Two recent decisions (one from the Ninth Circuit Court of Appeals and one from the bankruptcy court in Delaware) have refined the issue of the scope of the mandatory subordination of Bankruptcy Code §510(b). Section 510(b) provides for subordination for any claims "arising from rescission of a purchaser or sale of a security of the debtor or an affiliate of the debtor, for damages arising from the purchase or sale of such security, or for reimbursement or contribution allowed under §502 on account of such claim..."

Such claims (commonly thought of as encompassing securities fraud claims) are treated on an equal basis with the security from which such claim arose. That is, if a party had a securities fraud claim relating to the purchase or sale of common stock, those damages would not be entitled to be treated as a general unsecured claim, but rather would be treated on the same level as common stock. The same for preferred stock. The subordination is not discretionary; all such claims must be subordinated.

The pair of decisions from the Ninth Circuit and Delaware bankruptcy courts refine, and further define, the extent of the mandatory subordination of Bankruptcy Code §510(b), and these decisions will be heralded by unsecured creditors as keeping these types of claims from diluting the ranks of the unsecured creditors.

The Ninth Circuit case of American Broadcasting Systems Inc. v. Nugent, 240 F.3d 823 (9th Cir. 2001), and the Bankruptcy Court for the District of Delaware decision in In re International Wireless Communications Holdings Inc., 257 B.R. 739 (Bankr. D. Del. 2001), both examined §510(b) and were called upon to apply the section to facts outside of the standard securities fraud action context.

The American Broadcasting decision involved an interesting issue. That case involved a large claim by a creditor who was originally a shareholder of a corporation (Betacom Inc.), which merged with American Broadcasting Systems (ABS), a company owning and operating numerous radio stations. As part of the merger, the Betacom shareholder was to receive shares of stock in ABS. ABS was essentially a "roll-up" of numerous small radio stations with the idea that, after ABS had acquired a sufficient number of stations nationwide, it would go public. For a number of convoluted reasons (including litigation), the Betacom shareholders never received the delivery of the certificates for the ABS stock that were promised to them as consideration for the merger, although they already transferred their Betacom stock to ABS. These ABS shares were being held in escrow, and were still held in escrow at the time that ABS had to file its chapter 11 bankruptcy petition after failing to consummate an IPO.

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[T]he Ninth Circuit reasoned that shareholders bargained for substantially more risk than creditors, and that it would be inherently unfair to dilute creditor claims...

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The trouble began prior to the filing. In 1992, the shareholders brought an action against ABS for breach of the merger agreement. The shares in ABS allotted to the former Betacom shareholders were being held in escrow. While that lawsuit was pending, ABS filed a chapter 11 bankruptcy petition. The disgruntled former Betacom shareholders filed a large claim based on the breached merger agreement.

ABS sought to use Bankruptcy Code §510(b) to subordinate all of the claims brought by the shareholders. The bankruptcy court ruled in favor of the debtors and subordinated the shareholder claims. The district court, however, reversed and held that in order for §510(b) to apply, an actual purchase or sale of stock is required. The district court reasoned that because the merger agreement had never been fully consummated (since the shares in ABS had never been delivered to the shareholders), it was uncertain as to whether or not a purchase or sale of securities had actually taken place. Accordingly, the provisions of Bankruptcy Code §510(b) did not apply.

The Ninth Circuit reversed the district court and expressly rejected each of the shareholders' attempts to avoid the implications of §510(b). The Ninth Circuit concluded that mandatory subordination is not limited to securities fraud claims, and instead relied on the concept that the "cushion of investment [is] provided by the shareholders." Specifically, the Ninth Circuit reasoned that shareholders bargained for substantially more risk than creditors, and that it would be inherently unfair to dilute creditor claims when those creditors relied on an "equity cushion" that invested capital gives to a business enterprise when extending credit.¹ The Ninth Circuit then went on to state that Bankruptcy Code §510(b) does not require physical possession of stock certificates by the claimant because "[n]othing in §510(b)'s text requires a subordinated claimant to be a shareholder." As part of the convoluted facts of this particular dispute, the Ninth Circuit did note that, coincidentally, it was the shareholders who were to blame for not actually being in physical possession of the ABS stock certificates because they refused to sign the deed of release that was required in order for the escrow agent to distribute the shares in ABS to those shareholders. That notwithstanding, the Ninth Circuit determined that the shareholders were experienced business people who traded their stock in Betacom for a chance at greater earnings in the multi-station ABS, and as such assumed the risk that ABS's public offering could fail, thereby resulting in a bankruptcy filing by ABS.

Finally, the Ninth Circuit noted that the main legislative rationales for the mandatory subordination under §510(b) are (i) there are material different risk and return expectations of creditors and equity-holders that should be recognized in bankruptcy cases, and (ii) in dealing with a business entity, creditors can justifiably rely on the "equity cushion" of invested capital when they extend credit. The Ninth Circuit stated that because an equity investor invests with expectations of possible unlimited financial return (that is, presumably, before the hi-tech bubble burst), it is immaterial whether the stockholder actually receives share certificates. The Ninth Circuit did seem to suggest, however, that it interpreted the facts of the ABS case as a situation in which creditors may have actually relied on the "equity contribution" in extending credit. It is unclear from the facts of that case what record there was in the lower court of creditor expectation or reliance.

The Delaware bankruptcy court's decision in International Wireless involved yet another broken promise to make an investor rich through an IPO. In that case, International Wireless Communications Holdings (IWCH) was the parent holding company for International Wireless Communications Pakistan (subsidiary). IWCH and the subsidiary entered into a series of agreements with Continental Communications Limited (CCL) in which (a) CCL transferred to the subsidiary approximately 8 million shares that CCL held in another corporation in exchange for $10 million in cash and 500,000 shares of IWCH; (b) IWCH and CCL agreed that IWCH would consummate an initial public offering of its stock within 18 months of the transaction, thereby enabling CCL to have a public market to sell the stock it was holding in IWCH; and (c) if IWCH failed to consummate the IPO, CCL had rights to obtain additional shares in IWCH for every year that the IPO consummation was delayed, or conversely CCL could file a registration statement and sell the IWCH shares it owned. In any event, the agreement provided a guarantee by IWCH to CCL that CCL would receive not less than approximately $6.1 million through the sale of the shares of IWCH that CCL held (and if CCL was unable to obtain that amount of money from the shares it held, IWCH would issue CCL more shares to make up any deficiency).

Yet another victim of the hi-tech bubble burst, IWCH and its subsidiaries filed chapter 11 petitions in Delaware prior to the end of the 18-month period. CCL (or more specifically, CCL's successor) filed a claim in the amount of the $6.1 million based on the guaranteed investment return. The debtors filed a motion to subordinate that claim under Bankruptcy Code §510(b).

CCL argued that its claim did not arise from a stock purchase or sale because the claim did not arise upon the purchase of the IWCH securities, but rather as a damage claim for IWCH's failure to consummate the planned IPO. The bankruptcy court disagreed and held that CCL's breach of contract claim clearly related back to the original execution of the agreements, and that CCL's damages were directly based on its inability to sell the IWCH stock (which in turn was causally linked to the manner in which it obtained the stock). Moreover, the bankruptcy court flatly rejected CCL's assertion that its claim was outside the scope of Bankruptcy Code §510(b) because CCL fashioned the claim as a breach-of-contract claim and not a fraud claim. The Delaware bankruptcy court reasoned that (a) §510(b) has no express language that limits its scope to fraud claims, and (b) if CCL's arguments were accepted, shareholders would always avoid §510(b) by simply framing their claims as breach of contract and not fraud. The Delaware bankruptcy court held that, no matter how you slice it, CCL's claim was for damage that was related to the purchase of the IWCH stock. Stockholders bargained for a different risk than creditors. The court further distinguished two cases cited by CCL in which creditors had surrendered stock for debt, and noted that in those cases the debt claims were clearly outside the reach of §510(b) because the shareholders had surrendered all the risks and benefits of equity ownership.

Read together, these two decisions broadened the scope of §510(b) in that (1) they explicitly reject the minority decisions that have held that §510(b) is limited to securities fraud claims, and (2) the mandatory subordination provisions of §510(b) extend to essentially all claims of parties that bargain for the risks and rewards of equity ownership, regardless of how those claims are framed.

So get to the back of the line, shareholders—and stay there!

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Footnotes

¹ This theory is a bit odd. Stock is not always sold for cash—sometimes it's given for services rendered, as compensation for officers, etc. The whole concept of an "equity cushion" in a business created by equity securities transactions seems simplistic. Return to article