Even after being reduced to judgment and secured by a lien, a claim arising in part from the purchase or sale of securities will be subordinated under Section 510(b), the Ninth Circuit Bankruptcy Appellate Panel held on March 21.
Expanding on its own decision nine years ago, which was upheld in the Ninth Circuit, the BAP also ruled that the creditor’s lien was subordinated, not just the claim. See Pensco Tr. Co. v. Tristar Esperanza Props., LLC (In re Tristar Esperanza Props., LLC), 488 B.R. 394 (B.A.P. 9th Cir. 2013), aff’d., 782 F.3d 492, 495 (9th Cir. 2015).
The holdings are important for lawyers effecting corporate divorces.
The BAP opinion by Bankruptcy Judge Gary A. Spraker teaches that contracts should apportion the consideration in a corporate divorce between value derived from the business and other claims that one former owner might have against the other. Why? Because, the entire claim arising from the divorce will be subrogated in bankruptcy, unless the contract specifies the value related to claims other than the value of the business.
The Messy Divorce
Two individuals had been business partners for years. We shall refer to one as the seller and the other as the buyer.
When the relationship fell apart, they sued and countersued. The outcome was a settlement where the seller transferred his interest in the businesses to the buyer in return for four payments in future years totaling some $49 million. The agreement did not apportion any part of the payments between the value of the businesses and other claims that the seller had, such as breach of contract, fraud or embezzlement. The buyer and the businesses were both liable for the $49 million.
The settlement agreement gave the seller a security interest in the businesses to secure the payments. There was also a provision barring the buyer from taking distributions from the businesses that would prevent payment of the installments.
The buyer defaulted. Eventually, the seller won a jury verdict for more than $24 million. The verdict became a judgment that the seller recorded as a lien against property of the buyer and his businesses, which had been found to be alter egos.
The buyer and his businesses filed chapter 11 petitions that were converted to chapter 7. The debtors had assets of some $13 million and secured claims of $95 million, including the seller’s secured claim, which had risen to $35 million with interest.
The trustee moved to subordinate the seller’s claims and lien. “For the purpose of distribution under this title,” Section 510(b) says that
a claim . . . for damages arising from the purchase or sale of [a security of the debtor or of an affiliate of the debtor] . . . shall be subordinated to all claims or interests that are senior to or equal the claim or interest represented by such security, except that if such security is common stock, such claim has the same priority as common stock.
On summary judgment, Bankruptcy Judge Erithe A. Smith subordinated the claims and the lien. To no avail, the seller appealed to the BAP.
Subordination Interpreted Broadly
Citing Tristar and other authorities, Judge Spraker said that the Ninth Circuit “broadly interprets the scope” of Section 510(b). He added, “the Ninth Circuit has held that a claim ‘arises from’ the purchase or sale of securities whenever it shares a ‘nexus or causal relationship.’”
Judge Spraker saw “no material difference” between Tristar and the case on appeal. In Tristar, the creditor had obtained a judgment arising from the sale of a membership interest in a business. In the buyer’s bankruptcy, the Ninth Circuit rejected the idea, Judge Spraker said, “that § 510(b) did not apply because the claim had been reduced to judgment and was a debt as of the petition date.” Tristar, supra, 782 F.3d at 495-97.
Because the seller had a claim arising from the sale of securities, Judge Spraker held that the claim was subordinated, just like Tristar.
But no, the buyer said. The claim resulted in part from the buyer’s violation of the provision in the settlement agreement precluding him from receiving distributions from the businesses.
Judge Spraker rejected the argument, saying that the breach “shares a direct causal link with the conveyance of his equity interests.”
Next, the seller argued that some of the value accorded to the settlement arose from claims other than the sale of the businesses.
Judge Spraker responded by saying there was nothing in the settlement agreement to apportion the price between the sale of the businesses and other claims. Furthermore, he said that “California law . . . simply does not permit apportionment of cash consideration within a contract when the contract itself does not provide some basis or means for attributing consideration between the various items or services for which it was given.”
Were he to apportion the sale price, Judge Spraker said he “would impermissibly read into the mandatory language of § 510(b) a requirement that the claim ‘solely’ arise from the purchase or sale of securities.”
Judge Spraker likewise upheld subordination of the lien. He cited the Supreme Court for holding that “claim” includes a mortgage lien. See Johnson v. Home State Bank, 501 U.S. 78, 83-84 (1991). He said that subordination of the claim “necessarily encompasses the entirety of [the seller’s] ‘right to payment.’”
But wait, the seller said. Liens ride through chapter 7, and the lien was not avoided.
Judge Spraker said that the lien was not extinguished, just subordinated. If the assets were sufficient to pay all other creditors in full, the seller’s lien would kick in.
The seller made several other creative arguments, all of which Judge Spraker rejected.
Even after being reduced to judgment and secured by a lien, a claim arising in part from the purchase or sale of securities will be subordinated under Section 510(b), the Ninth Circuit Bankruptcy Appellate Panel held on March 21.
Expanding on its own decision nine years ago, which was upheld in the Ninth Circuit, the BAP also ruled that the creditor’s lien was subordinated, not just the claim. See Pensco Tr. Co. v. Tristar Esperanza Props., LLC (In re Tristar Esperanza Props., LLC), 488 B.R. 394 (B.A.P. 9th Cir. 2013), aff’d., 782 F.3d 492, 495 (9th Cir. 2015).
The holdings are important for lawyers effecting corporate divorces.
The BAP opinion by Bankruptcy Judge Gary A. Spraker teaches that contracts should apportion the consideration in a corporate divorce between value derived from the business and other claims that one former owner might have against the other. Why? Because, the entire claim arising from the divorce will be subrogated in bankruptcy, unless the contract specifies the value related to claims other than the value of the business.