In Brief: Second Circuit Reaffirms Broad Scope of Bankruptcy Code’s Subordination of Shareholder Claims

by Jones Day

Jones Day

Section 510(b) of the Bankruptcy Code provides a mechanism designed to preserve the creditor/shareholder risk allocation paradigm by categorically subordinating most types of claims asserted against a debtor by equityholders in respect of their equity holdings. However, courts do not always agree on the scope of this provision in attempting to implement its underlying policy objectives. In In re Lehman Brothers Holdings Inc., 2017 WL 1718438 (2d Cir. May 4, 2017), the Second Circuit reaffirmed the broad scope of section 510(b), ruling that breach of contract claims asserted by employees who were awarded restricted stock units entitling them to common stock were properly subordinated under section 510(b).

Subordination in Bankruptcy

The concept of claim, debt, or lien subordination is well recognized under federal bankruptcy law. A bankruptcy court’s ability to reorder the relative priority of claims or debts under appropriate circumstances is part and parcel of its broad powers as a court of equity. The statutory vehicle for applying these powers in bankruptcy is section 510 of the Bankruptcy Code.

Section 510(a) makes a valid contractual subordination agreement enforceable in a bankruptcy case to the same extent that it would be enforceable outside bankruptcy.

Section 510(b) subordinates claims arising from the purchase or sale of a security of the debtor or an affiliate of the debtor to "all claims or interests that are senior to or equal the claim or interest represented by the security, except that if such security is common stock, such claim has the same priority as common stock."

Finally, misconduct that results in injury to creditors can warrant the "equitable" subordination of a claim under section 510(c).

A related but distinct remedy is "recharacterization," whereby a court orders an asserted claim to be treated as if it were an interest. Because the Bankruptcy Code does not expressly empower a bankruptcy court to recharacterize debt as equity, some courts disagree as to whether they have the authority to do so and, if so, the source of such authority.

To date, seven circuit courts of appeal have held that a bankruptcy court’s power to recharacterize debt derives either from the court’s broad equitable powers, including those set forth in section 105(a) of the Bankruptcy Code, which provides that "[t]he court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of [the Bankruptcy Code]," or from section 502(b)(1), which provides in relevant part that "the court . . . shall allow [a] claim . . . except to the extent that . . . such claim is unenforceable against the debtor and property of the debtor, under any agreement or applicable law."

Subordination of Shareholder Claims Under Section 510(b)

Section 510(b) provides as follows:

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 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.

The purpose of section 510(b), consistent with the Bankruptcy Code’s "absolute priority" rule, is to prevent the bootstrapping of equity interests into claims that are on a par with other creditor claims. According to this rule, unless creditors are paid in full or agree otherwise, shareholders cannot receive any distribution from a bankruptcy estate.

Many courts have decided cases under section 510(b) by reviewing the traditional allocation of risk between a company’s shareholders and its creditors. Under this policy-based analysis, shareholders are deemed to undertake more risk in exchange for the potential to participate in the profits of the company, whereas creditors can expect only repayment of their fixed debts. Accordingly, shareholders, and not creditors, assume the risk of a wrongful or unlawful purchase or sale of securities. This risk allocation model is sometimes referred to as the "Slain/Kripke theory of risk allocation." Because of the parties’ differing expectations for risk and return, it is perceived as unfair to allow a shareholder to recover from the limited assets of a debtor as a creditor by "converting" its equity stake into a claim through the prosecution of a successful securities lawsuit. The method by which such a conversion is thwarted is subordination of the shareholder’s claim under section 510(b).


Prior to filing the largest chapter 11 case in history in September 2008, Lehman Brothers Holdings Inc. ("Lehman") gave its employees restricted stock units ("RSUs") as part of their compensation. Each RSU represented a contingent right to own shares of Lehman’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 obligated Lehman only to deliver the stock and expressly provided that Lehman was not obligated to pay any cash in respect of the RSUs. The documents also contained subordination provisions, which provided that RSU claims asserted against Lehman in bankruptcy would be subordinated under section 510(b) 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 Lehman’s general creditors in bankruptcy.

Lehman employees holding RSUs that had not yet been converted into common stock when Lehman filed for bankruptcy filed claims asserting, among other things, breach of contract for Lehman’s failure to pay the cash value of RSUs that never vested. Lehman objected to the claims, seeking to disallow them as equity interests or, in the alternative, to subordinate the claims to the claims of general unsecured creditors under section 510(b).

The bankruptcy court ruled that the RSU claims should be disallowed as equity interests or, alternatively, that they should be subordinated under section 510(b). The district court affirmed the decision on both grounds.

The Second Circuit’s Ruling

A three-judge panel of the Second Circuit agreed with the lower courts that the RSU claims must be subordinated under section 510(b). However, the court ruled that not all of the RSU claims should be disallowed.

At the outset, the Second Circuit noted that it need not, as the bankruptcy court had determined, decide whether an RSU is an "equity security" pursuant to section 101(16) of the Bankruptcy Code. Even if it were, the Second Circuit explained, the RSU holders were not barred from asserting proofs of claim because "at least some of their claims are not duplicative of proofs of interest."

Citing In re USA Commercial Mortg. Co., 377 B.R. 608 (B.A.P. 9th Cir. 2007), the court explained that a proof of claim can be disallowed as an equity interest only if it is duplicative of an interest in an equity security. Therefore, the Second Circuit panel reasoned, if the holder of an equity interest asserts a claim based on 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 cannot be reclassified as an equity interest.

According to the panel, because claims asserted by the RSU holders alleging breach of contract were not duplicative of equity interests that the RSUs represented, such claims should not be disallowed, even if the underlying RSUs qualified as equity securities.

However, the Second Circuit concluded, in keeping with the broad interpretation of section 510(b) and its legislative history, the RSU claims should be subordinated because they "arose from the purchase or sale of a security." First, the court found that an RSU is a "security" because: (i) it falls within the scope of the broad language used to define "security" in section 101(49) of the Bankruptcy Code; (ii) 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; and (iii) the RSU holders had the same risk and benefit expectations as common stock holders, since the value of the RSUs depended on the value of Lehman’s common stock.

Next, the Second Circuit panel found that, applying the interpretation of "purchase" articulated in In re Enron Corp., 341 B.R. 141 (Bankr. S.D.N.Y. 2006), the employees’ receipt of RSUs in exchange for labor constituted a "purchase" for purposes of section 510(b). According to the court, cases cited by the RSU claimants regarding involuntary exchanges were inapposite because the claimants in this case could have left the company instead of accepting RSUs.

Finally, the court determined that 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.


Lehman reinforces the broad scope of section 510(b), consistent with its underlying policy objective of preventing interest holders from transforming their rights as shareholders to claims with priority on a par with the claims of creditors.

Interestingly, in ruling that the bankruptcy court erred in ruling that the employees’ claims must be disallowed because an RSU constitutes an "equity security" (as defined by section 101(16) of the Bankruptcy Code), rather than a "claim" (as defined by section 101(5)), the Second Circuit panel did not discuss a bankruptcy court’s power to recharacterize debt as equity. Although the Second Circuit has not weighed in on recharacterization, many courts in the circuit have recognized the legitimacy of the remedy under appropriate circumstances. See, e.g., In re Aeropostale, Inc., 555 B.R. 369 (Bankr. S.D.N.Y. 2016); Weisfelner v. Blavatnik (In re Lyondell Chem. Co.), 544 B.R. 75 (Bankr. S.D.N.Y. 2016).

Written by:

Jones Day

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