Judgment Claim And Lien Securing It Were Properly Subordinated Under Section 510(b) Of The Bankruptcy Code

• Published date: 01 August 2022
• Subject Matter: Corporate/Commercial Law, Insolvency/Bankruptcy/Re-structuring, Corporate and Company Law, Insolvency/Bankruptcy, Securities, Shareholders
• Law Firm: Jones Day
• Author: Mr Mark Douglas and Oliver Zeltner

Section 510(b) of the Bankruptcy Code provides a mechanism designed to preserve the creditor/shareholder risk allocation paradigm by categorically subordinating claims asserted against a debtor by equity holders arising from the purchase or sale of securities of the debtor or an affiliate of the debtor. The purpose of this provision is to ensure that creditors are paid before equity holders, including in situations where an equity holder asserts a claim for damages related to the purchase or sale of the debtor's (or an affiliate's) stock. Section 510(b) implicitly recognizes that, as compared with creditors, equity holders bargained for potentially greater returns in exchange for greater risk, and it is designed to preserve that risk allocation between creditors and shareholders in bankruptcy. However, courts do not always agree on the scope of the provision in attempting to implement its underlying policy objectives.

A bankruptcy appellate panel for the Ninth Circuit ("BAP") recently examined this issue in Kurtin v. Ehrenberg (In re Elieff), 637 B.R. 612 (B.A.P. 9th Cir. 2022). The panel affirmed a bankruptcy court order categorically subordinating secured judgment claims asserted against the debtor by an individual with whom the debtor co-owned certain investments. The BAP agreed with the bankruptcy court that the claims, although transformed into a secured judgment, were for damages arising from the purchase or sale of the securities of the debtor or an affiliate and were therefore properly subordinated under section 510(b). The BAP further held that the liens securing the claims should also have been subordinated under section 510(b).

Subordination in Bankruptcy

The concept of claim, debt, or lien subordination is well recognized under federal bankruptcy law. A bankruptcy court's ability to reorder the relative priority of claims or debts under appropriate circumstances is part and parcel of its broad powers as a court of equity. The statutory vehicle for applying these powers in bankruptcy is section 510 of the Bankruptcy Code.

Section 510(a) makes an otherwise valid contractual subordination agreement enforceable in a bankruptcy case to the same extent that it would be enforceable outside bankruptcy.

Section 510(b) generally subordinates claims arising from the purchase or sale of a security of the debtor or an affiliate of the debtor to all claims that are senior or equal to the claim or interest represented by the security.

Finally, section 510(c) provides that misconduct that results in injury to creditors or shareholders can, "[n]otwithstanding subsections (a) and (b) of this [section 510]," result in the "equitable" subordination of a claim or interest or the issuance of an "order that any lien securing such a subordinated claim be transferred to the estate."

Subordination of Claims Under Section 510(b)

Section 510(b) provides as follows:

For the purpose of distribution under this title, 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.

The purpose of section 510(b), consistent with the Bankruptcy Code's "absolute priority" rule, is to prevent the bootstrapping of equity interests into claims that are on a par with other creditor claims. According to this rule, unless creditors are paid in full or agree otherwise, shareholders cannot receive any distribution from a bankruptcy estate. See generally Collier on Bankruptcy ' 510.04[1] (16th ed. 2022).

Interest holders have resorted to a wide array of devices and/or legal arguments in an effort to overcome the effect of section 510(b), including contractual provisions purporting to entitle them to damages upon the issuer's breach of a stock purchase agreement and alternative theories of recovery, such as unjust enrichment and constructive trust. See generally Stucki v. Orwig, 2013 WL 1499377 (N.D. Tex. Apr. 12, 2013) (discussing case law).

In deciding cases under section 510(b), some courts have highlighted the traditional allocation of risk between a company's shareholders and its creditors. Under this policy-based analysis, shareholders are deemed to undertake more risk in exchange for the potential to participate in the profits of the company, whereas creditors can expect only repayment of their fixed debts. Accordingly, shareholders, and not creditors, assume the risk of a wrongful or unlawful purchase or sale of securities. This risk allocation model is sometimes referred to as the "Slain/Kripke theory of risk allocation," as described in a 1973 law review article written by Professors John J. Slain and Homer Kripke titled "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). See, e.g., In re SeaQuest Diving LP, 579 F.3d 411, 420 (5th Cir. 2009); In re Betacom of Phoenix, Inc., 240 F.3d 823, 829 (9th Cir. 2001); In re Granite Partners, L.P., 208 B.R. 332, 336 (Bankr. S.D.N.Y. 1997).

Because of the parties' differing expectations for risk and return, it is perceived as unfair to allow a shareholder to recover from the limited assets of a debtor as a creditor by "converting" its equity stake into a claim through the prosecution of a successful securities lawsuit. The mechanism by which such a conversion is thwarted is subordination of the shareholder's claim...