Co-underwriters with Lehman Brothers Inc. do not have contribution claims against the liquidated investment bank arising from offerings in which the Lehman broker was the lead underwriter in the sale of its parent’s securities, according to a Dec. 14 decision in the Second Circuit upholding two lower courts.
The appeals court decision, by Circuit Judge Dennis Jacobs, revolved around an interpretation of Section 510(b), which subordinates claims based on the purchase or sale of securities to the same level as the securities themselves. Lehman presented a twist on the typical case because the co-underwriters were raising claims against the Lehman broker that was not the issuer of the securities.
Bankruptcy Judge James M. Peck ruled in January that hedge fund managers and underwriters in substance do not have claims to be paid in the Lehman brokerage liquidation under the Securities Investor Protection Act. Judge Peck’s opinion was upheld in September 2015 by District Judge Shira A. Scheindlin in Manhattan. Judge Jacobs’ opinion for the appeals court adopted Judge Scheindlin’s rationale.
The underwriters filed contribution claims against the Lehman broker as lead underwriter, claiming that the bankrupt brokerage was liable to them for its share of the costs of defense and settlements after being sued for misstatements when the Lehman parent sold its securities. One underwriter claimed $78 million, while another sought $250 million.
The underwriters argued that Section 510(b) did not apply because the securities were sold by the Lehman parent, not by the Lehman brokerage itself. Judge Jacobs rejected the underwriters’ narrow reading of the statute. The circuit’s opinion is based on both the rules of statutory construction and legislative history.
Judge Jacobs held that “claims arising from securities of a debtor’s affiliate should be subordinated in the debtor’s bankruptcy proceeding to all claims or interests senior or equal to claims in the bankruptcy proceeding that are of the same type as the underlying securities.”
In the affiliate context, the underwriters unsuccessfully contended that Section 510(b) is invoked only if the affiliated companies are substantively consolidated or if one affiliate guaranteed payment of another’s obligation. Judge Jacobs saw no “textual hook” for a narrow reading of the statute.
The Lehman decision shows how a law review article can be pivotal more than 40 years after publication. In discerning congressional intent, Judge Jacobs relied heavily on a 1973 article by Profs. Homer Kripke and John Slain advocating for the “risk-allocation rationale” that was eventually adopted in Section 510(b).
Quoting the circuit’s 2006 Enron decision, Judge Jacobs said that the rationale behind Section 510(b) prevents “disappointed shareholders from recovering their investment losses by using fraud and other securities law claims to bootstrap their way to parity with general unsecured creditors.” He added that every lower court to confront the affiliate-securities issue reached the same result.
When affiliates have differing capital structures, Judge Jacobs said it could be “messy” to figure out where the subordinated claims should lodge in the distribution waterfall. Since the bankruptcy court is a court of equity, and bankruptcy judges have experience in deciding how to classify claims, Judge Jacobs said that bankruptcy courts are “best situated” to pigeonhole subordinated claims into distribution schemes. In the Lehman case, he said, it won’t much matter because unsecured creditors, whose claims have priority over the underwriters’ subordinated claims, will consume the entire unsecured estate.