[1]In the latest installment of the Lehman Brothers subordination litigation, the U.S. Bankruptcy Court for the Southern District of New York held that certain creditors’ claims were not claims for damages arising from “securities of the debtor,” and did not have to be subordinated to claims of creditors, notwithstanding that the debtor was treated as an issuer, for regulatory purposes, as an issuer of the mortgage-backed securities.[2]
Facts
"Between May 2006 and November 2007, Federal Home Loan Bank of Pittsburgh (FHLB) purchased mortgaged-backed securities (MBS) claims associated with six different nondebtor trusts, each reflecting unpaid principal balances and a coupon rate, and each representing the right to a share of certain cash flows by the residential mortgage loans owned by each trust."[3] "FHLB claimed that monetary damages from the debtors stemming from alleged material misrepresentations in the registrations statements and related offering documents prepared and distributed by the debtors in connection with the debtors’ marketing of the MBS were all in violation of numerous securities laws."[4]
The debtors assert that the MBS purchased by FHLB were securities “of the debtor” as used in § 510(b) of the Bankruptcy Code, and as a result, the MBS claims filed by FHLB should be subordinated to the debtors’ unsecured creditors pursuant to § 510(b).[5] The debtors argue that because the debtor’s Structured Asset Securities Corp. (SASCO), as a depositor of the MBS, is considered the “issuer” of the MBS under federal securities laws, the MBS must be securities of the debtors and therefore arise from the purchase or sale of securities of the debtors or their affiliates and § 510(b) mandates their subordination.[6] FHLB disagreed, asserting that the MBS did not provide FHLB with an ownership interest in any of the debtors or a right to payment by any of the debtors.[7] Rather, FHLB argued that nondebtor trusts issued the MBS and were set for the sole purpose of holding title to a pool of underlying residential mortgages backing the MBS, the MBS certificates that FHLB purchased represented rights to a certain portion of cash flows that were generated by the mortgage loans, which were the only source of payment on the MBS certificates.[8]
Analysis
Section 510(b) provides that “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 a security, or for reimbursement or contribution allowed under section 502 on account of such claim, shall be subordinated to all claims or interests that are senior to or equal [to] the claim or interests that are senior to or equal [to] 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.”[9] The bankruptcy court found that while the MBS are debt securities, they are not securities “’of the debtor or of an affiliate of the debtor’” as such a term is utilized in § 510(b).[10] "The debt obligations under the MBS represent claims to the cash flows from the pools of mortgage loans wherein the risk underlying the MBS obligations is tied to the wherewithal of the borrowers on the loans in the pools of the mortgages, not of the debtors."[11]
The MBS holders receive a stream of payments from the borrowers who owe principal and interest on the mortgage loans in the collateral pool, but not from any stream of payments from the debtor.[12] Payments in the certificates of the cash flow of the collateral did not come from any business or assets of the debtors. The relationship between the debtors and FHLB with respect to the FHLB and the MBS is not one of a traditional debt securityholder and the company borrower to which it looks for payment on its debt claim.[13] As a result, while the product that was sold happens to be a financial product and a security under the federal securities laws, its unique characteristics and lack of relationship to the debtors’ capital structure led the court to conclude that the MBS should not be considered a security “of” the debtor as such term is used in § 510(b).[14]
Takeways
The Lehman court shows that in order to subordinate a claim, such claims have to have a connection to the capital structure of the debtor, not a third party.
[1] None of the statements contained in this article constitute the official policy of any judge, court, agency or government official or quasi-governmental agency.
[2] In re Lehman Brothers Inc., 513 B.R. 624 (Bankr. S.D.N.Y. 2014).
[3] Id. at 626.
[4] Id.
[5] Id.
[6] Id.
[7] Id.
[8] Id.
[9] Id. at 628-629 (quoting 11 U.S.C. § 510(b)).
[10] Id. at 631.
[11] Id.
[12] Id.
[13] Id.
[14] Id.