Mandatory Subordination Under Section 510(b) Extends To Claims Arising From Purchase Or Sale Of Affiliate’s Securities

Section 510(b) of the Bankruptcy Code provides a mechanism designed to preserve the creditor/shareholder risk allocation paradigm by categorically subordinating most types of claims asserted against a debtor by equity holders in respect of their equity holdings. However, courts do not always agree on the scope of this provision in undertaking to implement its underlying policy objectives. A New York bankruptcy court recently addressed this issue in In re Lehman Brothers Inc., 2014 BL 21201 (Bankr. S.D.N.Y. Jan. 27, 2014). Concluding that the provision is unambiguous, the court ruled that claims asserted against a debtor arising from securities issued by the debtor's corporate parent are subject to subordination under section 510(b).

SUBORDINATION IN BANKRUPTCY

The concept of claim or debt 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 a bankruptcy case is section 510 of the Bankruptcy Code.

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

Section 510(b) addresses mandatory, or "statutory," subordination of shareholder claims (also sometimes referred to as "categorical" subordination). Section 510(b) automatically subordinates to the claims of ordinary creditors any claim: (i) arising from the rescission of a purchase or sale of a security of the debtor or an affiliate; (ii) for damages arising from the purchase or sale of such a security; or (iii) for reimbursement or contribution on account of such a claim.

Finally, misconduct that results in injury to creditors can warrant the "equitable" subordination of a claim under section 510(c).

SUBORDINATION OF SHAREHOLDER CLAIMS UNDER SECTION 510(b)

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

Shareholders have resorted to a wide array of devices and/ or legal arguments in an effort to overcome this basic legal premise, 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 BL 98362 (N.D. Tex. Apr. 12, 2013) (discussing case law).

Many courts have decided cases under section 510(b) by reviewing the traditional allocation of risk between a company's shareholders and its creditors. Under this policy-based analysis, shareholders are deemed to expect more risk in exchange for the potential to participate in the profits of the company, whereas creditors...