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Business Bankruptcy Issues Recent Developments

Mandatory Subordination: How Even A Money Judgment Can Be Treated Like Equity In Bankruptcy

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When an insolvent entity files for bankruptcy, it can be tough to be a creditor. But holding equity — stock in a corporation or a membership interest in an LLC, a limited liability company — can be even worse. Under bankruptcy’s “absolute priority rule,” creditors generally must be paid in full before equity gets anything. That usually means that holders of equity, or claims treated as equity, get nothing.

Section 510(b) Mandatory Subordination. A recent decision by the U.S. Court of Appeals for the Ninth Circuit in In re Tristar Esperanza Properties, LLC serves as a good reminder of the special bankruptcy rules involving mandatory subordination of certain equity-like claims. More on the Tristar case in a minute, but first let’s take a look at the provision that spells out the mandatory subordination rule. Section 510(b) of the Bankruptcy Code 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.

Whole Categories Of Claims Subordinated. Unlike equitable subordination of claims under Section 510(c) of the Bankruptcy Code, which the bankruptcy court may impose if the specific circumstances merit it, Section 510(b) subordination is mandatory and applies to entire categories of claims. These include securities fraud or rescission claims, whether individually or as part of a class action, against the bankrupt company arising from the purchase or sale of its stock or other security.

  • A securities fraud claim by current or former stockholders alleging fraud in the purchase of common stock, leading to damages when the stock price dropped? Subordinated to the level of common stock.
  • A lawsuit for damages to stockholders for breach of an agreement to register or issue shares of common stock? Subordinated to the level of common stock.
  • A lawsuit seeking to rescind a purchase of common stock, and get back the purchase price, due to alleged fraud? Subordinated to the level of common stock.
  • A judgment in any of those cases against the issuer of the stock? You guessed it — subordinated to the level of common stock.

Why Are These Claims Subordinated? Congress enacted Bankruptcy Code Section 510(b), as one court said, “to prevent disappointed shareholders . . . from recouping their investment in parity with unsecured creditors.” Put another way, Section 510(b) ensures that claims of true creditors are not diluted by claims of stockholders or former stockholders seeking damages arising from their stock interests.

  • As the old saying goes, creditors just want to get paid. Stockholders, on the other hand, invest risk capital in hopes of sharing in a company’s profits and “upside” potential. With that chance, however, comes the risk of losing their equity investment.
  • If claims arising out of the purchase or sale of securities were not subordinated, creditors would recover less and shareholders (or former shareholders) would effectively be paid on the same level as creditors, not below them as the absolute priority rule dictates.
  • To avoid this outcome, the Bankruptcy Code imposes mandatory subordination on these types of equity-related claims, preventing shareholders from transforming an equity-like claim into a judgment or proof of claim entitled to creditor treatment in bankruptcy.
  • As a side note, mandatory subordination is similar in concept but nevertheless different from recharacterization of a debt as equity, which involves an analysis on a case by case, rather than category, basis.

Subordination Only As To The Bankrupt Entity. The fact that these claims are subject to mandatory subordination in a bankruptcy of the issuer or its affiliate does not mean that securities fraud or other claims will be subordinated against third parties, including underwriters or directors and officers, or that insurance proceeds might not still be available to settle those claims. However, once an issuer files bankruptcy, claims against its assets in the bankruptcy estate will face mandatory subordination.

Are There Any Exceptions? Lower courts have held that mandatory subordination does not apply to convertible promissory notes where the conversion feature was never invoked, or to an “old and cold” promissory note for an equity repurchase made many years before the bankruptcy (although in the Tristar decision the Ninth Circuit noted that it was not reaching that issue). The Ninth Circuit held in In re American Wagering, Inc., 493 F.3d 1067 (9th Cir. 2007), that a claim under an employment agreement, where the claimant was never an equity investor and compensation was simply calculated based on the price of stock, should not be subordinated under Section 510(b). Depending on the circumstances, particular claims might be subject to an equitable subordination challenge under Section 510(c) of the Bankruptcy Code but, as noted, that is a separate legal standard and analysis.

The Tristar Esperanza Properties Decision. On April 2, 2015, the U.S. Court of Appeals for the Ninth Circuit issued a 12-page decision in In re Tristar Esperanza Properties affirming the lower courts’ decisions to subordinate under Section 510(b) a money judgment in favor of Jane O’Donnell, a member of the LLC. O’Donnell had exercised her right to withdraw from the LLC and require Tristar to purchase her membership interest based on the valuation procedure in the LLC operating agreement. She and Tristar could not agree on a valuation, and O’Donnell brought an arbitration action, receiving a $410,000 award in her favor. When Tristar failed to pay she confirmed the arbitration award in state court and got a state court judgment.

  • Less than a year later Tristar filed a Chapter 11 bankruptcy case, and O’Donnell filed a proof of claim based on the state court judgment.
  • Tristar filed an adversary proceeding seeking to subordinate her claim under Section 510(b), among other challenges. The bankruptcy court granted Tristar summary judgment and the Bankruptcy Appellate Panel affirmed.
  • On appeal to the Ninth Circuit, O’Donnell’s main arguments were that although her LLC membership interest was a security of the debtor, her claim was neither for “damages” nor “arising from the purchase or sale” of the membership interest.
  • The Ninth Circuit rejected both arguments, interpreting both clauses of Section 510(b) broadly.
    • First, it held that her claim was for “damages,” in this case for breach of contract, and Section 510(b)’s damages clause should be read broadly. It rejected her argument that fixed, admitted debts should be excluded from the scope of “damages” in Section 510(b), noting that the very broad definition of “claim” in Section 101(5)(A) of the Bankruptcy Code makes no such distinction.
    • Second, even though O’Donnell was a judgment creditor and no longer an equity holder at the time Tristar filed bankruptcy, the Ninth Circuit emphasized that Section 510(b) applies if a creditor claim “arises from the purchase or sale of a security.” A claim will be subordinated if there is a sufficient nexus or causal relationship between the claim and the purchase or sale of securities.

The Ninth Circuit’s Rationale. The Ninth Circuit elaborated on the rationale for mandatory subordination, quoting from its earlier decision in In re Betacom of Phx., Inc., 240 F.3d 823 (9th Cir. 2001) and explaining:

Our straightforward reading of the ‘arises from’ language in § 510(b) comports with congressional intent. As we have said, ‘[t]here are two main rationales for mandatory subordination: 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.’ Although O’Donnell did not enjoy the benefits of equity ownership on the date of the petition, she bargained for an equity position and thus embraced the risks that position entails.

Conclusion. The Ninth Circuit is essentially telling investors “once a shareholder, always a shareholder,” at least if a claim in bankruptcy arises from an equity interest. Even though O’Donnell had transformed her LLC membership interest into a money judgment, it was still subordinated and treated like equity. This new decision reminds us once again that Section 510(b)’s mandatory subordination rules impact entire categories of claims and make it extremely difficult to collect on any equity-like claim in bankruptcy.

 

Image Courtesy of Flickr by Ervins Strauhmanis

Business Bankruptcy Issues Recent Developments

Winter 2014 Edition Of Bankruptcy Resource Now Available

I hope you had a wonderful holiday season and Happy New Year everyone.

To start the new year off, the Winter 2014 edition of the Absolute Priority newsletter, published by the Bankruptcy & Restructuring group at Cooley LLP, of which I am a member, has been released. The newsletter gives updates on current developments and trends in the bankruptcy and workout area. Follow the links in this sentence to access a copy of the newsletter. 

This edition of Absolute Priority covers a range of cutting edge topics, including:

  • An Eleventh Circuit ruling that indirect benefits from a Subchapter S election can constitute reasonably equivalent value for fraudulent transfer purposes;
  • The Ninth Circuit’s decision permitting recharacterization claims; and
  • A recent Seventh Circuit decision on the validity of a cross-collateralized real estate lien.

It also reports on some of our recent representations, including for official committees of unsecured creditors in Chapter 11 cases involving major retailers and others, and our work for Chapter 11 debtors. Recent committee cases include Mervyn’s Holdings, Appleseed’s Intermediate Holdings, and Underground Energy, among others. Recent debtor representations include Cylex (now Immunology Partners), IntraOp Medical (now MC Liquidation), and Nirvanix.

I hope you find the latest edition of Absolute Priority to be of interest. Please note that this will be the final issue in newsletter format, as soon our group will be providing future insights through a new Absolute Priority blog, in addition to this In The (Red) blog. Stay tuned for more details. 

Business Bankruptcy Issues Recent Developments

Ninth Circuit Opens The Door To Recharacterization Of Debt As Equity

In bankruptcy, prepetition loans made by insiders are often investigated, and sometimes challenged, by debtors, creditors’ committees, or trustees. The two most frequent challenges brought are that (1) the loans in question are not really debt and should be recharacterized as equity, and (2) the debt should be equitably subordinated below the claims of all or some other creditors. Recharacterization focuses on the intent of the parties (e.g., did the parties intend for the debt to be repaid or treated like equity) and the characteristics of the alleged debt instrument. Equitable subordination, on the other hand, generally requires, among other facts, a showing of inequitable conduct on the insider’s part. A successful challenge on either basis usually means the insider receives nothing on its claim since most debtors cannot pay all creditors in full. 

The Ninth Circuit BAP Had Rejected Recharacterization Claims. For the past 27 years, although recharacterization challenges have been advanced in cases elsewhere around the country, lower courts in the Ninth Circuit have largely rejected them. Instead, they have tended to follow the holding of a 1986 decision by the Ninth Circuit Bankruptcy Appellate Panel, In re Pacific Express, Inc., 69 B.R. 112 (B.A.P. 9th Cir. 1986), which shut the door on recharacterization claims.

  • In Pacific Express, the Bankruptcy Appellate Panel held that the characterization of claims as equity or debt was governed exclusively by equitable subordination principles under Section 510(c) of the Bankruptcy Code.
  • This meant that no separate challenge based only on recharacterization of debt as equity could be pursued. 

The Ninth Circuit Opens The Door.  With a decision issued last week by the U.S. Court of Appeals for the Ninth Circuit, made at the Circuit level and not by the lower BAP court, those days are over. In its April 30, 2013 opinion in In the Matter of: Fitness Holdings Int’l, the Ninth Circuit held that recharacterization and equitable subordination address distinct concerns, and a recharacterization challenge separate from equitable subordination is permissible. (Follow the link in the prior sentence to read the opinion.) The Fitness Holdings court stated that recharacterization determines whether there is a claim to be paid at all while equitable subordination considers whether an allowed claim should be subordinated to other claims. The Ninth Circuit held that the Pacific Express court erred in holding that the characterization of claims as equity or debt is governed solely by Bankruptcy Code Section 510(c).

  • The case arose in the context of a fraudulent transfer claim originally brought on behalf of the bankruptcy estate by the creditors’ committee. The committee alleged that the debtor’s pre-bankruptcy repayment of a loan made by its sole shareholder was a constructively fraudulent transfer, a transfer made at a time when the debtor was insolvent or otherwise financially impaired and for which it did not receive "reasonably equivalent value."
  • Normally, repayment of a loan provides a debtor with reasonably equivalent value because it discharges an equal amount of debt owed by the debtor. However, the complaint sought to recharacterize the loan itself as an equity interest.  If recharacterized, the repayment would be treated as a distribution to equity for which the debtor received no value in return. 
  • In a footnote, the Ninth Circuit also called out the district court for erroneously holding that it, an Article III court, was bound by a decision of the Bankruptcy Appellate Panel.

State Law Applies To Recharacterization Claims. Having opened the door, the Ninth Circuit then determined how recharacterization claims should be considered. Specifically, the Court ruled that bankruptcy courts should look to state law to determine whether a challenged debt claim should be characterized as debt or equity. The Ninth Circuit followed the Fifth Circuit’s decision in In re Lothian Oil Inc., 650 F.3d 539 (5th Cir. 2011), which applied state law, rejecting the approach used in the Third and Sixth Circuits, which have developed their own set of factors based on a bankruptcy court’s general equitable authority under Section 105(a) of the Bankruptcy Code. This widened a split among the circuits but the Ninth Circuit held that Supreme Court authority, including Travelers Cas. & Sur. Co. of Am. v. Pac. Gas & Elec. Co., 549 U.S. 443 (2007), requires state law to govern the substance of claims and, as a result, also the characterization of a claim as debt or equity. (Read this prior post for more information on the Travelers case.)  In Fitness Holdings, the Ninth Circuit did not reach the issue of whether the loan should actually be recharacterized, instead sending the case back to the lower courts for further proceedings.

Conclusion. The Fitness Holdings decision aligns the Ninth Circuit with most other courts around the country in permitting a claim to be challenged on grounds that it should be recharacterized as equity instead of a true debt. Although the case arose in the context of a fraudulent transfer claim, the holding that recharacterization claims may be made separately from equitable subordination claims seems likely to be applied outside of that context. That said, a recharacterization claim is not easy to establish, and not every insider loan will be susceptible to such a challenge. Also, recharacterization claims have not typically been brought in state court. It remains to be seen how application of state law, as opposed to the well-developed factors used by bankruptcy courts in other circuits, will impact the viability of recharacterization claims. Nevertheless, given Fitness Holdings, recharacterization is now an issue that major shareholders and other insiders, as well as debtors, creditors’ committees, and trustees, will need to keep in mind in bankruptcy cases in the Ninth Circuit.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Summer 2012 Edition Of Bankruptcy Resource Now Available

The Summer 2012 edition of the Absolute Priority newsletter, published by the Bankruptcy & Restructuring group at Cooley LLP, of which I am a member, has now been released. The newsletter gives updates on current developments and trends in the bankruptcy and workout area. Follow the links in this sentence to access a copy of the newsletter. You can also subscribe to the blog to learn when future editions of the Absolute Priority newsletter are published, as well as to get updates on other bankruptcy and insolvency topics.

The latest edition of Absolute Priority covers a range of cutting edge topics, including:

  • Decisions from courts in Delaware and California interpreting the Supreme Court’s 2011 Stern v. Marshall decision and its impact on the ability of bankruptcy courts to enter final judgments in fraudulent transfer and other cases;
  • The Section 546(e) defense to fraudulent transfer claims; and
  • Issues involving the recharacterization of a non-insider’s loans as equity.

This edition also reports on some of our recent representations, including our work for official committees of unsecured creditors in Chapter 11 cases involving major retailers and others. Recent committee cases include Ritz Camera & Image, Blockbuster, Orchard Brands, Wave 2 Wave Communications, Signature Styles, Urban Brands, and Mervyn’s Holdings, among others.

I hope you find the latest edition of Absolute Priority to be of interest.

Business Bankruptcy Issues Recent Developments

Winter 2012 Edition Of Bankruptcy Resource Now Available

The Winter 2012 edition of the Absolute Priority newsletter, published by the Bankruptcy & Restructuring group at Cooley LLP, of which I am a member, has recently been released. The newsletter gives updates on current developments and trends in the bankruptcy and workout area. Follow the links in this sentence to access a copy of the newsletter. You can also subscribe to the blog to learn when future editions of the Absolute Priority newsletter are published, as well as to get updates on other bankruptcy and insolvency topics.

The latest edition of Absolute Priority covers a range of cutting edge topics, including:

  • The Supreme Court’s recent Stern v. Marshall decision and its impact on the ability of bankruptcy courts to enter final judgments in certain cases;
  • Recent decisions on the ability of secured creditors to credit bid their debt in bankruptcy asset sales;
  • Issues involving the recharacterization of debt as equity; and
  • The ability of directors and officers to obtain coverage under a D&O liability policy purchased by a bankrupt company.

This edition also reports on some of our recent representations, including our work for official committees of unsecured creditors in Chapter 11 cases involving major retailers and others. Recent committee cases include Blockbuster, Orchard Brands, Alexander Gallo Holdings, Claim Jumper, Signature Styles, Urban Brands, and Mervyn’s Holdings, among others.

I hope you find the latest edition of Absolute Priority to be of interest.

Business Bankruptcy Issues The Financially Troubled Company

Second Liens And Recharacterization: Is More Litigation Around The Corner?

In many Chapter 11 bankruptcy cases, unsecured creditors investigate whether a basis exists to recharacterize existing secured debt as equity. The reason? A successful challenge can turn first or second lien secured debt into "back-of-the-line" capital contributions, enabling unsecured creditors to realize a much greater recovery. A recent article by two of my Bankruptcy & Restructuring Group colleagues at Cooley Godward Kronish LLP, Ronald R. Sussman and Michael A. Klein, digs deeper into the complex issues behind these claims.

Appearing in the October 2008 edition of The Journal of Corporate Renewal published by the Turnaround Management Association, the article is entitled "Recharacterization Battles Likely in Next Round of Bankruptcies." You can access a copy of the article, reprinted with permission of The Journal of Corporate Renewal (© 2008, The Journal of Corporate Renewal), by clicking on its title in the prior sentence. It first discusses the concept of recharacterization itself, including the key factors courts typically apply. Next, the article compares recharacterization to the doctrine of equitable subordination under Section 510(c) of the Bankruptcy Code and examines some of the key differences between the two.

After setting the stage, the article then looks ahead to what appears to be a coming wave of bankruptcy cases. It focuses on how future efforts by unsecured creditors to challenge second lien loans — a type of financing that has become a major part of corporate capital structures over the past several years — may fare:

The next wave of bankruptcies undoubtedly will include attempts by unsecured creditors to recharacterize second lien debt as equity, especially when the second lien holder is an insider of the debtor. However, the current framework established by Bankruptcy Courts presents significant obstacles to unsecured creditors seeking to knock out the second lien claims of lenders that provided capital on a purportedly secured basis to a struggling debtor that was unable to find capital from alternative sources.

The article observes that, given the present state of the law, courts will have to embrace a more flexible legal standard if unsecured creditors are to have success in recharacterizing second lien debt as equity. It concludes by offering a different approach for addressing recharacterization with this new landscape in mind. Unsecured creditors, lenders, insolvency professionals and others confronting these issues will find the article to be a helpful and interesting read.