The Bottom Line
The Second Circuit affirmed the bankruptcy and district courts’ decisions subordinating claims asserted against the Debtor by holders of restricted stock units. However, while the court agreed with the lower courts that the claims must be subordinated under section 510(b) of the Bankruptcy Code, the court did not agree that all of the claims must also be disallowed as equity interests. The decision provides a thoughtful analysis of what constitutes an equity interest versus a claim, although the conclusion was to subordinate the claims to general unsecured creditors anyway.

What Happened?
In In re Lehman Brothers Holdings Inc., 2017 WL 1718438 (2d Cir. May 4, 2017), the Debtor’s former employees filed proofs of claim seeking cash payments equivalent to amounts previously paid to them in the form of restricted stock units (RSUs) as part of their compensation. The RSUs were contingent rights to own shares of the Debtor’s common stock that would vest after five years. During the five-year holding period, the shares of common stock were held in a trust for the benefit of RSU holders.

The documents governing the RSUs required the Debtor only to deliver the stock and expressly provided that the Debtor was not obligated to pay any cash in respect of the RSUs. The documents also contained subordination provisions, which dictated that RSU claims asserted against the Debtor in bankruptcy should be subordinated under section 510(b) of the Bankruptcy Code and should be afforded the same priority as equity interests. Finally, the trust agreement provided that all assets held in the trust (including shares of common stock) were subject to the claims of general creditors in bankruptcy.

Each of the RSU holders who filed claims held RSUs that had not yet been converted into common stock when the Debtor filed its chapter 11 petition. The Debtor filed objections to the RSU claims, seeking to disallow the claims as equity interests or, alternatively, to subordinate the claims to those of general unsecured creditors.

The Bankruptcy Court for the Southern District of New York sustained the Debtors’ objections to the RSU claims on the grounds that the claims must be disallowed as equity interests and, alternatively, found that, as claims, they must be subordinated under section 510(b). On appeal, the District Court for the Southern District of New York affirmed the decision on both grounds.

While the Second Circuit agreed with the lower courts’ findings that the RSU claims must be subordinated under section 510(b), it did not agree that all of the RSU claims should be disallowed and characterized as equity interests. Citing In re USA Commercial Mortg. Co., 377 B.R. 608, 615 (B.A.P. 9th Cir. 2007), the court opined that a proof of claim can only be disallowed as an equity interest if it is duplicative of an interest in an equity security. It follows, the court explained, that if the holder of an equity interest asserts a claim based on a fraud or breach of contract that occurred in connection with its purchase of the equity interest, such claim is distinct from the claimant’s underlying equity interest and thus could not be reclassified as an equity interest. Here, the court found that some of the RSU holders’ claims allege that the Debtor breached a contractual obligation by failing to pay them cash on account of RSUs that did not vest. These claims, the court concluded, are not “duplicative” of equity interests the RSUs may have represented and therefore would not be disallowed even if the underlying RSUs were deemed equity securities. In essence, these were independent claims albeit based upon the RSUs. Because not all claims could be reclassified as equity interests, the court found it unnecessary to determine whether an RSU constituted an “equity security” (as defined in the Bankruptcy Code).

Upon reviewing the case law and legislative history relevant to section 510(b), and thus whether any claim stood on equal footing with other unsecured claims, the court broadly construed each prong of the statute and found that the RSU claims must be subordinated – that is, the claims “arose from the purchase or sale of a security.” The court’s analysis is described below:

• Security – An RSU is a “security” because (1) it is adequately covered by the broad language used to define “security” in the Bankruptcy Code, and (2) it “bear[s] many of the hallmark characteristics of a security,” including limited voting rights and the receipt of dividends in the form of additional RSUs. Most importantly, the value of the RSUs were tied to the value of the Debtor’s common stock, and thus holders of RSUs had the same risk and benefit expectations as holders of common stock.

• Purchase or Sale – Applying the interpretation of “purchase” set forth in In re Enron Corp., 341 B.R. 141, 151 (Bankr. S.D.N.Y. 2006), the receipt of RSUs in exchange for labor constituted a “purchase” for purposes of section 510(b). Cases regarding involuntary exchanges are inapposite because the claimants here were free to refuse the award of RSUs by leaving the company.

• Arising From – The RSU claims “arose from” securities transactions because they would not have existed but for the claimants’ agreement to receive part of their compensation in the form of RSUs.

As a result of its analysis, the court held that the RSU claims “arose from the purchase or sale of securities” and therefore must be subordinated under section 510(b).

Why This Case Is Interesting
The Second Circuit’s decision clarifies the narrow scope of claims that may be reclassified as equity and disallowed and suggests that courts should employ a more careful analysis to determine the bases for claims asserted by equity holders. Going forward, courts will be more likely to focus on whether an equity holder’s proof of claim is duplicative of its equity interest or if it instead reflects an independent claim that is related to, but different from, its underlying equity interest (e.g., a breach of contract claim related to the purchase of the equity security).

However, the practical impact of this decision may not be very significant in the end because these claims will often still be subordinated given the broad construction of section 510(b). Nevertheless, better to be subordinated than disallowed as at least subordinated claims will be entitled to a recovery in circumstances where general unsecured creditors are paid in full and subordinated claims must be paid in full before equity holders receive any distributions.