Even if former Lehman Brothers employees had valid claims for breaches of contract resulting from contingent awards of worthless common stock, those claims, like their claims for the securities themselves, are subordinated under Section 510(b), the Second Circuit held in an opinion on May 4.
For part of their compensation, some Lehman employees were awarded the right to participate in an incentive plan where they were granted the right to own Lehman common stock after a five-year holding period. In the meantime, they had voting rights, with dividends paid by issuance of additional stock.
Employing the legal principles set forth in a decision by the bankruptcy court in New York in a similar dispute involving Enron Corp., Bankruptcy Judge Shelley C. Chapman in Manhattan ruled that the claims filed by Lehman workers based on their contingent stock awards must be subordinated under Section 510(b) and, alternatively, that the contingent stock awards were equity securities entitling them only to file proofs of interest, not proofs of claim.
Judge Chapman was upheld last year by District Judge Richard J. Sullivan in Manhattan, prompting some of the workers to appeal to the Second Circuit.
Writing for the court of appeals, Circuit Judge Robert D. Sack said that some of the workers might have claims for breach of contract that would be “analytically distinct from equity interests,” even if the employees could only file proofs of interest based on the contingent stock rights themselves. He therefore analyzed whether the bona fide claims – as distinct from claims based on the securities themselves – nonetheless fell under Section 510(b), which subordinates “a claim arising from . . . a purchase or sale of a security . . . [or] for damages arising from the purchase or sale of such a security . . . .”
Citing a law review article by then-professor, now-Senator Elizabeth Warren, Judge Sack said that “Section 510(b) safeguards the absolute priority rule” and therefore must be interpreted “broadly.” For a claim to fall under that section, he said there are three conditions: (1) The rights must be securities, (2) that were acquired in a purchase, and (3) resulted in damages arising from that purchase.
On the first issue, Judge Sack said that the workers’ contingent stock rights did not fall neatly within any of the 14 enumerated examples of securities in Section 101(49). Because the list is not exclusive since the definition employs the word “includes,” he relied on the “residual clause” in Section 101(49)(A)(xiv) to conclude that the rights were securities because they “resemble other securities specifically enumerated in subsection (A).” He therefore said that the stock rights were securities because they “bear the hallmarks of interests commonly known as securities.”
Interpreting the notion of a purchase “broadly,” Judge Sack held that the second condition was met because the workers received stock in exchange for labor.
On the third condition, Judge Sack said the claims arose from the purchase of securities because “they would not have arisen but for” the workers’ agreement to take the contingent stock rights as “part of their compensation.”
Judge Sack said the workers had no independent claims for restitution because they suffered no “actual injury” when the stock became worthless with Lehman’s bankruptcy. The complete loss of value, he said, defeats “their breach of contract claims and, thus, their right to restitution.”
Having decided that the employee’s claims are subordinated, Judge Sack found no reason to decide, like the two lower courts, whether the contingent stock rights amounted to securities barring the employees from asserting claims on par with the defunct broker’s creditors.