The Broad but Underused Subordination Under § 510(b)

Section 510(b) of the Bankruptcy Code expressly subordinates claims arising from the purchase or sale of a security in the debtor or an affiliate to the level of equity. It thus functions as a form of recharacterization. Despite its broad scope, § 510(b) is relatively underused, making it a potentially powerful tool for creative debtors, committees and trustees.

Section 510(b) Plain Language

Sandwiched between the enforceability of subordination agreements in § 510(a) and equitable subordination in § 510(c), § 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 [11 USCS § 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.[1]

The plain language is quite broad: “a claim arising from rescission of a purchase or a sale of a security.” This language is in fact broader than the primary policy behind § 510(b), which is to properly allocate risk between investors and creditors.[2] Simply put, the policy is that equity cannot improve its position in the bankruptcy distribution scheme.

How Broad?         

“Security” is defined in § 101(49) to include notes, stock, bonds, certificates of deposit, interests in limited partnerships, and any “other claim or interest commonly known as a security.”[3] The definition of “security” is not exclusive and arguably should include securities as defined under the Securities Act of 1933, which generally includes “a transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”[4] Thus, § 510(b) potentially reaches transactions far beyond the garden-variety claims disgruntled stockholders may assert. For example, a holder of a promissory note should beware when asserting a fraud claim. Such a claim may be subordinated under § 510(b) even without recharacterization because a note may be a “security.”

Examples of the more obvious claims covered by § 510(b) are investors’ claims for fraud in the sale of securities, claims that the investor retained securities as the result of fraud,[5] settlement agreements resulting from pre-petition claims for fraud in the sale of securities,[6] and a claim that an issuer breached an agreement to use best efforts to register its stock,[7] among others. These claims are relatively easy to see as arising from the purchase of securities and fitting the purpose of the statute.

The phrase “arising from” in § 510(b) broadens the reach of the statute to claims that do not arise exclusively from the sale of securities, meaning that while the purchase of the security is essential for invoking § 510(b), the circumstance of the claim may not have much to do with the purchase of the securities. For example, indemnification claims of officers and directors and underwriters of insurance that covered the illegal issuance of securities have been subordinated under § 510(b).[8] These claims do not arise from the claimant’s purchase of securities and arguably would not result in equity improving its position, since the claimants were not shareholders, but they nonetheless could be found to “arise from “a purchase or sale of a security.”

Another non-garden variety example of a claim subject to subordination under § 510(b) is found in In re Peregrine Systems.[9] In that case, following a merger between two corporations, the former shareholder of the non-surviving corporation received stock in the surviving entity and an employment contract and was required to sign a noncompete agreement.[10] The claims arising from the merger agreement, including breach of the employment agreement, were subordinated under § 510(b).[11] Yet another example is the subordination of the judgment of a former member of a limited liability company for his mandatory payment on withdrawal.[12] More sophisticated securities have tended to escape subordination under § 510(b), generally by resorting to the purpose of the statute,[13] but the risk for subordination still exists.

How Does It Work?

Under § 510(b), a subordinated claim has a priority lower than the class of claims or interests from which the claim arises. A subordinated claim that does not arise from common stock — e.g., a claim relating to a subordinated corporate debt security — is relatively easy to value and prioritize. Thus, a bondholder’s fraud claim would not be a general unsecured claim, but would be subordinated to the class of the claims that includes the bond. If the estate were solvent, the allowed subordinated claim would be paid. If the claim arises from common stock, however, it is unclear how to value the resulting subordinated claim. Assuming a solvent estate where equity is not canceled, no case addresses whether the claimant gets no more than the number of shares giving rise to the claim, or the number of shares calculated by dividing the dollar value of the damages claim by the value of equity to be distributed under the proposed plan. The former appears to be more in keeping with the purpose of the statute.

Subordination under § 510(b) appears to be mandatory, rather than permissive, as the statute provides that claims “shall be subordinated.” Also, subordination under § 510(b) applies solely to distribution. Subordination should not apply prior to distribution, meaning the holder of a claim subject to subordination retains whatever pre-distribution rights under the Code the holder may have.

Conclusion

Relatively few cases apply § 510(b) other than securities fraud actions, leaving fertile ground for argument in other circumstances. For example, the statute might apply to the non-compete agreement or the “consulting contract” that is part of the typical sale of a small business. In other cases, forward-looking plaintiffs’ counsel may be advised to attempt to plead around the potential effect of § 510(b) if possible, and in all events to warn their clients that a victory on the securities fraud claim may turn pyrrhic. Creative parties and counsel will find opportunities to use § 510(b) in novel ways for companies small and large.