Second Circuit Revisits Mandatory Subordination Under Section 510(b)

The most straightforward application of section 510(b) is in the case of a shareholder fraud claim. Suppose a group of claimants are defrauded into purchasing stock of a company. The fraud is later uncovered and the company files for bankruptcy protection. Unsecured creditors are projected to receive less than full recoveries and shareholders, nothing. The defrauded shareholders have obtained judgments against the bankruptcy estate for rescission on account of the fraud. Under the Bankruptcy Code, these judgments are “claims.” Absent section 510(b), these defrauded shareholders would have general unsecured claims on the same priority level as other creditors such as trade creditors and ordinary unsecured noteholders.

Section 510(b), however, subordinates these claims to the other claims. It may, at first glance, not seem fair. Why should these defrauded shareholders be treated worse than ordinary claimants? The answer is that these shareholders bargained to be treated as investors. When they purchased the stock, they were investing in the company, with the expectation of a return on their investment consummate with the performance of the company. Ordinary creditors make no such bargain. They, generally, bargain only for repayment of principal and interest. The drafters of the Bankruptcy Code included section 510(b) in recognition that it would have been unfair to dilute the claims of ordinary creditors with creditors who bargained for the benefits and risks of shareholders. In re Granite Partners, L.P., 208 B.R. 332 (Bankr. S.D.N.Y. 1997) and In re Geneva Steel Co., 281 F.3d 1173 (2002) each provide examples of section 510(b) subordination in the fraud claim context. These two cases also make clear that the statute also applies to a fraudulent maintenance claim for post-investment fraud and not merely to fraudulent inducement claims.

Over time, a series of circuit-level court decisions applied section 510(b) subordination to breach of contract claims as well. In In re Betacom of Phoenix, Inc., 240 F.3d 823 (9th Cir. 2001), the debtor failed to close a merger agreement that provided that, as acquirer, the debtor would transfer certain of its shares to the target's shareholders. The claimants/target shareholders filed claims for the breach and the debtor sought subordination. The claimants argued that the statute applied only to fraud claims, that section 510(b) was inapplicable because they never enjoyed the rights of stock ownership and because, since the merger agreement never closed, there was no actual sale or purchase of securities triggering the statute. Id. at 828.

The Ninth Circuit disagreed. Citing prior lower court decisions including Granite, the Ninth Circuit cautioned against an overly restrictive interpretation of section 510(b). Citing Granite, the court looked to the legislative history of the statute, which makes clear that Congress “relied heavily” on a 1973 article by two law professors in crafting Section 510(b). Id. at 829, citing H. Rep. 95-595 at 195 (1977), Slain & Kripke, The Interface Between Securities Regulation and Bankruptcy-Allocating Risk of Illegal Securities Issuance Between Securityholders and the Issuer's Creditors, 48 N.Y.U. L. Rev. 261 (1973). The Slain & Kripke article asserted that “the dissimilar expectations of investors and creditors should be taken into account in setting a standard for mandatory subordination. Shareholders expect to take more risk than creditors in return for the right to participate in firm profits. The creditor only expects repayment of a fixed debt. It is unfair to shift all of the risk to the creditor class since the creditors extend credit in reliance on the cushion of investment provided by the shareholders.” Id. In Betacom, because the claimants had the expectation of shareholders, section 510(b) applied.

The Third Circuit applied the same rationale as Betacom, but went a little further in In re Telegroup, Inc., 281 F.3d 133 (3d Cir. 2002). The stock was delivered, but the debtor breached the underlying stock purchase agreement's requirement that, as issuer, it use its best efforts to register its stock and ensure that it's freely tradable. The Third Circuit found “arising from” ambiguous. Looking at the statute's legislative history, it held that the post-transfer breach of its registration obligations fell within the meaning of the statute and its legislative history. As in Betacom, the claimant bargained to be treated as a shareholder, holding that subordination under section 510(b) is appropriate where there is “some nexus or causal relationship between the claim and the purchase of securities.”

The Second Circuit followed Betacom in In re Med Diversified, Inc., 461 F.3d 251 (2d Cir. 2006). The court held that breach of an employee termination agreement that provided for the transfer of stock as severance was subject to subordination. The Second Circuit found “arising from” ambiguous in statutory text and examined the legislative history, focusing on the Slain & Kripke article. The Second Circuit reduced the interpretation to require subordination if the claimant “(1) took on the risk and return expectations of a shareholder, rather than a creditor, or (2) seeks to recover a contribution to the equity pool presumably relied upon by creditors in deciding whether to extend credit to the debtor.” Because the claimant took on the risk and expectations of a shareholder, its claim was subject to subordination. Med Diversified also cited the Enron opinion decided months earlier by the bankruptcy court for the Southern District of New York. In Enron, the debtor's employees brought fraudulent inducement claims for damages related to the acceptance of stock options over cash and fraudulent maintenance claims for their decision not to exercise when vested. The bankruptcy court subordinated these claims under section 510(b). See In re Enron Corp., 341 B.R. 141 (Bankr. S.D.N.Y. 2006). The Second Circuit opined again in In re Marketxt Holdings Corp., 346 Fed. Appx. 744 (2d Cir. 2009), where it held that “a finding that subordination furthers either the risk-expectations or equity pool rationale is sufficient for a court to require” subordination.” Id. at 746 (state court judgment for damages arising from purchase or sale of security requires mandatory subordination).

In contrast, in 2007, the Ninth Circuit declined to apply section 510(b) in In re American Wagering, Inc., 493 F.3d 1067. In American Wagering, the debtor had breached a consulting contract to provide 4% of the monetary value of an IPO, but not stock itself. Years prior to the bankruptcy, the claim was reduced to a money judgment. The court distinguished Betacom because in this case, compensation “was to be valued on the basis of the debtors' share price upon completion of the IPO, the contract did not provide for that compensation in the form of shares. His
potential to earn greater profits as a shareholder did not exist.” Id. at 1072-73 (emphasis in original). The court also found it of note that from the outset of the dispute, the claimant sought to reduce its claim to a money judgment and never attempted to recover stock. Similarly, in In re Nations Rent, Inc., 381 B.R. 83 (Bankr. D. Del. 2008) claimants received notes and tangential make-whole claims in exchange for their interests in entities that the debtor acquired. The make whole payments due were tied to the value of the debtors' common stock on a date certain. The bankruptcy court was persuaded that the make-whole amounts were not damages arising from fraud or the issuance of stock, but rather “claims to recover payment due under agreements of sale of businesses.” Id. at 92. Instead, these amounts “exist to provide the [claimants] with their bargained for sales price. [These amounts] are deferred compensation with a formula which serves as a damage buffer.” See also In re Motels of America, Inc., 146 B.R. 542 (Bankr. D. Del. 1992) (contractual claim of former employee to put stock to debtor not subject to section 510(b) subordination as former employee contracted away shareholder rights).

CIT Group Inc. v. Tyco Int'l. Ltd.

The facts of CIT result from a complex divestment. Tyco International Ltd. (Tyco) sought to divest itself of its equity in CIT Nevada, held indirectly through a holding company, TCH. Prior to divestment, TCH had incurred net operating losses totaling approximately $794 million. This divesture was done in three steps: 1) a merger of CIT Nevada and TCH; 2) a merger of the newly combined entity with a Delaware corporation, which created “new CIT”; and 3) an initial public offering of new CIT stock. Post-IPO, Tyco ceased to be a shareholder of CIT (as new). The parties entered into a series of agreements to effectuate the merger, including a Tax Agreement. Among other things, pursuant to the Tax Agreement, CIT agreed to make a formula-based payment to Tyco tied to the tax benefit received by CIT, plus interest. Tyco claimed approximately $190 million of benefits due and various breaches of the Tax Agreement.

CIT sought to subordinate Tyco's claim. It argued that, following Telegroup, there was a causal connection between the claim under the tax agreement and the underlying securities agreement to require subordination. It argued that section 510(b) subordination was appropriate because “the Tyco Claim arises directly from the sale of CIT's shares through the IPO because it asserts damages for the purported breach of one of the principal contracts executed in connection with the sale of shares.” Id at 9. While the bankruptcy court agreed there was a nexus between the Tax Agreement and the IPO, it declined to find such a “mere connection” supports that a claim “arises from” the purchase or sale of a security. The Court also rejected that the Tax Agreement was “so integral a part of the IPO as to be a part of the securities offering itself ' .”

The court held that the Tax Agreement, while arguably integral, was not a mere supplement. It distinguished In re Int'l Wireless Comm. Holdings, Inc., 257 B.R. 739 (Bankr. D. Del. 2001) (subordinating claim for breach of a supplement to a share purchase agreement which required the issuer to conduct an IPO by a date certain). Rather, the bankruptcy court was persuaded that Tyco's expectations were that of a creditor. Following NationsRent, it held that merely because the value was variable, didn't mean that the creditor bargained to become a shareholder. It did “not include an interest in the firm's future equity value or management.” The court also found ample authority that a former shareholder can divest itself of a debtor's shares in exchange for a contractual payment obligation without being subject to section 510(b).

By summary order dated Sept. 6, 2012, the Second Circuit affirmed “substantially for the reasons stated in its thoughtful and comprehensive December 21,2011 Memorandum of Opinion,” determining CIT's arguments “meritless.”

Conclusion

CIT further clarifies that just because a claim arises from or in connection with a transaction containing an equity component does not mean that the specific claim is subject to subordination. Before bringing potentially costly subordination litigation, bankruptcy practitioners should understand that even where a claim is rooted in an equity transaction or contains an equity component, if the specific claim at issue carries traditional debt expectations and not the “risk and return expectations” of equity, a court may decline to subordinate.

Bankruptcy practitioners should also advise their corporate colleagues of the potential subordination risks in equity transactions containing debt components and vice versa. Where possible in complex transactions, drafters should clearly delineate what pieces constitute debt and how that debt is to be repaid (in cash or equity), especially where the debt is linked to the stock price or is issued in connection with a restructuring, as in CIT.

Adam H. Friedman is a member of this newsletter's Board of Editors and a partner in the Business Restructuring and Bankruptcy Department of Olshan Frome Wolosky LLP in New York. Jonathan T. Koevary is an associate of the firm, in the same department. They may be reached at [email protected] and [email protected], respectively.

For the third time in six years, the Second Circuit visited mandatory subordination of claims under Title 11 of the United States Code (the Bankruptcy Code). In CIT Grp. Inc. v. Tyco Int'l. Ltd., No. 12-1692-bk, the Second Circuit affirmed a bankruptcy court decision holding that claims arising under a tax-sharing agreement entered into as part of stock divestment restructuring was not subject to mandatory subordination under section 510(b) of the Bankruptcy Code. In this article, we discuss the history of mandatory subordination and the current state of the law.

History

Bankruptcy Code section 510(b) provides in pertinent part that: “a claim arising from rescission of a purchase or sale of a security of the debtor ' for damages arising from the purchase or sale of such a security ' shall be subordinated to all claims or interests that are senior to or equal the claim or interest represented by such security.” 11 U.S.C. ' 510(b). In short, the provision ensures that those who bargained to be treated as investors do not find themselves elevated to the priority status of creditors should a claim arise on account of their investments. The provision is about expectations: If a party expected to be treated as a shareholder, the provision ensures that the party will be treated as a shareholder, even though it has a claim of a creditor.

The most straightforward application of section 510(b) is in the case of a shareholder fraud claim. Suppose a group of claimants are defrauded into purchasing stock of a company. The fraud is later uncovered and the company files for bankruptcy protection. Unsecured creditors are projected to receive less than full recoveries and shareholders, nothing. The defrauded shareholders have obtained judgments against the bankruptcy estate for rescission on account of the fraud. Under the Bankruptcy Code, these judgments are “claims.” Absent section 510(b), these defrauded shareholders would have general unsecured claims on the same priority level as other creditors such as trade creditors and ordinary unsecured noteholders.

Section 510(b), however, subordinates these claims to the other claims. It may, at first glance, not seem fair. Why should these defrauded shareholders be treated worse than ordinary claimants? The answer is that these shareholders bargained to be treated as investors. When they purchased the stock, they were investing in the company, with the expectation of a return on their investment consummate with the performance of the company. Ordinary creditors make no such bargain. They, generally, bargain only for repayment of principal and interest. The drafters of the Bankruptcy Code included section 510(b) in recognition that it would have been unfair to dilute the claims of ordinary creditors with creditors who bargained for the benefits and risks of shareholders. In re Granite Partners, L.P., 208 B.R. 332 (Bankr. S.D.N.Y. 1997) and In re Geneva Steel Co., 281 F.3d 1173 (2002) each provide examples of section 510(b) subordination in the fraud claim context. These two cases also make clear that the statute also applies to a fraudulent maintenance claim for post-investment fraud and not merely to fraudulent inducement claims.

Over time, a series of circuit-level court decisions applied section 510(b) subordination to breach of contract claims as well. In In re Betacom of Phoenix, Inc., 240 F.3d 823 (9th Cir. 2001), the debtor failed to close a merger agreement that provided that, as acquirer, the debtor would transfer certain of its shares to the target's shareholders. The claimants/target shareholders filed claims for the breach and the debtor sought subordination. The claimants argued that the statute applied only to fraud claims, that section 510(b) was inapplicable because they never enjoyed the rights of stock ownership and because, since the merger agreement never closed, there was no actual sale or purchase of securities triggering the statute. Id. at 828.

The Ninth Circuit disagreed. Citing prior lower court decisions including Granite, the Ninth Circuit cautioned against an overly restrictive interpretation of section 510(b). Citing Granite, the court looked to the legislative history of the statute, which makes clear that Congress “relied heavily” on a 1973 article by two law professors in crafting Section 510(b). Id. at 829, citing H. Rep. 95-595 at 195 (1977), Slain & Kripke, The Interface Between Securities Regulation and Bankruptcy-Allocating Risk of Illegal Securities Issuance Between Securityholders and the Issuer's Creditors, 48 N.Y.U. L. Rev. 261 (1973). The Slain & Kripke article asserted that “the dissimilar expectations of investors and creditors should be taken into account in setting a standard for mandatory subordination. Shareholders expect to take more risk than creditors in return for the right to participate in firm profits. The creditor only expects repayment of a fixed debt. It is unfair to shift all of the risk to the creditor class since the creditors extend credit in reliance on the cushion of investment provided by the shareholders.” Id. In Betacom, because the claimants had the expectation of shareholders, section 510(b) applied.

The Third Circuit applied the same rationale as Betacom, but went a little further in In re Telegroup, Inc., 281 F.3d 133 (3d Cir. 2002). The stock was delivered, but the debtor breached the underlying stock purchase agreement's requirement that, as issuer, it use its best efforts to register its stock and ensure that it's freely tradable. The Third Circuit found “arising from” ambiguous. Looking at the statute's legislative history, it held that the post-transfer breach of its registration obligations fell within the meaning of the statute and its legislative history. As in Betacom, the claimant bargained to be treated as a shareholder, holding that subordination under section 510(b) is appropriate where there is “some nexus or causal relationship between the claim and the purchase of securities.”

The Second Circuit followed Betacom in In re Med Diversified, Inc., 461 F.3d 251 (2d Cir. 2006). The court held that breach of an employee termination agreement that provided for the transfer of stock as severance was subject to subordination. The Second Circuit found “arising from” ambiguous in statutory text and examined the legislative history, focusing on the Slain & Kripke article. The Second Circuit reduced the interpretation to require subordination if the claimant “(1) took on the risk and return expectations of a shareholder, rather than a creditor, or (2) seeks to recover a contribution to the equity pool presumably relied upon by creditors in deciding whether to extend credit to the debtor.” Because the claimant took on the risk and expectations of a shareholder, its claim was subject to subordination. Med Diversified also cited the Enron opinion decided months earlier by the bankruptcy court for the Southern District of New York. In Enron, the debtor's employees brought fraudulent inducement claims for damages related to the acceptance of stock options over cash and fraudulent maintenance claims for their decision not to exercise when vested. The bankruptcy court subordinated these claims under section 510(b). See In re Enron Corp., 341 B.R. 141 (Bankr. S.D.N.Y. 2006). The Second Circuit opined again in In re Marketxt Holdings Corp., 346 Fed. Appx. 744 (2d Cir. 2009), where it held that “a finding that subordination furthers either the risk-expectations or equity pool rationale is sufficient for a court to require” subordination.” Id. at 746 (state court judgment for damages arising from purchase or sale of security requires mandatory subordination).

In contrast, in 2007, the Ninth Circuit declined to apply section 510(b) in In re American Wagering, Inc., 493 F.3d 1067. In American Wagering, the debtor had breached a consulting contract to provide 4% of the monetary value of an IPO, but not stock itself. Years prior to the bankruptcy, the claim was reduced to a money judgment. The court distinguished Betacom because in this case, compensation “was to be valued on the basis of the debtors' share price upon completion of the IPO, the contract did not provide for that compensation in the form of shares. His
potential to earn greater profits as a shareholder did not exist.” Id. at 1072-73 (emphasis in original). The court also found it of note that from the outset of the dispute, the claimant sought to reduce its claim to a money judgment and never attempted to recover stock. Similarly, in In re Nations Rent, Inc., 381 B.R. 83 (Bankr. D. Del. 2008) claimants received notes and tangential make-whole claims in exchange for their interests in entities that the debtor acquired. The make whole payments due were tied to the value of the debtors' common stock on a date certain. The bankruptcy court was persuaded that the make-whole amounts were not damages arising from fraud or the issuance of stock, but rather “claims to recover payment due under agreements of sale of businesses.” Id. at 92. Instead, these amounts “exist to provide the [claimants] with their bargained for sales price. [These amounts] are deferred compensation with a formula which serves as a damage buffer.” See also In re Motels of America, Inc., 146 B.R. 542 (Bankr. D. Del. 1992) (contractual claim of former employee to put stock to debtor not subject to section 510(b) subordination as former employee contracted away shareholder rights).

CIT Group Inc. v. Tyco Int'l. Ltd.

The facts of CIT result from a complex divestment. Tyco International Ltd. (Tyco) sought to divest itself of its equity in CIT Nevada, held indirectly through a holding company, TCH. Prior to divestment, TCH had incurred net operating losses totaling approximately $794 million. This divesture was done in three steps: 1) a merger of CIT Nevada and TCH; 2) a merger of the newly combined entity with a Delaware corporation, which created “new CIT”; and 3) an initial public offering of new CIT stock. Post-IPO, Tyco ceased to be a shareholder of CIT (as new). The parties entered into a series of agreements to effectuate the merger, including a Tax Agreement. Among other things, pursuant to the Tax Agreement, CIT agreed to make a formula-based payment to Tyco tied to the tax benefit received by CIT, plus interest. Tyco claimed approximately $190 million of benefits due and various breaches of the Tax Agreement.

CIT sought to subordinate Tyco's claim. It argued that, following Telegroup, there was a causal connection between the claim under the tax agreement and the underlying securities agreement to require subordination. It argued that section 510(b) subordination was appropriate because “the Tyco Claim arises directly from the sale of CIT's shares through the IPO because it asserts damages for the purported breach of one of the principal contracts executed in connection with the sale of shares.” Id at 9. While the bankruptcy court agreed there was a nexus between the Tax Agreement and the IPO, it declined to find such a “mere connection” supports that a claim “arises from” the purchase or sale of a security. The Court also rejected that the Tax Agreement was “so integral a part of the IPO as to be a part of the securities offering itself ' .”

The court held that the Tax Agreement, while arguably integral, was not a mere supplement. It distinguished In re Int'l Wireless Comm. Holdings, Inc., 257 B.R. 739 (Bankr. D. Del. 2001) (subordinating claim for breach of a supplement to a share purchase agreement which required the issuer to conduct an IPO by a date certain). Rather, the bankruptcy court was persuaded that Tyco's expectations were that of a creditor. Following NationsRent, it held that merely because the value was variable, didn't mean that the creditor bargained to become a shareholder. It did “not include an interest in the firm's future equity value or management.” The court also found ample authority that a former shareholder can divest itself of a debtor's shares in exchange for a contractual payment obligation without being subject to section 510(b).

By summary order dated Sept. 6, 2012, the Second Circuit affirmed “substantially for the reasons stated in its thoughtful and comprehensive December 21,2011 Memorandum of Opinion,” determining CIT's arguments “meritless.”

Conclusion

CIT further clarifies that just because a claim arises from or in connection with a transaction containing an equity component does not mean that the specific claim is subject to subordination. Before bringing potentially costly subordination litigation, bankruptcy practitioners should understand that even where a claim is rooted in an equity transaction or contains an equity component, if the specific claim at issue carries traditional debt expectations and not the “risk and return expectations” of equity, a court may decline to subordinate.

Bankruptcy practitioners should also advise their corporate colleagues of the potential subordination risks in equity transactions containing debt components and vice versa. Where possible in complex transactions, drafters should clearly delineate what pieces constitute debt and how that debt is to be repaid (in cash or equity), especially where the debt is linked to the stock price or is issued in connection with a restructuring, as in CIT.

Adam H. Friedman is a member of this newsletter's Board of Editors and a partner in the Business Restructuring and Bankruptcy Department of Olshan Frome Wolosky LLP in New York. Jonathan T. Koevary is an associate of the firm, in the same department. They may be reached at [email protected] and [email protected], respectively.