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By Luke A. Barefoot and Samuel Hershey
Luke Barefoot is a partner in Cleary Gottlieb’s New York office. His practice focuses on bankruptcy litigation, insolvency, corporate restructuring and related disputes. Samuel Hershey is an associate in Cleary Gottlieb’s New York office. His practice focuses on litigation and restructuring.
Section 510(b) of the Bankruptcy Code was conceived as a means to protect the absolute priority rule by preventing enterprising equity holders from bootstrapping their claims into equivalent status with claims held by general creditors. The potential breadth of its language, however, has produced unintended and illogical results in cases concerning securities issued by a debtor's affiliate. The inclusion of “affiliate” securities in section 510(b) has led courts to concoct varying interpretations of the statute, some of which are in tension and, at times, even in contradiction. Courts have struggled with how to properly subordinate affiliate securities that are plainly incompatible with the debtor's estate structure – a difficulty that is only compounded when the debtor is a corporate entity that has not issued public securities, such as in In re Lehman Bros. Inc., 2015 BL 408529, 808 F.3d 942 (2d Cir. 2015), or, even more problematic, a human being, such as in In re Khan, 2014 BL 346386, 523 B.R. 175 (B.A.P. 9th Cir. 2014) and In re Del Biaggio, 2016 BL 276415, 834 F.3d 1003 (9th Cir. 2016). Troublingly, recent decisions have only deepened the confusion, calling on bankruptcy courts to somehow extrapolate an affiliate's capital structure onto the debtor's, no matter how incompatible. See Lehman, 808 F.3d 942; Del Biaggio, 834 F.3d 1003.
In keeping with the underlying purposes of the statute and the inherently relative nature of the subordination remedy, courts should begin their analysis with identification of the claims or interests, if any, to which creditors may be properly subordinated. Specifically, in the case of claims arising from affiliate securities, section 510(b) should be reinterpreted so as to apply only in cases where there are actual claims or interests that correspond to the affiliate's security, such as cases involving a pledge or guaranty by the debtor, that ties the affiliate securities to the debtor's estate.
I. Section 510(b) – Background and Purpose
Section 510(b) provides:
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.
11 U.S.C. §510(b). Like many laws, it began as a legislative solution to a judicially-created problem.
Prior to the incorporation of the absolute priority rule through the Bankruptcy Code, courts had long held that various principles, ranging from estoppel in pais to mandatory subordination, precluded security holders from asserting claims on parity with general unsecured creditors. See, e.g., In re Racine Auto Tire Co., 290 F. 939, 941–42 (7th Cir. 1923) (collecting cases); H.R. Rep. No. 95-595, at 194 (1977). An abrupt and unwelcome change occurred with Oppenheimer v. Harriman Nat'l Bank & Trust Co. of City of N.Y. In that Depression-era case, the Supreme Court held, for the first time, that shareholders in an insolvent bank could seek recovery on fraud claims arising from their shares pari passu with general unsecured creditors. See301 U.S. 206, 214 (1937); see also H.R. Rep. No. 95-595, at 194 (1977). Whatever sense that holding made in 1937 (and in the context of rampant bank failures), by the time of the formulation of the Bankruptcy Code in the late 1970s, Oppenheimer had created a backdoor means for security holders in all types of businesses to seek equal recovery with other creditors to whom they were intended to be junior in right. See H.R. Rep. No. 95-595, at 194 (1977). The situation called out for redress.
The problem was most prominently identified by two law school professors, John Slain and Homer Kripke, in their article The Interface between Securities Regulation and Bankruptcy – Allocating the Risk of Illegal Securities Issuance between Securityholders and Issuer's Creditors, 48 N.Y.U. L. Rev. 261 (1973). Slain and Kripke asserted that the absolute priority rule had been subverted by “a class of cases … [where] a dissatisfied investor may rescind his purchase of stock or subordinated debt by proving that the transaction violated federal or state securities laws … [and] either shares pari passu with, or is preferred to, claims of general creditors.” Slain & Kripke, supra, at 261. This gamesmanship resulted, they argued, from “the unthinking application of the policies underlying the securities laws at the expense of policies underlying bankruptcy distribution.” Id.at 268. Their solution, simply stated, was to reframe the issue as one of “risk allocation,” restoring the “normal expectation that equity investment and junior debt will bear the first losses of the enterprise.” Id. at 263. In other words, all claims arising from ownership, purchase or sale of securities – not just the rights arising from the securities themselves – should be subordinated to general unsecured claims.
The rationale for this policy was two-fold. First, the so-called “risk-allocation rationale,” which recognizes that creditors and equity-holders have different risk and return expectations. Creditors are typically owed a fixed sum of money; equity-holders, however, possess an ownership interest that allows for greater returns at the price of greater risk. To allow equity-holders to pursue such higher returns while skirting the concomitant higher risks by reframing the nature of their claim would enable them to effectively game the system. For a second rationale, Slain and Kripke observed that creditors typically expect an “equity cushion” to absorb the brunt of the drop in value before the losses seep into the other creditor constituencies. Allowing equity-holders to achieve parity with general unsecured creditors confounds those creditors' legitimate expectations.
Rarely has an article had so immediate and profound an effect. In drafting the Bankruptcy Reform Act of 1978, Congress noted that “[t]he argument for mandatory subordination is best described by professors Slain and Kripke,” and largely based this provision of the code on their analysis. H.R. Rep. No. 95-595, at 194 (1977). The result was section 510(b) – an “administratively more workable” solution than the court-made rules that had previously prevailed. Id. at 196. But this legislative attempt to correct judicial missteps has itself been subverted insofar as the statute was further expanded to include “affiliate” securities – a topic on which the legislative history of section 510(b) is, unhelpfully, silent. See Bankruptcy Act Revision, Hearings on H.R. 31 and H.R. 32 Before the Subcommittee on Civil & Constitutional Rights of the H. Comm. on the Judiciary , 94th Cong. 27, App'x 1 at 1, 142, App'x 2 at 355 (1976) (proposed 1975 bankruptcy acts, which do not address affiliates); see also Lehman, 519 B.R. at 442 n. 47 (“[T]he legislative history of section 510(b) does not discuss the inclusion of affiliates in the statute.”).
II. Section 510(b)’s Problematic Application to Debtor Affiliates
Despite its worthy objectives, section 510(b) has been interpreted in ways that stray far from its intended meaning and purpose where claims arising from “affiliate” securities transactions occur.
a) Shares in a Corporate Affiliate
These cases arising from the purchase or sale of securities issued not by the debtor, but by the debtor's affiliate, have produced divergent results. Such was the case in In re Lehman Bros. Inc., 808 F.3d 942. There, a class of creditors in Lehman Brothers Inc. (“LBI”), a subsidiary of, and lead underwriter to, its parent, Lehman Brothers Holdings Inc. (“Lehman”), brought claims for contribution in LBI's SIPA proceeding arising from losses incurred from underwriting Lehman securities. The debtor-affiliate relationship between LBI and Lehman did nothing to avert several complications. First, although the creditors' claims were against LBI, those claims arose from their service as underwriters for Lehman and the purchase and sale of Lehman securities. Second, LBI had no publicly issued equity and no debt securities whatsoever, and so, unlike Lehman, had no corresponding priorities in its capital structure for many of the instruments issued by Lehman and underwritten by the claimants. Finally, LBI's bankruptcy was being adjudicated in a separate proceeding under a separate statute – SIPA rather than Chapter 11 – which has its own unique priority scheme given the classification of customer claims.
These incongruities naturally created difficulties in interpreting whether section 510(b) should apply to the LBI underwriters, and, if so, how. Indeed, section 510(b)’s requirement that claims arising from a securities purchase be subordinated “to all claims or interests that are senior to or equal the claim or interest represented by such security” failed to provide any clarity. LBI itself had not issued many of the types of securities represented in the Lehman capital structure – and indeed, no debt securities whatsoever. Even more problematic, the securities in question were being adjudicated in a separate bankruptcy proceeding for the issuer, such that there was no claim or interest in LBI “represented by such security.” The claimants argued that this rendered section 510(b) inapplicable.
In the first circuit decision to address the application of section 510(b) to claims arising from affiliate securities, the Second Circuit disagreed. Reasoning that “in the affiliate securities context, ‘the claim or interest represented by such security’ means a claim or interest of the same type as the affiliate security,” the court held that the underwriters' claims were subordinated under section 510(b). Lehman, 808 F.3d at 946. In practical effect, the Second Circuit adopted the novel mandate previously promulgated by the district court: bankruptcy courts should determine the priority of affiliate equity claims “by reference to the type of claim or interest represented by such security.” In re Lehman Bros. Inc., 519 B.R. 434, 452 (S.D.N.Y. 2014) (emphasis added). However, the statute refers not to a “type” of claim, but rather to “the claim or interest” actually represented by the security. As such, this leaves bankruptcy courts to attempt to transmogrify by analogy one capital structure into what may be an entirely different structure for its affiliate. Unsurprisingly, the Second Circuit noted that “[w]hen a bankruptcy court subordinates claims arising out of securities that were issued by the debtor's affiliate, it may become somewhat messy to superimpose the capital structure of the affiliate onto that of the debtor.” Lehman, 808 F.3d at at 950. Nevertheless, the Court imposed exactly that responsibility, expressing its faith that a “bankruptcy court is well-suited to engage in that kind of classification and discrimination.” Id. at 951. In the context of Lehman, this would mean subordinating claims based on their places in fictitious classes that could only be derived from the estate structure of an entirely dissimilar affiliate.
b) Shares in an Individual
The difficulties posed in Lehman, already severe, would only intensify. In In re Del Biaggio, the Ninth Circuit confronted a similar dilemma, except this time, the affiliate of the issuing debtor was not a corporation without analogous securities, but an individual – an entity that, by definition, cannot have equities in its estate structure, nor the various levels of debt securities (first lien, second lien, senior, subordinated, etc.) that are common for corporate issuers.
The facts, at least, were straightforward. After defrauding investors into buying shares in the Nashville Predators NHL franchise, William Del Biaggio III declared bankruptcy, tanking the Predator's profits and leaving his victims with claims arising from their shares totaling tens of millions of dollars. Taking its cues from the Lehman court, the Ninth Circuit held that even in this case, it was the duty of the bankruptcy court to “superimpose” the capital structure of the share-issuing affiliate – i.e., the Nashville Predators – onto the capital structure of the debtor – i.e., William Del Biaggio. See Del Biaggio, 834 F.3d at 1014. The impossibilities inherent in such a process are self-evident.
Nor did they escape judicial notice. Two years before Del Biaggio was decided, In re Khan – a decision by the Ninth Circuit's own Bankruptcy Appellate Panel – came out the other way. As in Del Biaggio, Khan involved claims in the bankruptcy of an individual that derived from securities in a corporate affiliate. However, in stark contrast to the court in Del Biaggio, the Khan court found that “[n]either the language of the statute nor the object and policy of mandatory subordination … support the view that Congress intended mandatory subordination to apply in an individual debtor case.” In re Khan, 523 B.R. 175, 183 (B.A.P. 9th Cir. 2014). Rather, section 510(b) only made sense in a “corporate case” context. Khan, 523 B.R. at 183. Though abrogated by Del Biaggio, the reasons behind the Khan court's holding merit consideration. Unfortunately, such reflection does not seem forthcoming, as the Ninth Circuit denied the Del Biaggio claimants' petition for re-hearing en banc, seeLTC of William Del Biaggio III v. David Freeman, Case No. 13-17500, Dkt. No. 37 (9th Cir., Oct. 12, 2016), and the claimants subsequently opted not to pursue a petition for a writ of certiorari to the Supreme Court.
At bottom, as the Khan court observed, the rationales underlying section 510(b) simply do not apply to cases involving individuals. Creditors of the estate of an individual (as in Khan and Del Biaggio) cannot possibly have expectations of an equity cushion. Neither, for that matter, can creditors of a corporate estate that has never issued securities, as in Lehman. Nor does the risk-reward framework make sense in either context. Equity holders have no expectations of outsize profits from the debtor if the shares belong to its affiliate. Nor, more obviously, can they be “owners” of an individual debtor such that they should risk bearing a disproportionate share of that individual's potential losses.
These considerations, moreover, say nothing of the difficulties posed by applying section 510(b) to non-corporate debtors or corporate debtors without publicly issued securities. The Second Circuit's glib mandate to “superimpose” one debtor's estate structure onto another's ignores the latent problems in such an endeavor – the asymmetrical estate structures of corporations and individuals; the divergent estates of security-issuing and non-security-issuing affiliates; or simply the disparities in capital structure that can exist between any two security-issuing corporate debtors. Such applications of section 510(b) require bankruptcy courts to hypothesize capital structures out of whole cloth – and, in so doing, extend the statute beyond what its framers seemingly ever intended.
Most problematic, by starting with the premise that subordination is mandatory, Lehman and Del Biaggio ignore the crucial problem of where claims arising from affiliate securities should fall in the estate structure. Subordination is an inherently relative undertaking such that the level to which claims are subordinated is the sine qua non of the exercise. In treating the act of subordination as the end-game of the section 510(b) analysis, Lehman and Del Biaggio failed to recognize two distinct questions: (i) whether the securities are affiliate securities potentially subject to section 510(b); and (ii) the inevitable follow-up of whether there are any cognizable claims represented by those securities in the debtor's proceeding so as to permit subordination. Instead, in a results-driven approach, the recent decisions leave bankruptcy courts not only with the task of manufacturing estate structures, but also without guidance as to where in those estate structures claims arising from affiliate securities should lie. This approach all but guarantees unpredictability and inconsistency.
c) An Emerging (Albeit Unfortunate) Consensus?
With the Second and Ninth Circuits apparently coalescing around the similar approaches pronounced in Lehman and Del Biaggio, the general framework for applying section 510(b) to affiliate securities may be poised to conform, even if it leaves lower courts with an unworkable mandate. This is particularly notable where the rationale these authorities adopt is markedly different from even the lower court decisions that preceded them.
Specifically, the district court in Del Biaggio recognized that there were no claims or interests represented by the affiliate securities in the debtor's capital structure. However, the court nonetheless subordinated the affiliate-securities claims to phantom claims fictionally located below the bottom of the debtor's waterfall. In re Del Biaggio, 2013 BL 319638 (N.D. Cal. Nov. 18, 2013) (“Under section 510(b), Freeman's claim could not have greater priority to the Del Biaggio estate than the security from which his claim arises … Shares in a subsidiary or affiliate do not give rise a claim directly against the assets of a parent company.”). In this way, the district court suggested that precisely because there were no legitimate claims or interests represented by the affiliate securities, the resulting claims should be subordinated to non-existent claims. The Ninth Circuit found this “less than zero” approach less persuasive than the approach adopted by the Second Circuit in Lehman. Del Biaggio, 834 F.3d at 1013-15.
Similarly, the bankruptcy court in Lehman never suggested extrapolating the capital structure of LBI's affiliate into the SIPA proceeding. Instead, the bankruptcy court held that the contribution claims arising from Lehman securities were somehow also the claims or interests “represented by” those securities for purposes of section 510(b). In this way, the bankruptcy court reflexively subordinated those claims to themselves. In re Lehman Bros. Inc., 503 B.R. 778, 786-87 (Bankr. S.D.N.Y.). Neither the district court nor the Second Circuit adopted this view. Indeed, the Second Circuit found this approach implausible as a textual matter. Lehman, 808 F.3d at 947 n.5.
III. Suggested Reforms
Given the degree to which section 510(b) has strayed from its intended purpose, a reinterpretation is in order. The foremost goal of such reinterpretation should be recognizing that section 510(b) applies only to corporate debtors. Its history and purpose, as well as the legislative record, simply do not support its application to individuals. More broadly, however, courts applying section 510(b) must seek to identify the actual claims or interests represented by the security at issue, if any, in the debtor's proceeding. In so doing, courts will be forced to locate where in the debtor's estate structure these claims properly lie, and will avoid the impossible task of fabricating an estate structure and the risk of misvaluing a class of claims in the process.
This solution not only has the appeal of bringing simplicity and predictability back to section 510(b), but also the advantage of being difficult to game. By adopting these measures, section 510(b) can continue to serve its useful purpose while returning clarity, fairness and predictability to the creditor constituencies it impacts.
Copyright © 2017 The Bureau of National Affairs, Inc. All Rights Reserved.
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