The Very Long Arms of Bankruptcy Code Section 510(b)

Background

Bankruptcy Code section 510(b) provides for mandatory subordination of, among other things, claims arising from rescission of, or damages arising from, the purchase or sale of a security of a debtor. Security is defined in the bankruptcy code to include a long list of instruments including stock and a catchall -- “other claim or interest commonly known as ‘security’.” The section thus has three elements, damages, purchase or sale and security. Each of these elements raises issues that are subject to courts’ decisions in a variety of factual scenarios. But our discussion here is focused on the curious case of Linn Energy.

Facts

The underlying facts of Linn Energy are far too complicated to address in detail. In a nutshell, the claimant was entitled to certain dividend distributions made by a successor to the debtor to a trust, in which the claimant held a type of trust interest. In addition, the claimant owned certain percentage of the company stock. Later on, the company merged, and to settle a related dispute, which involved retiring the shares, the merged company agreed to continue to pay the beneficiary payment equaling the dividends he would have been entitled to, had the shares not retired. These were not dividends, but “deemed dividends.” Next, the company engaged with a share-for-share exchange with Linn Energy and to induce the claimant to approve the transaction, Linn Energy agreed to assume the deemed dividends arrangement.

But, after the closing, Linn Energy stopped making the payments and brought an action to declare it owed the claimant nothing. The claimant counterclaimed for breach of contract and related causes of action. As the saga’s last chapter, Linn Energy filed for bankruptcy, the (estate of the now deceased) claimant filed a claim and the debtors moved to subordinate it under section 510(b). The bankruptcy court subordinated the claim to the level of equity and the claimant appealed.

The Fifth Circuit’s Ruling

The Fifth Circuit affirmed: “Because we conclude the deemed dividends gave the [claimant] benefits normally reserved for equity investors, we conclude subordination of all of the [claimant’s] claims was appropriate.”

Damages

The Court noted that the claimant did not deny seeking damages within the meaning of the term in the bankruptcy code, although it was surprised that he did not argue that he was seeking only “the simple recovery of an unpaid debt.” Here, the Court hints at the fact the meaning of the term damages in section 510(b) is quite possibly distinguished for a claim for a breach of contract.

Was the Claim Based on a Security?

The claimant argued that the right to receive deemed dividends does not qualify as a security. The debtors argued, and the Court agreed, that the right fell with the catchall portion of the term -“other claim or interest commonly known as ‘security’.” That is because, his risk profile was the same as an equityholder -he risked getting nothing if there were no dividends made, but his upside was theoretically limitless. Thus, he faced the same risks as a traditional shareholder. The Court recognized that he did not have a right to vote or participate in management, but noted that these are not rights that shareholders universally have.

Does the Claim Arise from Purchase or Sale of a Security?

Following prior case law, the Court recognized that the “arise from” element is given a broad reading and requires some nexus or causal relationship from the claim and the sale. Here, the Court traced the origins of the claim for deemed dividends to the various transactions involving the securities of Linn Energy’s predecessors. In addition, the policies underlying section 510(b) justified subordination because the “arise from” element is less important than whether the interest the claimant is asserting is more like a creditor’s or investor’s interest. Here, the Court concluded, the claimant’s interest “was certainly more like an investor’s interest than a creditor’s interest.”

Final Thoughts

Section 510(b) was designed to protect the equity cushion that creditors rely on when extending credit and to uphold the absolute priority rule. In concept, this sounds simple. But how far can this principle go? In Linn Energy, it was used to subordinate a claim based on a contractual obligation dating back forty years. It is doubtful that creditors who extended credit to Linn Energy and its predecessors really relied on the claimant’s interest as equity. The statutes of limitation on almost every criminal offense would have expired, but subordination apparently lives forever (at least in the Fifth Circuit).

Read the opinion >>