A split decision from the Ninth Circuit on automatic subordination of a securities claim under Section 510(b) shows once again how hard cases can make bad law. The majority’s sympathy for a defrauded investor may have influenced the appeals court to elevate a claim related to securities to the status of an unsecured claim.
A man was given 6 million shares in a small company in 2001 in return for unreimbursed expenses and compensation. After he left the company in 2009 as the result of a stroke, two other founders caused the company to cancel the stock. Raising claims for conversion and fraud, the man sued the two co-founders and won a judgment in state court that he should recover damages and that his stock should be reinstated.
Following more hearings, the state court concluded that reinstating the stock would lead to further, endless litigation. Deciding that the plaintiff should instead receive the value of the stock, the state court awarded him damages of almost $4 million for conversion, based on the value of the stock in 2009.
The two co-founders filed chapter 13 petitions and moved to subordinate the $4 million claim under Section 510(b). The bankruptcy court ruled that the claim was not subject to subordination and was upheld by the Bankruptcy Appellate Panel, but on different grounds: The BAP held that Section 510(b) did not apply in an individual’s debtor case.
The two debtors appealed and lost again 2/1 in the Ninth Circuit, with the majority’s opinion written by Circuit Judge Ferdinand F. Fernandez.
Judge Fernandez held that the claim was not the type for applying automatic subordination. He could not affirm on the ground relied upon by the BAP because the Ninth Circuit, in the meantime, had handed down Liquidating Trust Committee of the Del Baggio Liquidating Trust v. Freeman (In re Del Baggio), holding that Section 510(b) does apply in individuals’ cases. To read ABI’s discussion of Del Baggio, click here.
Section 510(b) automatically subordinates “a claim arising from rescission of a purchase or sale of a security of the debtor or of an affiliate of the debtor [or] for damages arising from the purchase of such a security.”
Assuming that the two debtors were “affiliates” of the company they each partially owned, Judge Fernandez said that Section 510(b) did not apply because the “claims did not arise out of a purchase or sale of securities,” but from the debtors’ “actions many years later (2009) when they fraudulently converted” the stock.
The damages, Judge Fernandez said, “were not remotely related to the purchase; they were simply a judgment measured by the value of the converted property when the conversion took place.”
Although the Ninth Circuit had subordinated claims in other cases where there was “no actual purchase or sale,” Judge Fernandez said that those cases “arose from a purchase or sale transaction.” While “arising from” calls for a “broad interpretation,” he said that Section 510(b) “stops short of encompassing every transaction that touches on or involves stock.”
Judge Fernandez best explained the result when he said that the claim “did not arise out of the purchase of the securities and the risks that the purchase might entail. It arose out of the Debtors’ conversion of the securities many years later.”
Circuit Judge Johnnie B. Rawlinson dissented, saying that the “claim did arise from the purchase or sale of a security under Section 510(b).” She said that the later conversion of the stock “did not erase the fact” that the claim “arose from his previous purchase of securities.”
Quoting from Del Baggio, she said subordination is proper “‘where there exists some nexus or causal relationship between the claim and the purchase of the securities.”
For both the majority and the dissent, the bulk of the opinions are devoted to justifying the result in comparison with prior Ninth Circuit decisions on Section 510(b). The opinions show that Section 510(b) would profit from having a bright-line test. Someone should write a definitive law review article.