Long-standing precedent in the First Circuit had held that claims arising out of stock redemptions, including notes payable to the former shareholders as the consideration for the redemption of their stock, were subject to subordination to the claims of creditors when the corporation later became insolvent without any showing of inequitable conduct on the part of the shareholders. See Matthews Bros. v. Pullen, 268 F. 827 (1st Cir. 1920); Keith v. Kilmer (In re Nat’l Piano Co.), 261 F. 733 (1st Cir. 1919). In a recent decision, the First Circuit, finding that intervening Supreme Court rulings were contrary, reversed that precedent to the extent it created no-fault subordination of such claims as a class. Merrimac Paper Co., Inc. v. Harrison (In re Merrimac Paper Co., Inc.), No. 05-1010 (1st Cir., August 25, 2005).
According to the Merrimac Paper court, the prior line of authority “derives from the general precept that stockholders may not receive any of the assets of an insolvent corporation until the corporation’s creditors are paid in full.” Id., slip op. at p. 13. Keith and Matthews Bros. were based on the idea that stockholders should not be able to subvert that precept “by structuring hastily engineered stock redemption agreements as a means of substituting debt for equity (and, thus, sharing company assets ratably with creditors).” Id. However, the court found that the Supreme Court’s opinions in Noland and Reorganized CF&I Fabricators of Utah had discouraged subordination of claims based merely on the status of such claims, without more: “These two cases make it transparently clear that the bankruptcy court erred in subordinating both the secured and unsecured portions of the appellant’s claim. The appellant has a non-priority claim based on the Note, but—just as in CF&I—the bankruptcy court’s decision to subordinate the claim was not premised on the specific facts of the case but, rather, on the taxonomic status of the claim.” Id. at 18-19.
However, the court found generally sound the basic principle of Keith and Matthews Bros., i.e. “that equity holders should not be able to artificially evade the debt-over-equity paradigm.” Id. at 20. However, that principle could not be used to subordinate all claims arising out of all redemptions; the court must consider whether subordinating a particular claim would be fair based on the totality of circumstances in the individual case. Id. Thus, if the facts showed a “hastily engineered” redemption in order to elevate endangered equity to debt status, the court, on the facts, could still subordinate the claim.