Mandatory Subordination Of Affiliate Securities Claims

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...