United States: Bankruptcy Court In SDNY Decides Question Of Section 510(B) Subordination Of Claims Arising From Securities Of An Affiliate Of The Debtor

Mandatory subordination pursuant to section 510(b) of the Bankruptcy Code is commonly applied where claims arise from the purchase or sale of securities that were issued by the debtor.  Less common is the situation where a debtor seeks subordination of claims that arise from a transaction involving securities of an affiliate of the debtor.  This fact pattern was addressed by U.S. Bankruptcy Court Judge James M. Peck of the Southern District of New York in a decision in which the court upheld the subordination of such claims by the trustee overseeing the liquidation of Lehman Brothers Inc. (LBI) under the Securities Investor Protection Act of 1970 (SIPA).

Section 510(b) of the Bankruptcy Code states that claims shall be subordinated when "arising from rescission of a purchase or sale of a security of the debtor or of an affiliate of the debtor, for damages arising from the purchase or sale of such a security, or for reimbursement or contribution allowed under section 502 on account of such a claim."

In 2013, the LBI trustee filed two separate motions seeking, among other things, to subordinate unsecured general creditor claims in reliance on the "affiliate of the debtor" language of section 510(b).  The claims subject to the motions involved securities that were issued by Lehman Brothers Holdings Inc. (LBHI), the former parent and an undisputed affiliate of LBI.

The first motion concerned claims by various underwriters of LBHI securities who alleged that they were entitled to indemnification, contribution, or reimbursement from LBI as co-underwriter for those securities.  These underwriter claimants asserted that they had incurred more than $300 million in settlements and legal fees as a result of defending claims brought against them by investors of the LBHI securities.  The trustee argued that these claims were subject to subordination under the plain language of the statute because they sought reimbursement or contribution and arose from the purchase or sale of securities issued by LBI's parent.  (The question of whether claims for contribution by underwriters of a debtor's securities are subject to section 510(b) was undisputed, as it had already been answered in the affirmative in In re Jacom Computer Servs., Inc., 280 B.R. 570 (Bankr. S.D.N.Y. 2002)).

The underwriter claimants argued in favor of a narrow reading of section 510(b), focusing on the language of the statute which states that applicable claims "shall be subordinated to all claims or interests that are senior to or equal the claim or interest represented by such security." (emphasis added).   The claimants argued that because no claims or interests represented by LBHI securities were present in the SIPA proceeding, there were no claims or interests to which the underwriters' claims could be subordinated.

The second motion was filed by a former prime brokerage customer seeking damages arising from the failure of LBI to complete an agreement to buy LBHI bonds the last trading day before LBHI went bankrupt.  The trustee argued that this claim should be subordinated pursuant to section 510(b) because it arose from the failure by LBI to purchase securities that were issued by LBI's parent.  The claimant argued that the language of section 510(b) was ambiguous as applied to these facts because the underlying securities, issued by an affiliate of the debtor, were not themselves valid claims against the debtor.   As such, the claimant argued, its claim could not be subordinated to a claim "represented by such security."

Judge Peck agreed with the trustee that the plain language of section 510(b) applied to the claims, and found it unnecessary to consider the legislative history of this provision or the theories and public policy behind subordination.  Though the underlying securities were of an affiliate in a different bankruptcy proceeding and not part of LBI's capital structure, the claims nevertheless fit within the statutory framework and were properly subject to subordination under section 510(b) to all claims that are senior or equal to the general unsecured claims against LBI.  The court held that the claims were based on the LBHI securities from which they arose.  Judge Peck noted that "[a]lthough claimants have been creative in their attempts to portray the language of section 510(b) as unclear and inapplicable to their claims, the statute is clear in requiring subordination" because ultimately "[i]n both of these circumstances, the bonds were issued by an affiliate of LBI and the claims made against LBI arise out of and are based upon transactions that relate to these bonds."¹  The matter is now on appeal to the district court.

Footnote

1.     In re Lehman Brothers Inc., No. 08-01420 (JMP), 2014 WL 288571, at *1 (Bankr. S.D.N.Y. Jan. 27, 2014).

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