Overruling a decision by its own Bankruptcy Appellate Panel, the Ninth Circuit held that the subordination provisions in Section 510(b) apply when the debtor is an individual, even though an individual obviously cannot issue stock in himself.
The Aug. 22 decision by Circuit Judge Diarmuid F. O’Scannlain embraced an opinion from December by the Second Circuit in the liquidation of the Lehman Brothers Inc. brokerage. In that opinion, the Manhattan appeals court held that subordination in Section 510(b) applies to claims arising from securities of a debtor’s affiliate. To read ABI’s discussion of Lehman, click here.
The Ninth Circuit case arose from the sale of a professional hockey team. One of the purchasers alleged that another in the buyout group committed fraud by misrepresenting his ability to inject $40 million in equity and pay some of the cost of debt financing.
It turned out that the other group member was embezzling from his clients. He defaulted on his obligations to the newly purchased hockey club, filed bankruptcy himself, and is now in prison.
The innocent purchaser filed a $38 million claim in the embezzler’s bankruptcy, representing his investment, a subordinated loan he made to the hockey club, and the money he spent as the result of a capital call by the team.
The liquidating trust for creditors objected to the claim, contending it should be subordinated under Section 510(b), which subordinates a claim “arising from” the purchase of a security “of the debtor or of an affiliate of the debtor.” The claim is subordinated to all claims “that are senior to or equal the claim or interest represented by such security.”
On summary judgment, the bankruptcy court subordinated the claim. The district court affirmed.
In holding that Section 510(b) does not apply when the debtor is an individual, the Ninth Circuit B.A.P. held in In re Kahn in 2014 that the statute is ambiguous. Judge O’Scannlain disagreed. He said the claim “clearly” arose from the sale of securities in the hockey team. “Nothing in Section 510(b) requires that the debtor be the seller of the securities at issue,” he said.
The B.A.P. in Kahn believed that subordination did not apply because an investor cannot have an expectation of profit in an individual. Judge O’Scannlain answered by saying that the statute’s inclusion of “an affiliate of the debtor” means that subordination is not limited to “damage claims related to a debtor’s own securities.”
The creditor assumed more risk by bargaining on a profit if the hockey club were successful. The debtor’s other creditors, Judge O’Scannlain said, “made no such gamble.” Not invoking subordination would give the creditor the “best of both worlds,” he said, by allowing the creditor to profit if the venture were successful and to hold a claim if it failed.
Even if subordination were invoked, the creditor contended he should be subordinated only to other claims related to the hockey club. Judge O’Scannlain relied on Lehman to provide one of several theories leading to the conclusion that claims are subordinated “notwithstanding varying priority schemes.”
Under “any legitimate reading of Section 510(b),” the investor’s claims were “rightly subordinate” to the debtor’s general unsecured creditor claims, he held.