United States: United States Court Of Appeals For The Second Circuit Holds That Claims Arising From Securities Of A Debtor's Affiliate Must Be Subordinated To Senior Or Equal Claims Of The Same Type As The Underlying Securities

On December 14, 2015, the United States Court of Appeals for the Second Circuit held that claims arising from securities of a debtor's affiliate must be subordinated to all claims or interests senior or equal to claims of the same type as the underlying securities in the bankruptcy proceeding. As a result, appellants' claims for contribution and reimbursement for losses incurred in the course of defending and settling securities fraud lawsuits brought by investors in securities issued by Lehman Brothers Inc.'s ("LBI") affiliate were subordinated to the claims of LBI's general unsecured creditors pursuant to Section 510(b) of the Bankruptcy Code. This decision, which the Court of Appeals based on precedent, textual support and legislative history, provides clarity with respect to the appropriate classification of claims in the affiliate securities context.


LBI was lead underwriter for unsecured notes issued by Lehman Brothers Holdings Inc. ("Lehman Holdings"), its affiliate and parent. Between 2004 and 2008, LBI and the appellants in these cases (the "Junior Underwriters") launched 22 offerings of Lehman Holdings securities, totaling $32.4 billion. A Master Agreement Among Underwriters (the "Agreement") governed the relationship between LBI and the Junior Underwriters. The Agreement created a right of indemnification and contribution among co-underwriters for losses or liabilities resulting from securities fraud claims arising out of the offerings.

Following the bankruptcy of Lehman Holdings and the Securities Investor Protection Act ("SIPA") liquidation proceeding of LBI, investors in Lehman Holdings notes filed securities fraud lawsuits against the Junior Underwriters, alleging material misstatement and omissions in the offering documents. The Junior Underwriters stated that they incurred $78 million in the defense and settlement of those claims, and asserted claims for contribution or reimbursement against LBI, as lead underwriter of the notes. The SIPA trustee objected, arguing1 that the claims were subject to mandatory subordination pursuant to Section 510(b) of the Bankruptcy Code. The Junior Underwriters argued that Section 510(b) could not be used to subordinate the claims in LBI's SIPA proceeding because the securities were issued by Lehman Holdings, not LBI; therefore, because the securities were not part of LBI's waterfall, Section 510(b) did not apply to the Junior Underwriters' claims.

The United States Bankruptcy Court for the Southern District of New York held that the Junior Underwriters' claims must be subordinated to the claims of general unsecured creditors, reasoning that when considering affiliate securities, the claims represented by the parent securities were the claims for contribution themselves, which were general unsecured claims connected in subject matter to the underlying securities. The United States District Court for the Southern District of New York affirmed on other grounds, focusing on the type of security rather than the type of claim, and reasoning that any ambiguity in Section 510(b) lies not in whether claims based on securities of an affiliate are to be subordinated, but rather how such subordination will occur. The District Court held that unsecured, non-equity securities – like the notes at issue – represent unsecured claims. As a result, in the eyes of the District Court, claims involving such securities must be subordinated to general unsecured claims.


The Court of Appeals agreed with the reasoning of the District Court, holding that in the affiliate securities context, "the claim or interest represented by such security" in Section 510(b) means a claim or interest of the same type as the affiliate security. As a result, the Court reasoned the proper tier for the Junior Underwriters' claims for contribution against LBI is the same tier as the claims would be placed in the affiliate case of LBHI, which for the Junior Underwriters' claims would be at a level subordinated to other claims.

The Court of Appeals justified its conclusion on several bases. First, it analyzed the text of Section 510(b) of the Bankruptcy Code. While noting that the phrase "represented by" from the statute is largely unhelpful, the Court of Appeals concluded that "[i]f the security is an unsecured debt instrument, the claim that is represented by that security is a general, unsecured claim."2 The Court of Appeals found the Junior Underwriters' construction of Section 510(b) (of the phrase "claim or interest represented by such security" as meaning claim or interest based on ownership of such security) to be too narrow, because it would operate only in two hypothetical instances: when a debtor's and its affiliate's estates are substantively consolidated in bankruptcy,3 and when the debtor had guaranteed payment on the securities of its affiliate. The Court of Appeals declined to adopt the Junior Underwriters' narrower construction of the affiliate provision, noting both the absence of a textual hook to do so and that Second Circuit precedent suggests that the provision should be read broadly.4 

The Court of Appeals further noted that the (albeit limited) legislative history supports a construction of Section 510(b) that reaches affiliate securities. Congress expressly included claims based on affiliate securities in drafting the statute, and expanded Section 510(b)'s reach in 1984 with the addition of claims for reimbursement and contribution.5 Both of these changes were meant to broaden – not narrow – the statute's reach. Finally, the Court of Appeals noted that the original enactment of Section 510(b) was motivated by an influential law review article6 calling for reinforcement of the absolute priority rule7 and mandatory subordination in a debtor's bankruptcy proceeding of claims alleging fraud and similar violations in the issuance of the debtor's securities. The article gave two policy rationales for subordination: the "risk-allocation rationale," which addresses the dissimilar risk and return expectations of shareholders and creditors, and the "equity cushion rationale," which addresses the reliance of creditors on the equity cushion provided by shareholder investment. The Court of Appeals stated that risk allocation, in particular, serves as an effective rationalization for subordination in situations where an affiliate's securities provide the basis for the claim, because the purchasers of the securities issued by the affiliate have taken on the risk-return expectation of investors, while the debtor's creditors have not.

Based on the above, the Court of Appeals held that claims arising from securities of a debtor's affiliate are to be subordinated to all claims or interests senior or equal to claims in the bankruptcy proceeding that are of the same type as the underlying securities (generally secured debt, unsecured debt and common stock). In reaching its decision, the Court of Appeals noted that in certain cases, a bankruptcy court may have to, for example, add tiers to the waterfall or group multiple levels of priority in order to superimpose the capital structure of the affiliate onto that of the debtor, but in doing so, indicated its belief that the Bankruptcy Court is well-suited to make such classification and determination,8 and that its approach works in broad strokes while preserving the flexibility needed by the Bankruptcy Court.


In interpreting the phrase "the claim or interest represented by such security" contained in Section 510(b) in the affiliate context, the Court of Appeals focused on the broad purpose of the statute. The opinion cited an Enron decision which stated: "Congress enacted § 510(b) to prevent disappointed shareholders from recovering their investment loss by using fraud and other securities claims to bootstrap their way to parity with general unsecured creditors in a bankruptcy proceeding."10 The Court of Appeals further stated that, in order to prevent such bootstrapping from being effected indirectly, the statute likewise subordinates claims for contribution and reimbursement based on payments made to disappointed investors.

The Junior Underwriters were unable to convince the Court of Appeals to limit the affiliate provision contained in Section 510(b). Instead, the Court of Appeals held that affiliate securities are within the reach of Section 510(b) based on the text, the legislative history, and the purposes of the statute. This decision provides some clarity for the application of Section 510(b) in an affiliate context.


1 Section 510(b) of the Bankruptcy Code provides that a claim arising from rescission of a purchase or sale of a security of a debtor or of an affiliate of the debtor, for damages arising from the purchase or sale of such a security, shall be subordinated to all claims or interests that are senior to or equal the claim or interest represented by such security. 11 U.S.C. § 510(b).

2 Citing Collier on Bankruptcy, 510.04[1] (16th ed. 2009).

3 With respect to this hypothetical, the Court of Appeals agreed with the District Court, which stated that it is unlikely that Congress relied on substantive consolidation to provide meaning to the "affiliate" language, given that such consolidation is not explicitly provided for in the Bankruptcy Code.

4 See In re Med Diversified, Inc., 461 F.3d 251 (2d Cir. 2006).

5 The Court of Appeals cited to other decisions concluding that the reimbursement and contribution amendment was a logical extension of the original risk-allocation rationale, and that Congress intended to ensure that the risks associated with the issuance of stock and securities were placed on the underwriter, who is in a better position to evaluate such risks, as opposed to general unsecured creditors (citing In re Mid-Am. Waste Sys., Inc., 228 B.R. 816, 824 (Bankr. D. Del. 1999).

6 Slain & Kripke, The Interface Between Securities Regulation and Bankruptcy – Allocating the Risk of Illegal Securities Issuance Between Securityholders and the Issuer's Creditors, 48 N.Y.U. L. Rev. 261 (1973).

7 The absolute priority rule provides that creditors recover in full before equity holders recover any of their investment.

8 The Court of Appeals pointed out that similar choices are made in chapter 11 reorganizations, in which bankruptcy judges determine whether securities are "substantially similar" to other securities and, as such, should be classified together.

10 In re Enron Corp., 341 B.R. 141, 158 (Bankr. S.D.N.Y. 2006).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

In association with
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.