Section 510(b) of the Bankruptcy Code provides a mechanism designed to preserve the creditor/shareholder risk allocation paradigm by categorically subordinating claims asserted against a debtor by equity holders arising from the purchase or sale of securities of the debtor or an affiliate of the debtor. The purpose of this provision is to ensure that creditors are paid before equity holders, including in situations where an equity holder asserts a claim for damages related to the purchase or sale of the debtor's (or an affiliate's) stock. Section 510(b) implicitly recognizes that, as compared with creditors, equity holders bargained for potentially greater returns in exchange for greater risk, and it is designed to preserve that risk allocation between creditors and shareholders in bankruptcy. However, courts do not always agree on the scope of the provision in attempting to implement its underlying policy objectives.
A bankruptcy appellate panel for the Ninth Circuit ("BAP") recently examined this issue in Kurtin v. Ehrenberg (In re Elieff), 637 B.R. 612 (B.A.P. 9th Cir. 2022). The panel affirmed a bankruptcy court order categorically subordinating secured judgment claims asserted against the debtor by an individual with whom the debtor co-owned certain investments. The BAP agreed with the bankruptcy court that the claims, although transformed into a secured judgment, were for damages arising from the purchase or sale of the securities of the debtor or an affiliate and were therefore properly subordinated under section 510(b). The BAP further held that the liens securing the claims should also have been 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 an otherwise valid contractual subordination agreement enforceable in a bankruptcy case to the same extent that it would be enforceable outside bankruptcy.
Section 510(b) generally subordinates claims arising from the purchase or sale of a security of the debtor or an affiliate of the debtor to all claims that are senior or equal to the claim or interest represented by the security.
Finally, section 510(c) provides that misconduct that results in injury to creditors or shareholders can, "[n]otwithstanding subsections (a) and (b) of this [section 510]," result in the "equitable" subordination of a claim or interest or the issuance of an "order that any lien securing such a subordinated claim be transferred to the estate."
Subordination of 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. See generally Collier on Bankruptcy ¶ 510.04 (16th ed. 2022).
Interest holders have resorted to a wide array of devices and/or legal arguments in an effort to overcome the effect of section 510(b), including contractual provisions purporting to entitle them to damages upon the issuer's breach of a stock purchase agreement and alternative theories of recovery, such as unjust enrichment and constructive trust. See generally Stucki v. Orwig, 2013 WL 1499377 (N.D. Tex. Apr. 12, 2013) (discussing case law).
In deciding cases under section 510(b), some courts have highlighted 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," as described in a 1973 law review article written by Professors John J. Slain and Homer Kripke titled "The Interface Between Securities Regulation and Bankruptcy—Allocating the Risk of Illegal Securities Issuance Between Securityholders and the Issuer's Creditors," 48 N.Y.U. L. Rev. 261 (1973). See, e.g., In re SeaQuest Diving LP, 579 F.3d 411, 420 (5th Cir. 2009); In re Betacom of Phoenix, Inc., 240 F.3d 823, 829 (9th Cir. 2001); In re Granite Partners, L.P., 208 B.R. 332, 336 (Bankr. S.D.N.Y. 1997).
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 mechanism by which such a conversion is thwarted is subordination of the shareholder's claim under section 510(b).
Notwithstanding general agreement regarding the policy underlying section 510(b), many courts have found the statutory language to be ambiguous. See SeaQuest, 579 F.3d at 421. In In re Am. Hous. Found., 785 F.3d 143 (5th Cir. 2015), the Fifth Circuit concluded that a claim should be subordinated under section 510(b) if: (i) the claim is for "damages"; (ii) the claim involves "securities"; and (iii) the claim "arise[s] from" a "purchase or sale." With respect to the third element, the court explained, "[f]or a claim to 'arise from' the purchase or sale of a security, there must be some nexus or causal relationship between the claim and the sale." Id. at 156 (quoting SeaQuest, 579 F.3d at 421) (internal quotation marks omitted). The Second Circuit applied a slightly different formulation of the test in In re Lehman Bros. Holdings Inc., 855 F.3d 459, 472-78 (2d Cir. 2017), where it examined whether: (i) the claimant owns a security; (ii) the claimant acquired the security by means of a purchase or sale; and (iii) the claimant's damages arose from the purchase or sale of the security or the rescission of such a purchase or sale.
Section 101(49) of the Bankruptcy Code defines the term "security" broadly to "include" notes, stock, treasury stock, bonds, debentures, and an extensive catalogue of other investments. In addition, the definition contains a broad residual clause providing that a security also includes "any other claim or interest commonly known as [a] 'security.'" The scope of the residual clause is broad. See SeaQuest, 579 F.3d at 418.
The statutory definition also expressly excludes a number of items, including, among other things, currency, checks, drafts, bills of exchange, bank letters of credit, commodity futures contracts, forward contracts, options, and warrants.
Section 101(16) of the Bankruptcy Code defines an "equity security" to mean shares in a corporation or any "similar security," limited partnership interests, and certain warrants or rights.
In Lehman Brothers, the Second Circuit noted that "some interests will not perfectly match any of the specific examples in [the Bankruptcy Code's definition of security]," and that, should this be the case, it is of "most significance" that a claimant "ha[s] the same risk and benefit expectations as shareholders." Lehman Brothers, 855 F.3d at 473-74; accord In re Linn Energy, 936 F.3d 334, 344 (5th Cir. 2019) (even though the beneficiary of a stock trust did "not fit perfectly in the investor box," his claims should be subordinated under section 510(b) because his entitlement to "deemed dividends" originally arising from the trust "was certainly more like an investor's interest than a creditor's interest"); In re WorldCom, Inc., 2006 WL 3782712, at *6 (Bankr. S.D.N.Y. Dec. 21, 2006) ("The form in which the equity interest is held is ultimately irrelevant. So long as the claimant's interest enabled him to participate in the success of the enterprise and the distribution of profits, the claim will be subordinated pursuant to section 510(b).").
The Bankruptcy Code does not define "damages." However, many courts have reasoned that "the concept of damages under Section 510(b) has the connotation of some recovery other than the simple recovery of an unpaid debt due on an instrument." American Housing, 785 F.3d at 153-54 (internal quotation marks omitted) (citing cases and ruling that claims seeking compensation for fraud or breach of fiduciary duty are claims for damages under section 510(b) as well as claims "predicated on post-issuance conduct," including breach of contract claims).
Beginning in the early 1990s, Bruce Elieff (the "debtor") and Todd Kurtin ("Kurtin") were partners or joint venture owners in a series of real estate investment and development projects in California (the "joint entities"). In 2003, Kurtin sued the debtor and certain separately owned entities in state court asserting claims for breach of contract, breach of fiduciary duty, conversion, embezzlement, constructive fraud, and related claims. The parties settled the litigation in 2005. Under the settlement agreement, Kurtin agreed to surrender his interests in the joint entities to the debtor in exchange for approximately $50 million payable in four installment during the next year. The debtor and the joint entities were liable for the initial $21 million installment, but only the joint entities were liable for the remainder.
The settlement agreement granted Kurtin a lien on the projects owned by the joint entities to secure the settlement payment obligation. It also prohibited the debtor from taking any distribution from the any of the joint entities if it would prevent the joint entities from paying the settlement debt. In the event of a default, Kurtin was entitled to a judgment from the state court against the joint entities in the amount of the payment shortfall. The settlement agreement provided that any disputes regarding its terms were subject to arbitration.
After the joint entities defaulted on the third installment, Kurtin sought entry of a judgment against them in the amount of $22.5 million, but the court denied the request because the joint entities were not parties to the state court litigation.
Kurtin commenced an arbitration proceeding seeking reformation of the settlement agreement to add "material terms." The arbitrator ruled that the agreement should be amended to provide that, if the default was not cured by June 30, 2007, the debtor was obligated to transfer his interests in the joint entities to Kurtin. However, Kurtin never elected to enforce the provision.
Instead, in December 2007, Kurtin commenced a second lawsuit in state court against the debtor and the joint entities for breach of the settlement agreement and approximately $25 million in damages. Among other claims, the complaint alleged that the debtor breached the settlement agreement by taking distributions from the joint entities even though they failed to make the last installment payment.
A jury awarded Kurtin approximately $25 million. The award was later increased to nearly $34 million after a series of appeals and a new trial. In September 2019, Kurtin recorded his judgment against the debtor and two entities that the state court adjudged to be his alter egos.
In October 2019, the debtor and various affiliates (other than the joint entities) filed separate chapter 11 cases in the Central District of California. The following month, the debtor commenced an adversary proceeding against Kurtin seeking, among other things, subordination of his secured claims under section 510(b), transfer of Kurtin's judgment liens to the estate under section 510(c)(2), and avoidance of Kurtin's lien as a preferential and fraudulent transfer. Kurtin moved to dismiss.
The bankruptcy court declined to dismiss the debtor's subordination claims under section 510(b) and his avoidance claims. However, it dismissed the section 510(c)(2) claim, ruling that section 510(c)(2) does not apply to claims subordinated under section 510(b), but only to claims equitably subordinated under section 510(c)(1).
According to the bankruptcy court:
[T]he plain language of § 510(c)(2) does not support Plaintiffs' interpretation that the lien transfer provision of § 510(c)(2) applies to § 510(b). Significantly, § 510(b), which governs mandatory subordination includes its own remedy within the subjection, to wit, for distribution purposes, "a claim arising from damages from the purchase or sale of a security … shall be subordinated to all claims or interests that are senior …" § 510(b) (emphasis added). Section 510(c), therefore, cannot logically be read as providing both a duplicative remedy (subordination for distribution purposes) and an extra remedy (lien transfer) for § 510(b) claims.
Elieff v. Kurtin (In re Elieff), No. 19-ap-01205-ES (Bankr. C.D. Cal. Jan. 26, 2021), at pp. 28-29.
In June 2020, the bankruptcy court substantively consolidated the cases and appointed a chapter 11 trustee. The court later converted the case to a chapter 7 liquidation.
After conversion, the bankruptcy court considered Kurtin's motion for summary judgment on the remaining claims stated in the complaint (now being prosecuted by the chapter 7 trustee) complaint. Kurtin argued that most of the rights and obligations exchanged under the settlement agreement had little or nothing to do with his transfer of interests in the joint entities to the debtor and that, because the value of the joint entities was less than the debtor's initial $21 million settlement payment, none of the other installment payments had anything to do with the purchase or sale of securities within the meaning of section 510(b). However, he never submitted any evidence to support this allocation.
In January 2021, the bankruptcy court granted summary judgment to the trustee on the section 510(b) claim. It ruled that the plain terms of the settlement agreement established that the "crux" of the agreement involved the purchase and sale of securities of the debtor's affiliates (the joint entities) and that section 510(b) applied, even if some aspects of the agreement did not directly relate to the purchase or sale of securities. According to the court, section 510(b) relief is triggered whenever there is "some nexus" or "causal relationship" between the claim and the purchase or sale of securities of the debtor or its affiliates.
The bankruptcy court later clarified its ruling by issuing an order providing that, because Kurtin's judgment liens were "subsumed" within the term "claim" in section 510(b), the liens were subordinated for the same reasons and to the same extent that his claims had been subordinated. According to the bankruptcy court, "[b]oth the Kurtin Claim and the Kurtin Liens are subordinated by this relief because the term 'claim' referenced in § 510(b) includes both unsecured and secured, i.e., in rem lien rights to payment." Elieff v. Kurtin (In re Elieff), No. 19-ap-01205-ES (Bankr. C.D. Cal. Apr. 5, 2021) (citing 11 U.S.C. §§ 101(5) and 510(b); Johnson v. Home State Bank, 501 U.S. 78, 84 (1991)).
Kurtin appealed to the BAP.
The Bankruptcy Appellate Panel's Ruling
The BAP affirmed.
Subordination of Claims. Writing for the panel, U.S. Bankruptcy Judge Gary A. Spraker emphasized that the Ninth Circuit has broadly interpreted the scope of section 510(b). Elieff, 637 B.R. at 622 (citing Liquidating Tr. Comm. of the Del Biaggio Liquidating Tr. v. Freeman (In re Del Biaggio), 834 F.3d 1003, 1009 (9th Cir. 2016); Pensco Tr. Co. v. Tristar Esperanza Props., LLC (In re Tristar Esperanza Props., LLC), 782 F.3d 492, 495 (9th Cir. 2015)). In Del Biaggio, he noted, the Ninth Circuit held that a claim "arises from" the purchase or sale of securities whenever it "shares a 'nexus or causal relationship' with the purchase or sale of securities." Id. (citing Del Biaggio, 834 F.3d at 1009).
According to the BAP, there were no material differences between this case and Tristar. In Tristar, Judge Spraker explained, one member of a limited liability company ("LLC") sought to withdraw from the LLC, and the other member invoked its right to purchase the membership interest, but the parties could not agree on its value. After arbitration, the prevailing member reduced its award to judgment in state court. The other member filed for chapter 11 bankruptcy and sought an order subordinating the judgment claim under section 510(b). The Ninth Circuit ultimately ruled that the claim should be subordinated because the claim "originat[ed] from the failed sale of [the] membership interest and [the other member's] breach of the operating agreement's provisions regarding repurchase of membership interests." Tristar, 782 F.3d at 497.
As in Tristar, Judge Spraker wrote, "Kurtin's claim[s] based on Elieff's breach of [the settlement agreement] share a direct causal link with the conveyance of his equity interests in the Joint Entities," and therefore the bankruptcy court correctly subordinated the claims under section 510(b). Elieff, 637 B.R. at 623. In so ruling, the BAP rejected Kurtin's argument that section 510(b) did not apply because his claims arose from Elieff's post-settlement diversion of the assets of the joint entities. Kurtin's judgment, Judge Spraker explained, "was based on Elieff's breach of the Settlement Agreement … [and thus,] it shared a direct causal link to Kurtin's sale of his interests in the Joint Entities made in that very same agreement." Id.
The BAP also rejected Kurtin's argument that, because the initial $21 million installment payment under the settlement agreement "fully paid the securities sale aspect" of the agreement, Kurtin's judgment claims for the remaining installments "cannot constitute damages that arise from the sale of his securities under § 510(b)." According to Judge Spraker, the plain language of the settlement agreement indicated no "distinction of purpose between any of the Settlement Payments" or that the payments "were severable rather than indivisible." Id. at 624.
Subordination of Liens. Next, the BAP ruled that the bankruptcy court properly subordinated Kurtin's judgment liens as well as his claims under section 510(b).
According to the panel, in keeping with its purpose to prevent an equity investor from sharing pari passu with creditors based on "transmutation of its investment from equity to debt whether consensually or by a court ruling, … [s]ection 510(b) subordinates the entirety of a claim, including the creditor's in rem right to payment." This, Judge Spraker noted, is consistent with section 101(5) of the Bankruptcy Code, which defines "claim" to include "right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured." Id. at 626-27. He further explained that this conclusion also comports with the Supreme Court's ruling in Johnson, where the Court held that the term "claim" in the Bankruptcy Code includes mortgage liens.
According to the BAP, Kurtin's narrow reading of section 510(b) would "lead to incongruous if not absurd results" because the retention of his lien priority would allow him to be paid ahead of the claims of the unsecured creditors to which his claims had been subordinated. "In short," Judge Spraker wrote, "§ 510(b) statutorily precludes Kurtin from collecting his damages until the unsecured creditors are paid." Id. at 627.
The BAP noted that its rationale does not conflict with other provisions of the Bankruptcy Code, including sections 725 and 726. Section 725 provides that, before a final distribution of estate property under section 726, the trustee "shall dispose of any property in which an entity other than the estate has an interest, such as a lien, and that has not been disposed of under another section of [the Bankruptcy Code]." Section 726 provides that, "[e]xcept as provided in section 510," property shall be distributed in accordance with the five categories of claims and the residual debtor's interest set forth in the provision. According to the panel, the legislative history of section 725, which gives bankruptcy courts broad authority to order "dispositions" of estate property in which third parties hold interests or liens, indicates that section 725 was enacted by lawmakers "'in lieu of a section that directs a certain distribution to secured creditors.'" Id. (quoting H.R. Rep. No. 95-595, 382-83 (with emphasis added)). Thus, the BAP noted, section 725 "is explicitly subject to the mandatory effect of subordination under the plain language of § 510(b)." Id.
The BAP also found no conflict between section 510(b) and section 725. The latter statute, he explained, obligates the trustee to dispose of encumbered property prior to the final distribution of estate property under section 726 only. Judge Spraker noted that, in this case, the estate was not ready for final distribution, and it appeared that the trustee sought subordination of Kurtin's liens so that he could liquidate the encumbered assets under section 363(f) (allowing a sale free and clear of any interest) and section 506(d) (voiding liens securing claims that are not allowed, with certain exceptions). According to the BAP, if the trustee did not administer the encumbered assets, they would be disposed of prior to the estate's final distribution. Thus, it reasoned, subordinating Kurtin's liens would not violate section 725. Id. at 628.
The BAP also rejected Kurtin's argument that, because section 510(c)(2) specifically authorizes the court to transfer a "lien" securing an equitably subordinated claim to the estate, whereas section 510(b) refers only to subordination of a "claim," Congress did not intend for subordination of liens under section 510(b). According to Judge Spraker, "[l]ien transfer is a remedy distinct from lien subordination … and lien subordination under § 510(b)—and § 510(c)(1)—is nothing more than a recognition of the well-established proposition that a lien is an incident of the debt." Id.
In addition, the BAP rejected Kurtin's argument that interpreting section 510(b) to provide for lien subordination conflicts with the principle that liens generally pass through bankruptcy unaffected. In chapter 5 of the Bankruptcy Code alone, Judge Spraker explained, there are numerous provisions "that can drastically affect lien rights," indicating that Congress departed from this principle "when it perceive[d] a need and justification to affect such rights." Id. (citing 11 U.S.C. §§ 506(c), 506(d), 522(f), and 548). Given its conclusion that Congress intended for section 510(b) to extend to lien subordination, the BAP also found no merit to the contention that subordinating Kurtin's liens violated his due process rights.
Finally, the BAP rejected Kurtin's contention that, because the bankruptcy court did not avoid but merely subordinated his liens, any distribution of the proceeds of his collateral to other creditors would still be subject to his liens. This contention, the panel noted, ignores the fact that the bankruptcy court did not need to avoid Kurtin's subordinated liens because his claims were not entitled to payment from any source until unsecured creditors were paid in full.
The BAP's conclusion in Elieff that Kurtin's judgment claims were properly subordinated as claims for damages arising from the purchase or sale of the securities of the debtor's affiliates reinforces the broad scope of section 510(b), in keeping with its purpose to prevent the bootstrapping of equity interests into claims that are on a par with the claims of creditors. Given Kurtin's status as an interest holder and the nature of the dispute, the fact that he took the additional steps to transform his claims into secured judgment debts was irrelevant, and the BAP accordingly held that the claims retained their original priority on a par with equity interests.
The BAP's analysis concerning subordination of liens, as distinguished from claims, under section 510(b) is noteworthy, particularly because only a handful of other courts have addressed the issue in reported decisions, and none has explained its reasoning in such detail. See, e.g., In re Barkats, 2019 WL 3934799, at **7-8 (Bankr. D.D.C. Aug. 16, 2019) (unlike section 510(c), section 510(b) does not provide for the subordination of a lien); In re JTS Corp., 305 B.R. 529, 546 (Bankr. N.D. Cal. 2003) (denying summary judgment and noting that "it appears that the Amber Group's assertion of its lien rights seeks to retrieve an investment loss and should be subordinated under § 510(b)").
The BAP's reasoning concerning the inseparability of a claim and a lien securing it and the consequences of not subordinating the lien securing a claim subordinated under section 510(b) would appear to be sound. If a lien securing a subordinated claim were unaffected by the claim's subordination, the creditor would still have a superior interest in its collateral vis-à-vis the creditors that section 510(b) was intended to benefit.
Moreover, if section 510(b) were not interpreted to provide for the subordination of a lien as well as the claim it secures, it is unclear what mechanism the trustee could rely on to subordinate or avoid the lien and fulfill section 510(b)'s purpose. The Bankruptcy Code's provisions dealing with the avoidance of liens do not contemplate avoidance under the circumstances addressed by section 510(b). See 11 U.S.C. §§ 506(d) (avoidance of claims that secure certain disallowed claims); 522(f) (avoidance of judicial liens on and nonpossessory nonpurchase money security interests in certain exempt property); 544(a)(1) (avoidance of liens that are voidable under applicable nonbankruptcy law); 545 (avoidance of certain statutory liens); 548 (avoidance of obligations incurred with actual or constructive fraud); and 724(a) (avoidance of liens securing certain fines, penalties, or forfeitures, or for multiple, exemplary, or punitive damages that are not compensation for actual pecuniary loss).
The BAP's conclusion, therefore, seems reasonable. Even so, we are left to speculate why Congress specifically mentioned liens in providing for equitable subordination in section 510(c)(2), yet omitted to do so in connection with categorical subordination under section 510(b).