United States: Mandatory Subordination Of Affiliate Securities Claims

Last Updated: March 10 2016
Article by Ingrid Bagby and Christopher J. Updike

Most Read Contributor in United States, September 2017

The mandatory-subordination provision of § 510 (b) of the Bankruptcy Code serves the important purpose of preventing disappoint­ed shareholders from assuming the guise of credi­tors in order to enhance their recoveries in bank­ruptcy.1 By its terms, the statute requires subordi­nation of claims against a debtor arising from such debtor's securities, as well as claims arising from securities of the debtor's affiliates.2 These claims must be subordinated to "all claims or interests that are senior to or equal the claim or interest repre­sented by such security."3

However, if a debtor's capital structure does not contain any class of claims for securities issued by its affiliates (which is often the case), how should such claims be treated? The U.S. Court of Appeals for the Second Circuit recently addressed this ques­tion in the Lehman Brothers bankruptcy cases and held that claims arising from the securities of a debt­or's affiliate should be subordinated in the debtor's bankruptcy case to all claims or interests senior or equal to claims in the case that are the same type as the underlying security, rather than the exact secu­rity.4 The decision's equitable approach to apply­ing § 510 (b) to the practical realities of bankruptcy cases shows the confidence of appellate courts in the ability of bankruptcy judges to tailor an application of the statute to each case's unique circumstances. The decision also provides a useful reminder for holders of affiliate securities claims that a debtor's bankruptcy case does not represent an opportunity to enhance your bargained-for priority.

Mandatory Subordination

Section 510(b) provides:

[A] claim 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, shall be subordinated to all claims or interests that are senior to or equal the claim or interest represented by such security, except that if such security is com­mon stock, such claim has the same priority as common stock."5

John J. Slain and Homer Kripke discussed the genesis of the statute in an article published in 1973.6 The authors argued for the mandatory subordination of fraud and other securities law claims arising from the issuance of a debtor's securities on the basis that favorable treatment of such claims provides "investors [with] a windfall by giving them an opportunity to reap the ben­efits of a profitable entity and by allowing them to share with creditors in the event the enterprise was forced to reorganize or liquidate."7 Congress enacted § 510 (b) to prevent this "bootstrapping" by shareholders in a bankruptcy proceeding.8 In doing so, the statute honors (1) the dissimilar risk-and-return expectations of shareholders and creditors, and (2) the reliance of creditors on the equity cush­ion provided by shareholder investment — the very policy rationales advocated by Slain and Kripke, then later adopted by Congress.9

Neither Slain and Kripke nor the legislative history of § 510 (b) addressed claims arising from the securities of a debtor's affiliates, but Congress expressly included such claims in the final version of the statute. Presumably, Congress determined that subordination of affiliate securities claims also served the policy objectives behind § 510 (b).10

From a practical perspective, subordination of affiliate securities claims is not as straightforward as it may seem. Generally, debt and equity issued by a debtor's affiliate do not give rise to claims or interests that might be asserted direct­ly against the debtor's assets.11 Notable exceptions include instances whereby the debtor has guaranteed payment on the affiliate's security, or the estates of the debtor and its affiliate are substantively consolidated. Thus, a debtor's capital struc­ture often does not have an obviously appropriate place for the subordination of affiliate securities claims. Parties litigat­ing this issue usually dispute whether subordination is appli­cable only in the narrow circumstances described above, or also when such securities (or claims for ownership thereof) are absent from the debtor's capital structure. Most courts have adopted the latter approach and grant subordination.12

The Lehman Brothers Decisions

Between 2004-08, Lehman Brothers Holdings Inc. (LBHI) issued several billion dollars' worth of securities that were underwritten by Lehman Brothers Inc. (LBI), a broker-dealer and wholly owned subsidiary of LBHI, as well as several other underwriters (the "junior underwriters"). In September 2008, LBHI sought chapter 11 relief, and LBI was placed into liq­uidation pursuant to the Securities Investor Protection Act of 1970 (SIPA). Following commencement of these proceedings, investors in LBHI's securities filed securities fraud lawsuits against the junior underwriters, alleging material misstatements and omissions in the offering documents. (LBI was not a defen­dant because of the automatic stay.) In turn, the junior under­writers filed proofs of claim against LBI in its SIPA proceed­ing, asserting general unsecured contribution claims for their losses related to defense costs and settlement payments. The trustee in the LBI SIPA proceeding then sought subordination of the junior underwriters' claims pursuant to § 510 (b).13

The junior underwriters argued that § 510 (b) was inappli­cable to their claims. Although § 510 (b) clearly includes claims arising from securities of a debtor's affiliate, such claims are subordinated "to all claims or interests that are senior to or equal the claim or interest represented by such security." According to the junior underwriters, claims "represented by" LBHI securi­ties means claims that are based on ownership of LBHI securi­ties.14 Thus, their claims could be subordinated in the LBI SIPA proceeding only if there were existing claims in that proceeding based on ownership of the respective LBHI securities. Since the LBI estate did not independently contain securities issued by LBHI, the junior underwriters asserted that there were no claims to which their claims could be subordinated. "In other words, they argued that because the Lehman Holdings-issued securities were not otherwise part of LBI's waterfall, § 510 (b) did not apply to the Junior Underwriters' claims."15

The bankruptcy court overseeing the SIPA proceeding dis­agreed. It held that the junior underwriters' interpretation of § 510 (b) was hyper-technical, contorted and illogical.16 Instead, the court held that the "claims ... represented by such security" were, in fact, the junior underwriters' claims for contribution (and not for recovery on account of the LBHI securities them­selves), which constituted general unsecured claims against LBI connected in subject matter to the underlying securities.17 Thus, the bankruptcy court held that the junior underwriters' claims should be subordinated to the claims of general unse­cured creditors of LBI. The court added that "[i] f a claim 'rep­resented by such security' were to be restricted to a recovery from the issuer for amounts outstanding under the security, then no claim arising from the purchase or sale of affiliate securities would ever fit within the regime for subordination. Such a result would contradict express provisions of the stat­ute, which direct that such claims shall be subordinated."18

On appeal, the district court affirmed the bankruptcy court's decision, but on a different ground. The district court clarified that the issue was not whether affiliate securities claims were subject to subordination under § 510 (b) — they clearly are by the statute's plain terms — but rather how that subordination was to occur.19 In addition, "the level of subor­dination can be determined by reference to the type of claim or interest represented by such security — e.g., secured, unse­cured, common stock or equity. In cases involving affiliate securities, the type of security dictates the level of subordina­tion whether or not that security represents an actual claim in the debtor's case."20 The district court added that its interpreta­tion promoted the purposes of § 510 (b) by ensuring that credi­tors receive their distribution ahead of investors, and allocat­ing the risks and costs that are associated with the issuance of securities to underwriters rather than unsecured creditors.21

Upon further appeal by the junior underwriters, the Second Circuit adopted the district court's analysis and held that "[c] laims arising from [the] securities of a debtor's affili­ate should be subordinated in the debtor's bankruptcy pro­ceeding to all claims or interests senior or equal to the claims in the bankruptcy proceeding that are of the same type as the underlying securities."22 The Second Circuit noted that the junior underwriters' interpretation of § 510 (b) would be feasible only in two contexts: when the estates of a debtor and its affiliate are substantively consolidated, and when the debtor has guaranteed payment on the affiliate's securities. The court refused to endorse such a narrow reading given the longstanding precedent to interpret § 510 (b) broadly.23 Further, the Second Circuit agreed with the district court that it is "'unlikely that Congress ... relied on [substantive con­solidation] to provide meaning to the 'affiliate' language,' given that such consolidation is not provided for explicitly in the Bankruptcy Code," and, in fact, is not regularly granted.24

The Second Circuit admitted that "it may become some­what messy to superimpose the capital structure of the affili­ate onto that of the debtor" when subordinating affiliate securities claims.25 However, the court emphasized that its approach provides flexibility for bankruptcy courts, which are "well-suited to engage in that kind of classification and discrimination."26 Bankruptcy courts can utilize their equi­table powers to group claims for subordination into narrower subcategories, and, "[w] hen granular distinctions of prior­ity among the affiliate's securities are not mirrored in the debtor's estate ... add tiers to the waterfall, or in a different case, ... group multiple levels of priority."27

Conclusion

Section 510 (b) is by no means the model of clarity, and many courts have found its operative language to be ambiguous.28 However, the Second Circuit's decision in In re Lehman Brothers applies a common-sense approach to the statute and recognizes the particular expertise of bankruptcy courts in determining claim priorities. For example, during the claims-allowance process, bankruptcy courts regularly evaluate the appropriate priorities of asserted claims. Also, when considering plan confirmation, courts must decide whether claims and interests that are classified together under a plan are "substantially similar" as required by § 1122 of the Bankruptcy Code.29 The Second Circuit's analysis serves as a critical reminder for parties that just because their claim does not fit perfectly within a debtor's existing capital structure, it does not mean that they can avoid mandatory subordination. Parties have to be mindful of § 510 (b)'s reach and the strong policies behind it before determining that a securities-related claim should constitute a general unsecured claim.

Footnotes

1 Newton Nat'l Bank v. Newbegin, 74 F. 135, 140 (8th Cir. 1896) ("When a corporation becomes bankrupt, the temptation to lay aside the garb of a stockholder, on one pre­tense or another, and assume the role of a creditor, is very strong, and all attempts of that kind should be viewed with suspicion.").

2 11 U.S.C. § 510(b).

3 Id.

4 ANZ Secs. Inc., et al. v. Gibbons (In re Lehman Bros.), No. 14-3686, 2015 WL 8593604 (2d Cir. Dec. 14, 2015) ("Second Circuit Decision").

5 11 U.S.C. § 510(b).

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

7 See Rombro v. Dufrayne (In re Med Diversified Inc.), 461 F.3d 251, 256 (2d Cir. 2006) (citing Slain and Kripke) (citation omitted).

8 Baroda Hill Invs. Ltd. v. Telegrp. Inc. (In re Telegrp. Inc.), 281 F.3d 133, 142 (3d Cir. 2002) ("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.").

9 In re Med Diversified, 461 F.3d at 255-56; In re Telegrp., 281 F.3d at 138-41 (discussing legislative his­tory of § 510 (b)).

10 Second Circuit Decision at *5-6.

11 Liquidating Trust Comm. of the Del Biaggio Liquidating Trust v. Freeman (In re Del Biaggio), Case No. 12-CV-6447, 2013 WL 6073367, at *7 (N.D. Cal. Nov. 18, 2013) (citing In re VF Brands Inc., 275 B.R. 725, 727 (Bankr. D. Del. 2002)).

12 See, e.g., Templeton v. O'Cheskey (In re Am. Hous. Found.), 785 F.3d 143, 157 (5th Cir. 2015) (reject­ing argument that claimant holding affiliate securities claim "should be treated like any other creditor of [the debtor] because [the claimant] never assumed the risks of a ... shareholder' of the debtor [because] this line of reasoning would seem to preclude mandatory subordination of any claim arising from the purchase of an affiliate's securities (since the securities of the affiliate are not shares in the debtor) — a result at odds with the plain language of Section 510 (b).") (emphasis in original; citation omitted); VF Brands, 275 B.R. at 727 (concluding that "[a] pplying section 510 (b) requires that the claim of Money's Trust (which is based on damages from the purchase of stock of an affiliate of the [debtors]) must be subordinated to the claims of the general unsecured creditors of the [debtors], which in the absence of that section would be equal in priority to its claim"); Del Biaggio, 2013 WL 6073367, at *7 (rejecting argument that affiliate and debtor securities "are not senior or junior to each other because they simply to not compete for the same assets or distributions" and subordinating fraud claim to those of debtor's unsecured creditors).

13 The SIPA trustee also sought subordination of claims asserted by two entities that were not parties to the Second Circuit appeal.

14 In re Lehman Bros., 519 B.R. 434, 450-51 (S.D.N.Y. 2014) ("District Court Decision").

15 Second Circuit Decision at *2.

16 In re Lehman Bros., 503 B.R. 778, 787 (Bankr. S.D.N.Y. 2014) ("Bankruptcy Court Decision"), aff'd on other grounds, 519 B.R. 434 (S.D.N.Y. 2015).

17 Id. at 787.

18 Id. at 785 (emphasis in original).

19 District Court Decision at 449-50.

20 Id. at 452.

21 Id. at 450, 452.

22 Second Circuit Decision at *3 (emphasis added).

23 See, e.g., Racusin v. Am. Wagering Inc. (In re Am. Wagering Inc.), 493 F.3d 1067, 1072 (9th Cir. 2007) ("As a remedial statute, section 510 (b) should be interpreted broadly in order to effectuate the intent of Congress."); In re Med Diversified, 461 F.3d at 255 ("The holdings of most prominent decisions of local bankruptcy courts also support the broad interpretation of section 510 (b).") (citing cases).

24 Second Circuit Decision at *3-4.

25 Id. at *6.

26 Id.

27 Id. at *6 and n.11.

28 See, e.g., In re Med Diversified, 461 F.3d at 255 ("We find that the phrase 'arising from' ... is ambigu­ous."); In re Telegrp., 281 F.3d at 138 ("We conclude that the phrase 'arising from' is ambiguous."); Bankruptcy Court Decision at 784 ("[I] nterpreting section 510 (b) is 'ambiguous or unambiguous when juxtaposed against particular factual situations."') (quoting KIT Digital Inc. v. Invigor Grp. Ltd. (In re KIT Digital Inc.), 497 B.R. 170, 178 (Bankr. S.D.N.Y. 2013)).

29 11 U.S.C. § 1122.

Reprinted with permission from the ABI Journal, Vol. XXXV, No. 3, March 2016.

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.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
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
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
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.

Disclaimer

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.

Registration

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.

Cookies

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.

Links

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.

Mail-A-Friend

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.

Security

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.