In the 1939 case of Pepper v. Litton, the U.S. Supreme Court announced that equitable subordination, the power of the bankruptcy court to change the order in which creditors will be paid by a bankrupt debtor, must be used "to the end that fraud will not prevail, that substance will not give way to form, [and] that technical considerations will not prevent substantial justice from being done.", Exercised by early courts as an application of their equity powers in bankruptcy, equitable subordination was aimed at piercing formal and legal subterfuges to ensure that a bankruptcy estate was properly distributed among similarly situated creditors. Courts flexibly examined the conduct of creditors, originally focusing on insiders, to prevent superficially legal behavior from creating unfair or inequitable advantages in priority. In 1978, Congress formally recognized the importance of equitable subordination by codifying a provision for it at section 510(c) of the Bankruptcy Code. Congress specifically refrained, however, from defining or limiting the courts' application or development of the doctrine, leaving the shaping of this remedy to the courts themselves.
Jay L. Koh,
Equity Unbound: A Meaningful Test for Equitable Subordination,
Yale L. & Pol'y Rev.
Available at: https://digitalcommons.law.yale.edu/ylpr/vol16/iss2/7