptcy Court therefore could not enter final judgments. In the alternative, MNC argues that if these are “core” proceedings, the Bankruptcy Court’s jurisdiction to adjudicate these claims constitutes an impermissible grant of power to an Article I court proscribed by Northern Pipeline Constr. Co. v. Marathon Pipe Line Co., 458 U.S. 50, 102 S.Ct. 2858, 73 L.Ed.2d 598 (1982).

In Marathon, the United States Supreme Court held that Congress’ 1978 jurisdictional grant to non-Article III bankruptcy judges was unconstitutional on the ground that Congress impermissibly removed most, if not all, of the “essential attributes of the judicial power” from the Article III district court and vested them in a non-Article III adjunct, the bankruptcy court. Congress, responding to the decision in Marathon, enacted the Bankruptcy Amendments and Federal Judgeship Act of 1984, Public Law 98-353 (“1984 Act”). This legislation amended 28 U.S.C. § 1334 to provide in relevant part:

(a) Except as provided in subsection (b) of this section, the district court shall have original and exclusive jurisdiction of all eases under title 11.

(b) Notwithstanding any Act of Congress that confers exclusive jurisdiction on a Court or courts other than the district courts, the district court shall have original but not exclusive jurisdiction of all civil proceedings arising under title 11 or arising in or related to a case under title 11.

(d) The district court in which a case under title 11 is commenced or is pending shall have exclusive jurisdiction of all of the property, wherever located, of the debtor as of the commencement of such case, and of property of the estate.

28 U.S.C. § 1334 (Supp.1993). As part of the 1984 Act, Congress also enacted 28 U.S.C. § 157, which states in pertinent part: •

(a) Each district court may provide that any or all cases under title 11 and any or all proceedings arising under title 11 or arising in or related to a case shall be referred to the bankruptcy judges for the district.

28 U.S.C. § 157(a) (1993). Subsections (b) and (c) of section 157 divide cases heard by bankruptcy judges into “core” and “non-core” proceedings and define the relationship between the bankruptcy and district courts. Regarding “core” proceedings, section 157 provides:

(b)(1) Bankruptcy judges may hear and determine all cases under title 11 and all core proceedings arising under title 11, or arising in a ease under title 11, referred under subsection (a) of this section, and may enter appropriate orders and judgments, subject to review under section 158 of this title.

Id. § 157(b)(1). Subsection 157(b)(2) consists, in relevant part, of the following non-exhaustive list of core proceedings arising under title 11:

(A) matters concerning the administration of the estate;

(B) allowance or disallowance of claims against the estate or exemptions from property of the estate ...;

(E) orders to turn over property of the estate;

(F) proceedings to determine, avoid, or recover preferences;

(0) other proceedings affecting the liquidation of the assets of the,estate or the adjustment of the debtor-creditor or the equity security holder relationship, except personal injury tort or wrongful death claims.

Id. § 157(b)(2)(A), (B), (E), (F), (0). As to “non-core” proceedings, section 157 provides:

(c)(1) A bankruptcy judge may hear a proceeding that is not a core proceeding but that is otherwise related to a case under title 11. In such proceeding, the bankruptcy judge shall submit proposed findings of fact and conclusions of law to .the district court, and any final order or judgment shall be entered by the district judge after considering the bankruptcy judge’s proposed findings and conclusions and after reviewing de novo those matters to which any party has timely and specifically objected.

Id. § 157(e)(1). In contrast, the district court’s standard of review as to final judg *116 ments is set forth in 28 U.S.C. § 158, which provides in relevant part:

(a) The district courts of the United States shall have jurisdiction to hear appeals from final judgments, orders, and decrees ... of bankruptcy judges entered in cases and proceedings referred to the bankruptcy judges under section 157 of this title.... (e) An appeal under subsections (a) and (b) of this section shall be taken in the same manner as appeals in civil proceedings generally are taken to the courts of appeals from the district courts and in the time provided by Rule 8002 of the Bankruptcy Rules.

Id. § 158(a) & (c). Rule 52(a) of the Federal Rules of Civil Procedure applies the “clearly erroneous” standard to appeals taken from the district courts to courts of appeals. Therefore, the clear implication of sections 157 and 158 and Fed.R.Civ.P. 52(a) is that Congress intended that the “clearly erroneous” standard of review be applied to the bankruptcy judge’s findings of fact in appeals from final judgments such as those entered in “core” proceedings. Accord Matter of Excalibur Auto. Corp., 859 F.2d 454, 457 n. 3 (7th Cir.1988); In re Daniels-Head & As socs., 819 F.2d 914, 918 (9th Cir.1987); In re Osborne, 42 B.R. 988, 993 (W.D.Wis.1984).

The interplay between the Bankruptcy Code’s provisions as to “core” and “noncore” proceedings has been summarized as follows:

In noncore matters, the bankruptcy court acts as an adjunct to the district court, in a fashion similar to that of a magistrate or special master. In noncore matters, the bankruptcy court may not enter final judgments without the consent of the parties, and its findings of fact and conclusions of 'law in noncore matters are subject to de novo review by the district court.... In contrast to the bankruptcy court’s authority in noncore cases, the bankruptcy court may enter final judg-ménts in so-called core cases, which are appealable to the district court. The standard for appeal of core matters of the district court is the same as in other civil matters appealed from the district court to the circuits courts of appeal. 28 U.S.C. § 158(c).

In re Castlerock Properties, 781 F.2d 159, 161 (9th Cir.1986) (quoting In re Production Steel, Inc., 48 B.R. 841, 844 (M.D.Tenn. 1985)). Thus, the cornerstone of the jurisdictional system provided by Congress in the 1984 Act is the distinction between “core” and “non-core” matters. See id. The limitation that bankruptcy courts may only adjudicate (1) cases under title 11, and (2) “core” matters arising under title 11 or (3) arising in a case under title 11 brought the Bankruptcy Code within the strictures set forth in Marathon. Accord In re Daniels-Head, 819 F.2d at 917-18; In re Castlerock, 781 F.2d at 161—61; In re Osborne, 42 B.R. at 993-94. Therefore, the critical inquiry for purposes of compliance with Marathon is whether equitable subordination and reclamation are “core” matters such that the Bankruptcy Court properly entered final judgments.

Equitable subordination is unquestionably a “core” proceeding pursuant to section 157(b)(2). The section expressly provides that “core” proceedings include all matters concerning the administration of the bankrupt estate, all orders to turn over property of the estate, and all other proceedings affecting the liquidation of the assets of the estate or the adjustment of the debtor-creditor or the equity security holder relationship. Equitable subordination fits within all of these definitions. Moreover, the cases holding that equitable subordination is a “core” proceeding are legion. See, e.g., In re Holywell Corp., 913 F.2d 873, 879 (11th Cir.1990) (reviewing the bankruptcy court’s factual findings as to equitable subordination under “clearly erroneous” standard as required by 28 U.S.C. § 158(c) only for final judgments and orders); In re Clark Pipe, 893 F.2d 693 (5th Cir.1990) (same); In re Auto Specialties Mfg. Co., 153 B.R. 457, 461 (Bankr. W.D.Mich.1993) (presenting an extensive list of cases holding that equitable subordination is a “core” proceeding under § 157); accord In re F.A. Potts & Co., Inc., 115 B.R. 66, 71 (E.D.Pa.1990) (reviewing equitable subordination findings of fact by bankruptcy judge under “clearly erroneous” standard); In re Beck Rumbaugh Assocs., Inc., 114 B.R. 418 (E.D.Pa.1990) (same); In re Ludwig Honold *117 Mfg. Co., 46 B.R. 125 (Bankr.E.D.Pa.1985) (same).

Likewise, all courts that have considered the issue have determined that reclamation is also a “core” proceeding pursuant to section 157(b)(2). See, e.g., In re Wheeling-Pittsburgh Steel Corp., 74 B.R. 656, 658 (Bankr.W.D.Pa.1987) (reclamation proceeding under Pennsylvania U.C.C. section 2702 and 11 U.S.C. § 546 is a “core proceeding within the meaning of 28 U.S.C. § 157(b) (2)(0) ”); In re Continental Airlines, Inc., 125 B.R. 415, 416 (Bankr.D.Del.1991) (reclamation is a core proceeding under 28 U.S.C. § 157(b)(2)(A), (B), and (E)). In conclusion, equitable subordination and reclamation are “core” proceedings under the Bankruptcy Code. Therefore, pursuant to section 157(b)(1), the Bankruptcy Court had the power to enter final judgments as to these proceedings, and this Court’s review under the “clearly erroneous” standard clearly comports with the principles set forth in Marathon.

IV. EQUITABLE SUBORDINATION

It is a long-standing principle that bankruptcy courts, sitting as courts of equity, have the authority to subordinate claims on equitable grounds. See, e.g., Pepper v. Litton, 308 U.S. 295, 306-08, 60 S.Ct. 238, 245-46, 84 L.Ed. 281 (1939) (holding that bankruptcy courts have the equitable power “to sift the circumstances surrounding any claim to see that injustice is not done in the administration of the bankrupt estate”). Nevertheless, equitable subordination is an extraordinary departure from the “usual principles of equality of distribution and preference for secured creditors.” In re Osborne, 42 B.R. at 992.

Section 510(c) of the Bankruptcy Code codified pre-existing case law allowing bankruptcy courts to adjust the status of claims on equitable grounds. See In re CTS Truss, Inc., 868 F.2d 146, 148 (5th Cir.1989) (Congress’ intent in drafting § 510 was to “incorporate doctrines that had been well-developed in the courts for several decades preceding the enactment of the Bankruptcy Code”); see also In re Burden, 917 F.2d 115 (3d Cir.1990); In re Virtual Network Servs. Corp., 902 F.2d 1246 (7th Cir.1990); In re Clark Pipe, 893 F.2d 693 (5th Cir.1990), withdrawing 870 F.2d 1022 (5th Cir.1989); 3 Lawrence P. King, Collier on Bankruptcy ¶ 510.05 (15th ed. 1988). Section 510(c) states in relevant part:

Notwithstanding subsections (a) and (b) of this section, after notice and a hearing, the court may—

(1) under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or part of another allowed interest; or

(2) order that any lien securing such a subordinated claim be transferred to the estate.

11 U.S.C. § 510(c).

Because of Congress’ clear intent that section 510 codify then-existing principles of equitable subordination, most courts applying the doctrine have adopted the three-prong test articulated by the United States Court of Appeals for the Fifth Circuit on the eve of the Bankruptcy Code’s enactment:

(i) The claimant must have engaged in some type of inequitable conduct.

(ii) The misconduct must have resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant.

(in) Equitable subordination of the claim must not be inconsistent with the provisions of the Bankruptcy Act.

In re Mobile Steel Co., 563 F.2d 692, 700 (5th Cir.1977) (citations omitted); see, e.g., In re Missionary Baptist Found., 818 F.2d 1135, 1143 (5th Cir.1987) (“This formula was not a novel statement but rather, was arrived at through a ‘distillation of case law.’ ”) (quoting Collier’s ¶ 510.05[2], at 510-9); accord In re Beck Rumbaugh Assocs., Inc., 114 B.R. 418 (E.D.Pa.1990); In re F.A. Potts & Co., Inc., 115 B.R. 66 (E.D.Pa.1990).

Although there is general acceptance of the Mobile Steel three-part test, courts have struggled to define the precise conduct that constitutes grounds for equitable subordination. Generally, there are three eatego- *118 ríes of conduct that satisfy the first prong of the three-part test: (1) fraud, illegality, or breach of fiduciary duties; (2) undercapitali-zation; and (3) claimant’s use of the debtor as a mere instrumentality or alter ego. Clark Pipe, 893 F.2d at 699, citing In re Missionary Baptist Found., 712 F.2d 206 (5th Cir.1983); see also In re Herby’s Foods, Inc., 2 F.3d 128, 131 (5th Cir.1993); In re CTS Truss, Inc., 868 F.2d at 148-49.

Further, in applying equitable subordination principles, the courts differentiate between insider and non-insider claimants. As stated in In re Teltronics Servs., Inc., 29 B.R. 139, 169 (Bankr.E.D.N.Y.1983):

The primary distinctions between subordinating the claims of insiders versus those of non-insiders lie in the severity of misconduct required to be shown, and the degree to which the court will scrutinize the claimant’s actions toward the debtor or its creditors.

In In re N & D Properties, Inc., 799 F.2d 726, 731 (11th Cir.1986), the court discussed the differences in the burden of proof in insider and non-insider cases:

The burden and sufficiency of proof required are not uniform in all cases. Where the claimant is an insider or a fiduciary, the trustee bears the burden of presenting material evidence of unfair conduct. Once the trustee meets his burden, the claimant then must prove the fairness of his transactions with the debtor or his claim will be subordinated. If the claimant is not an insider or fiduciary, however, the trustee must prove more egregious conduct such as fraud, spoliation or overreaching, and prove it with particularity.

(citations omitted). Accord In re Osborne, 42 B.R. at 996 (“Once an objectant in an insider case supports allegations of impropriety with a substantial factual showing, the burden shifts to the insider creditor to prove the good faith and inherent fairness of its actions. However, the burden remains on the objectant in cases involving non-insider creditors.”); Mobile Steel, 563 F.2d at 701-02 (same).

Whether a claimant is an insider is a question of fact and subject to review under the “clearly erroneous” standard. See In re Herby’s Foods, Inc., 2 F.3d 128, 131 (5th Cir.1993) (citing In re Fabricators, 926 F.2d 1458, 1466 (5th Cir.1991)). Although “insider” is defined by the Bankruptcy Code at 11 U.S.C. § 101(31), courts applying the doctrine of equitable subordination look beyond the statutory definition and examine whether the party has attained fiduciary status by exercising control of the debtor. See Lawrence P. King, Collier on Bankruptcy ¶ 510.05 (15th ed. 1988); In re EMB Associates, Inc., 92 B.R. 9, 15-16 (Bankr.D.R.I. 1988) (suggesting that the term “insider” under 11 U.S.C. § 101(30) is merely illustrative and “must be applied flexibly on a ease by case basis”) (quoting In re Huizar, 71 B.R. 826, 831 (Bankr.W.D.Tex.1987)). Thus, courts have found that control over the debt- or may render non-insiders “fiduciaries” for purposes of equitable subordination; howey- . er, such control must be “virtually complete.” In re Osborne, 42 B.R. at 997. In Teltronics, the court summarized the “control” required to find that a creditor is a fiduciary of the debtor:

The cases cited above strongly suggest that a non-insider creditor will be held to a fiduciary standard only where his ability to command the debtor’s obedience to his policy directives is so overwhelming that there has been, to some extent, a merger of identity. Unless the creditor has become the alter ego of the debtor, he will not be held to an ethical duty in excess of the morals of the marketplace.

Teltronics, 29 B.R. at 171 (citing Rader v. Boyd, 252 F.2d 585, 587 (10th Cir.195