WHEN WILL MY CLAIM BE SUBJECT TO MANDATORY SUBORDINATION IN BANKRUPTCY

THE SET UP.
You are approached by a friend to invest in a nice limited liability company. Your friend tells you that you can buy 15% of the membership interest for $100,000.00. You think what a bargain and you accept the deal. A few months later and after finally reviewing the books of the company, you realize that the investment is not for you and you offer up your membership interest to the company and the company agrees to repurchase your interest. The problem is that your valuation of your interest is much higher than the company is willing to pay. That was the situation for Jane O’Donnell when she bought a 15% membership interest in Tristar Esperanza Properties, LLC (“Tristar”). Ms. O’Donnell pursued arbitration and won and then obtained a state court judgment for over $415,000.00. That was the good news. The bad news was that soon after getting the judgment, Tristar filed for bankruptcy.

THE PROBLEM.
Ms. O’Donnell filed a claim based on the state court judgment and expected to be paid the same percentage as all other unsecured creditors. The problem arose from a little discussed provision of the Bankruptcy Code, 11 U.S.C. 510(b), that provides:
“(b) For the purpose of distribution under this title, a claim arising from rescission of a purchase or sale of a security of the debtor or of an affiliate of the debtor, for damages arising from the purchase or sale of such a security, or for reimbursement or contribution allowed under section 502 [11 USCS § 502] on account of such a claim, 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.” Unlike 11 U.S.C. §510(c), equitable subordination, subordination under 11 U.S.C. 510(b) provides for mandatory subordination of any claim that “arising from the purchase or sale” of a security. As you will see from this posting, the Bankruptcy and appellate courts have taken a very broad view of what is a security and what “arising from the purchase or sale” means.

THE END RESULTS.
After several lower courts found that Ms. O’Donnell’s claim should be treated under 11 U.S.C. §510(b) as subordinated to all unsecured claims, the Court of Appeals for the 9th Circuit in Pensco Tr. Co. v. Tristar Esperanza Props. LLC (In re Tristar Esperanza Props., LLC), 782 F.3d 492 (9th Cir. 2015), also found against Ms. O’Donnell while clarifying a number of questions that arise from the application of the mandatory subordination under 11 U.S.C. §510(b).

WHY DID MS. O’DONNELL CARE?
Before discussing the case, why was Ms. O’Donnell fighting so hard not to be subordinated to unsecured creditors? The answer is simple, in either a chapter 7 or chapter 11 bankruptcy, the unsecured creditors get paid in full before anything is paid to the shareholders or members of the debtor company. Being subordinated to the unsecured creditors made it almost impossible for Ms. O’Donnell to receive any payment on her claim in the Tristar bankruptcy case.

THE REASON MS. O’DONNELL LOST.
The 9th Circuit first decides that a membership interest in a limited liability company is a “security of the debtor”. This issue was not disputed by either Tristar or Ms. O’Donnell. This puts Ms. O’Donnell’s claim clearly under the microscope of 11 U.S.C. §510(b). However, Ms. O’Donnell argued that her claim was not for damages arising from the sale of securities, but for a fixed debt as decided by the arbitrator and the state court. The 9th Circuit held that:
“It [11 U.S.C. §510(b)] extends beyond the securities fraud claims that the House of Representatives explicitly discussed in its report, Inre Betacom of Phx., Inc., 240 F.3d 823, 829 (9th Cir. 2001) (citing H.R. Rep. No. 95-595, at 195 (1977)), and reaches even ordinary breach of contract claims so long as there is a sufficient nexus between the claim and the purchase of securities, In re Am. Wagering, Inc., 493 F.3d 1067, 1072 (9th Cir. 2007)” Tristar at 495.

The 9th Circuit found that such a nexus existed with Ms. O’Donnell’s claim. The 9th circuit also discounted Ms. O’Donnell’s argument that she never sought damages in the arbitration but just a valuation of the membership interest, as well as, Ms. O’Donnell’s argument that she had converted her membership interest into a debt prior to the filing of the bankruptcy by having her claim reduced to judgment. The 9th Circuit does cite several Delaware Bankruptcy Cases and a case from the Bankruptcy Appellate Panel in the 9th Circuit that do hold that the status of a claim on the date of filing governs and based on those decisions Ms. O’Donnell might have prevailed on her theories, but the Court then goes on to reject those cases and holds that the debt arose from an equity interest and is therefor subordinated under 11 U.S.C. §510(b). The 9th Circuit states:
“The primary weakness in O’Donnell’s argument is that, in her attempt to effectuate her vision of congressional intent, she overlooks the statutory text. Section 510(b) does not ask what the claim is, but what it arises from. We have long interpreted “arises from” broadly, and not as the “snapshot in time” that O’Donnell urges” Tristar at 497.Ms. O’Donnell’s claim is relegated by the Court to a status below unsecured creditors’ claims in order of payment.

CASE OF LOCAL INTEREST.
In an interesting local decision involving 11 U.S.C. §510(b) and a claim arising out of contract to purchase subordinated secured notes that was not consummated before the filing of bankruptcy Judge Robson of the Bankruptcy Court for the Southern District of Florida, in a thorough discussion of the application and history of 11 U.S.C. §510(b), held:
“There is a nexus between the LOI, the breach of the LOI and the purchase of the Notes (a “security”). Accordingly, mandatory subordination pursuant to 11 U.S.C. § 510(b) is appropriate. The question then becomes: to what level of claim is the MezzCap claim to be subordinated? The plain language of the 510(b) provides that the MezzCap claim is to 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.” Although the claim was filed by MezzCap as a general unsecured claim, it is actually a claim arising out of an aborted contract to purchase secured debt securities. The status of the MezzCap claim is thus properly subordinated to all secured debt claims against the Debtor, which renders the MezzCap claim (assuming it is ultimately allowed) equal in priority to a general unsecured claim.” In re Patriot Aviation Servs., 396 B.R. 780, 789 (Bankr. S.D. Fla. 2008)

This case illustrates the nuances of applying 11 U.S.C. §510(b) to complex corporate transactions. Also it reinforces that fact that, at least in the Southern District of Florida, the Bankruptcy Court will take the broad view of 11 U.S.C. §510(b) as applying to almost any transaction that could be characterized as “arising from the purchase of securities.”


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