On August 10, 2017, the Supreme Court dismissed the writ of certiorari in PEM Entities LLC v. Levin as improvidently granted. See No. 16-492, 2017 WL 3429146, at *1 (U.S. Aug. 10, 2017).  This decision leaves the circuit courts split on the issue of whether to use federal or state law in recharacterizing insider debt as equity, a critical distinction that can be dispositive as to the treatment of debt claims made by insiders of debtors.

Case Background

In PEM Entities LLC, Province Grande Old Liberty, LLC (the “Debtor”) borrowed approximately $6.5 million from Paragon Commercial Bank (the “Loan”).  The Debtor subsequently defaulted on the Loan, eventually resulting in foreclosure proceedings.  The Debtor, its principal, and other related entities entered into a settlement agreement with the lender.  Under the settlement, Paragon Commercial Bank sold the $6.5 million Loan to PEM Entities, LLC (“PEM”) for around $1.2 million.  Critically, PEM was owned by insiders of the Debtor, relied solely upon principals of the Debtor to negotiate the settlement agreement, and failed to set out formal interest rates and payment schedules with the Debtor after the settlement of the loan.  When the Debtor could not maintain liquidity despite PEM’s intervention, the Debtor filed this Chapter 11 case, wherein PEM filed a secured claim for $7 million.   The Debtor’s unsecured debtholders moved to recharacterize the secured claim as equity.

Using the 11 factor federal test for recharacterizing insider debt claims laid out in Fairchild Dornier GmbH v. Official Comm. of Unsecured Creditors (In re Dornier Aviation (N. Am.), Inc.), 453 F.3d 225, 231 (4th Cir. 2006), the United States Bankruptcy Court for the Eastern District of North Carolina held that PEM’s claim would be recharacterized as equity rather than debt, moving the claim to lower priority status than the unsecured debtholders.  Both the district and circuit courts affirmed on appeal, with the Fourth Circuit signaling that the federal, rather than state, test for recharacterization would be proper and that PEM’s actions, while arguably debt in name, was at its core a capital investment in the company’s success rather than the temporary borrowing of money.

The Unresolved Circuit Split

The Supreme Court’s decision to dismiss the writ of certiorari in PEM Entities LLC leaves in place a Circuit split on whether to use federal or state law standards to recharacterize debt.  The Sixth, Tenth, Third, and Fourth Circuits all use a multi-factor test similar to the one used in PEM Entities, LLC that looks beyond form and to the substance of the transaction to decide whether it should be categorized as debt or equity.[1]  Similarly, the Eleventh Circuit applies a two-prong federal standard that also attempts to reach the substance of the transaction.[2]  On the other hand, the Fifth and Ninth Circuits have applied an approach to recharacterization based on the state law of the forum.[3]  These state laws vary greatly from state to state, but they are often more friendly to debtor insiders who invest in debt and look to the form of the transaction rather than the substance.

Reason for Dismissal

The circumstances of the dismissal further dampen the hopes of a quick resolution to this circuit split.  On October 11, 2016, PEM petitioned the Supreme Court for a writ of certiorari to review the Fourth Circuit decision on the issue of whether federal or state law should be applied to recharacterize debt as equity.  On June 27, 2017, this writ was granted only to be dismissed as improvidently granted six weeks later, prior to merits briefing, on August 10, 2017.  The Supreme Court is not obligated to explain its reasoning for dismissing certiorari and did not here.  Usually, certiorari is dismissed as improvidently granted if a party attempts to change its argument in its merits brief, if the dispute seems overly fact determinative, or if the Justices believe that the case has secondary issues that may prevent the court from reaching the merits also known as “vehicle” problems.

Here, certiorari was dismissed shortly after the parties filed a joint motion to confirm party status on July 21, 2017.  The original respondents for this action had settled a state court action which caused them to cease having a stake in the outcome of this case.  Instead, the parties moved the court for the Debtor to step into the unsecured debtors shoes as the respondents in this action, as they had a continued interest in defending the judgment below. Given the short period of time between the filing of this motion and the dismissal of certiorari as improvidently granted, as well as the fact that merits briefing was never even completed, it is likely that the Court dismissed this case due to “vehicle” issues.  That is, the Court decided that, due to the complexity of the party’s status and procedural posture, the likelihood that the Court would not reach the merits of the action had risen and it was no longer worth the risk of using its limited resources to hear the case.  This issue may continue to hamper attempts to bring the issue of this circuit split to the Supreme Court, as the interconnected and complex nature of relationships between parties in cases dealing with recharacterizing insider debt as equity rarely make the best simple and clear-cut vehicles for Supreme Court rulings.

[1].      See Bayer Corp. v. MascoTech, Inc. (In re AutoStyle Plastics, Inc.), 269 F.3d 726, 749-750 (6th Cir. 2001); Sender v. Bronze Grp., Ltd. (In re Hedged-Investments Assocs., Inc.), 380 F.3d 1292, 1298 (10th Cir. 2004); Cohen v. KB Mezzanine Fund II, LP (In re SubMicron Sys. Corp.), 432 F.3d 448, 455-456 (3d Cir. 2006); In re Dornier Aviation (N. Am.), Inc., 453 F.3d at  233-234.

[2].      In re N & D Properties, Inc., 799 F.2d 726, 733 (11th Cir. 1986) (two-pronged test, shareholder loans may be deemed capital contributions “where the trustee proves initial undercapitalization or where the trustee proves that the loans were made when no other disinterested lender would have extended credit.”).

[3].      See Grossman v. Lothian Oil Inc. (In re Lothian Oil Inc.), 650 F.3d 539, 543 (5th Cir. 2011); Official Comm. of Unsecured Creditors v. Hancock Park Capital II, L.P. (In re Fitness Holdings Int’l, Inc.), 714 F.3d 1141, 1148 (9th Cir. 2013).

A recent decision in the Bankruptcy Court for the District of Delaware explored the limits of mandatory subordination under section 510(b) of the Bankruptcy Code. In In re FAH Liquidating Corp., No. 13-13087(KG), 2017 WL 95115 (Bankr. D. Del. Jan. 10, 2017), Judge Kevin Gross ruled that membership units in special purpose vehicles that held securities of a debtor were outside the scope of section 510(b) because they were neither “securit[ies] of the debtor” nor securities of “an affiliate of the debtor.”  Because the claimants invested in special purpose vehicles that were insulated from the debtor, their securities law claims against the debtor were indirect and therefore not subject to mandatory subordination.

Prior to the Petition Date, the debtor’s predecessor, Fisker Automotive Holdings, Inc. (“Fisker”), issued preferred stock. Fisker engaged Advanced Equities, Inc. (“AEI”) to aid in raising private capital.  As memorialized in a Placement Agreement, AEI would receive, among other things, warrants that it could transfer to other broker-dealers that it designated as sub-agents.  One such sub-agent, Middlebury Securities LLC (“Middlebury Securities”), entered into a Sub-Placement Agreement with AEI.  Middlebury Securities solicited qualified investors for purchase of Membership Units in one or more[1] Special Purpose Vehicles, affiliated with Middlebury Securities, that themselves purchased or held Fisker’s preferred shares.  Notably, however, there was no direct contractual relationship between Fisker and Middlebury Securities; rather, each contracted separately with AEI.

Two sets of plaintiffs commenced securities lawsuits against controlling shareholders and current and former officers and directors of Fisker, and filed proofs of claim on account of securities law claims against Fisker. One set of plaintiffs had purchased Fisker’s preferred stock (the “Direct Purchasers”), while the other plaintiffs had purchased membership units in one or more of the Special Purpose Vehicles (the “Membership Unit Purchasers”).

The parties and the Bankruptcy Court agreed that the Direct Purchasers’ claims against Fisker were subject to mandatory subordination under section 510(b) of the Bankruptcy Code, which subordinates any “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.”[2]

The parties also agreed that the Membership Units were “securities” and that the plaintiffs’ claims arose from the purchase or sale of securities. However, the parties disputed the application of section 510(b) to the claims of the Membership Unit Purchasers.

Although the Membership Units did not represent direct interests in Fisker, the Liquidating Trustee argued that purchases of Fisker securities were “part of the causal link leading to” the alleged injuries, and thus the Membership Unit Purchasers’ claims arose from the purchase or sale of a debtor’s securities.  The Liquidating Trustee further argued that there was a “complete identity of economic interest” between the Membership Units and Fisker’s securities.

In the alternative, the Liquidating Trustee argued that the Membership Unit Purchasers’ claims arose from the purchase or sale of securities of “an affiliate of the debtor” because Middlebury Securities acted as an intermediary between Fisker and investors for purposes of raising capital for Fisker. In the Liquidating Trustee’s view, the Special Purpose Vehicles were “affiliates” of Fisker because they were operated under the Placement Agreement between Fisker and AEI, pursuant to which AEI designated Middlebury Securities as its sub-agent.

The Bankruptcy Court first rejected the Liquidating Trustee’s argument that the Membership Units were securities “of the debtor.” The Bankruptcy Court noted that the Membership Units were distanced and insulated from Fisker due to the Special Purpose Vehicles: the Special Purpose Vehicles were not debtors, the Membership Units were not part of Fisker’s capital structure, and the Membership Unit Purchasers did not have actual ownership interests in Fisker.

The Bankruptcy Court next addressed the Liquidating Trustee’s contention that the Membership Units were the securities of Fisker’s affiliates. Section 101(2) of the Bankruptcy Code defines an “affiliate” as, among other things, a “person whose business is operated under a lease or operating agreement by a debtor, or [a] person substantially all of whose property is operated under an operating agreement with the debtor.”[3]  Focusing on that definition, the Bankruptcy Court emphasized that there was no contract between Fisker and Middlebury Securities.  The Placement Agreement was between Fisker and AEI; AEI separately contracted with Middlebury Securities as sub-agent to sell Membership Units.  The Special Purpose Vehicles thus fell outside the scope of section 101(2)(C): they were not “operat[ing] under an operating agreement with the debtor” (emphasis added).

The Bankruptcy Court further noted that the Fifth Circuit has applied a more expansive view of section 101(2)(C) where a debtor is “in full control” of another entity. However, the Bankruptcy Court found that the Debtors did not exert sufficient control to make the Special Purpose Vehicle entities mere “shell conduit[s] between [the] debtor and [the] entity.”  AEI acted as an independent contractor, and it used its own authority to contract with Middlebury Securities.  In fact, Fisker’s agreement with AEI even prohibited Fisker from communicating directly with sub-agents (like Middlebury Securities) without AEI’s authority.

The Bankruptcy Court’s decision shows that even the broad terms of section 510(b) have limits. Where a special purpose entity is sufficiently insulated from the debtor whose securities it holds, an investor in the special purpose entity may be able to maintain unsubordinated claims against the debtor (or the debtors’ directors and officers).  Purchasers of securities should be aware that claims against debtors on account of purchases of membership interests in unaffiliated special purpose vehicles may potentially be due a higher priority than claims on account of direct purchases of the debtor’s securities.  For their part, debtors and trustees should be aware that they may not be able to rely on section 510(b) in defending against such claims.

[1].      The decision notes that only one Special Purpose Entity— Middlebury Ventures II— was identified by name on the record, although the term was used in the plural by the Plaintiffs. Id. at *5-6.  Thus, it was “unclear from the record whether [Middlebury Ventures II] is the only Special Purpose Vehicle that issued the Membership Units.” Id. at *7.

[2].      11 U.S.C. § 510(b).

[3].      11 U.S.C. § 101(2)(C).

The Bankruptcy Code contains specific provisions that permit the subordination or disallowance of claims of insiders or others that may not, at equity, be entitled to the same status as a regular prepetition claim holder. For example, such claims may be equitably subordinated under section 510(c) or disallowed under certain subsections of section 502. In addition, some courts have held that section 105 affords bankruptcy courts authority to reorder the priority of claims, even if the provisions of the Code that permit subordination or disallowance would not otherwise apply.  In such circumstances, Courts have recharacterized debt as equity investments, effectively subordinating the claims.

In a recent unpublished opinion, the Fourth Circuit Court of Appeals shed some light on the circumstances under which recharacterization of debt to equity may be appropriate. In In re Province Grande Old Liberty, LLC, Case No. 15-1669, 2016 WL 4254917 (4th Cir. Aug. 12, 2016), the debtor financed the acquisition of its principal asset, a golf and residential real estate development, through a loan from Paragon Commercial Bank (“Paragon”).  The debtor subsequently defaulted on the loan and Paragon initiating foreclosure proceedings.  In an effort to resolve the foreclosure proceedings, the debtor and Paragon entered into a settlement agreement pursuant to which Paragon agreed to sell its loan to a new company, PEM, at a significant discount.  PEM was owned by insiders of the debtor and funded its purchase of the loan through a combination of equity contributions from its members and outside debt.

The debtor filed its bankruptcy petitions in the United States Bankruptcy Court for the Eastern District of North Carolina on March 11, 2013, and its petitions listed PEM’s claim at $7,000,000, which included the principal of the original Paragon loan (as opposed to the loan purchase price) and accrued interest. Two creditors of the debtor, seeking to increase recoveries on their own claims, initiated an adversary proceeding to have PEM’s debt equitably subordinated or reclassified as an equity interest in the debtor.

The bankruptcy court granted summary judgment in favor of the creditors, concluding that PEM’s loan purchase was, in effect, a settlement and satisfaction of the Paragon loan and that the portion of the loan purchase price funded by equity contributions should be recharacterized as equity. The effect was to invalidate PEM’s claim for the principal amount of the loan originally owed to Paragon.

PEM appealed the bankruptcy court’s order to the United States District Court for the Eastern District of North Carolina, which affirmed the bankruptcy court’s judgment. PEM then filed an appeal to the Fourth Circuit Court of Appeals.

The issue before the Fourth Circuit was not one of first impression — the Fourth Circuit had long recognized that a bankruptcy court’s equitable powers include “the ability to look beyond form to substance,” and had previously articulated the factors to consider in evaluating a request for recharacterization. See Fairchild Dornier GMBH v. Official Comm. of Unsecured Creditors (In re Official Committee of Unsecured Creditors for Dornier Aviation (North America), Inc.), 453 F.3d 225 (4th Cir. 2006).

In Dornier Aviation the Fourth Circuit held that in evaluating whether a debt claim should be recharacterized as equity, the court must evaluate: (1) the names given to the instruments, if any, evidencing the indebtedness; (2) the presence or absence of a fixed maturity date and schedule of payments; (3) the presence or absence of a fixed rate of interest and interest payments; (4) the source of repayments; (5) the adequacy or inadequacy of capitalization; (6) the identity of interest between the creditor and the stockholder; (7) the security, if any, for the advances; (8) the corporation’s ability to obtain financing from outside lending institutions; (9) the extent to which the advances were subordinated to the claims of outside creditors; (10) the extent to which the advances were used to acquire capital assets; and (11) the presence or absence of a sinking fund to provide repayments. Id.

 In Province, the bankruptcy court weighed these factors and found that all of them weighed in favor of recharacterization.  In particular, the bankruptcy court emphasized certain facts, including that (1) the agreement to settle the Paragon loan was a settlement agreement and was entered into “in settlement of the loan,” (2) PEM was not a signatory to the settlement agreement and was not involved in negotiations of the agreement; instead the Debtor’s principals negotiated the settlement agreement and note purchase on behalf of PEM and Paragon believed the Debtor’s principals had the authority to bind PEM, (3) the failure of the Debtor and PEM to observe any formalities regarding loan repayment and (4) the identify of interests between the Debtor and PEM.  In its review, the Fourth Circuit reiterated the bankruptcy court’s findings and held that “the bankruptcy court properly ‘looked beyond form’ to determine that the ‘substance of the transaction’ was in fact the settlement agreement in which the Debtor used PEM as an extension of itself to complete what was, in effect, a satisfaction of the Paragon loan.” Province, 2016 WL 4254917 at *3.

The Fourth Circuit decision is notable however, because it dispensed of a specific challenge to the bankruptcy court’s decision. Namely, PEM contended that the bankruptcy court misapplied the Dornier factors by applying them to the wrong transaction.  PEM argued that the bankruptcy court should have limited its analysis to the inception of the Paragon debt, rather than to the later settlement agreement.  The Fourth Circuit disagreed, noting that “[t]he recharacterization decision itself rests on the substance of the transaction” involved.” Id. citing Dornier, 453 F.3d at 232 (emphasis in original).  In Province, the Fourth Circuit concluded that the settlement agreement was the “substance of the transaction,” notwithstanding the fact that PEM was not a signatory to the agreement, because it was the basis of the note purchase and gave rise to PEM’s claims. In this respect the Fourth Circuit’s decision in Province is particularly noteworthy as precedent for a court evaluating recharacterization to look beyond the facts giving rise to the underlying claim and ultimately to the economic substance of the entire context of the transaction, even if the creditor whose claim is at issue was not a party to all components of that context.

Bank of New York Mellon lost priority status for its claim of $312 million in the liquidation of Sentinel Management Group when the 7th Circuit held that it should have suspected Sentinel was misusing customer assets and conducted an investigation into the source of the collateral Sentinel had posted.  The 7th Circuit clarified the doctrine of “inquiry notice” in a bankruptcy proceeding in its decision, and the holding requires firms to be reasonably diligent in investigating any suspicions they have relating to their customers or risk the loss of their security interest in pledged collateral.

Sentinel, a trading firm, had (in violation of federal law) pledged its customers’ securities to Bank of New York Mellon and Bank of New York (“BNYM”) as collateral for $312 million of loans to support Sentinel’s proprietary trading.  Following the bankruptcy, BNYM asserted a senior secured claim against Sentinel based on these pre-petition loans. The bankruptcy trustee, Fredrick J. Grede asserted that the transfer of customer securities to the firm’s clearing account constituted a fraudulent transfer, and that BNYM had not accepted the securities “in good faith” because it was on ‘inquiry notice’ – it was aware of suspicious facts that should have prompted an investigation that would have uncovered Sentinel’s use of its customer’s assets.  The District Court originally ruled that no fraudulent transfer had occurred, and the 7th Circuit reversed that decision on appeal and ruled that Sentinel had made fraudulent transfers, and remanded for determination of if BNYM had been on inquiry notice. After the District Court held that BNYM had not been on inquiry notice, Sentinel’s trustee appealed again to the 7th Circuit.

At stake in a finding that BNYM had not received the securities “in good faith” was the priority of BNYM’s $312 million claim.  If BNYM had received the securities in good faith it was entitled to senior secured status and a full recovery, while if it had not received the securities in good faith it was entitled only to an unsecured claim.

The 7th Circuit held that a company or person is on inquiry notice if they have “knowledge that would lead a reasonable, law-abiding person to inquire further” or would make a reasonable person “suspicious enough to conduct a diligent search for possible dirt.”  It is not necessary that such search actually be done, and that the company did not know of fraud or other wrongdoing is not sufficient to avoid being on inquiry notice.

The 7th Circuit identified a specific email from a BNYM employee, asking how Sentinel was able to provide $300 million in collateral with less than $20 million in capital (and, as the 7th Circuit noted, the actual figure was closer to $2-3 million) as sufficient information for a reasonable person to have begun an investigation.  Furthermore, had BNYM conducted an investigation into how Sentinel was able to provide its collateral, it would have discovered Sentinel was pledging its customers assets based on documents already in the bank’s possession.  BNYM had never conducted such an investigation and had relied on Sentinel’s assurances, but the 7th Circuit held that given the apparent disconnect between Sentinel’s capital and Sentinel’s ability to supply collateral, a reasonable person would have investigated and discovered Sentinel was misrepresenting its rights in the collateral.

The Sentinel decision is a significant victory for the Sentinel trustee and offers significant support to future trustees of failed financial firms seeking to recover misused customer funds, and ultimately the customers whose funds or securities were misused.  To avoid similar results, companies must be diligent in investigating any suspicions with regard to collateral they have received.  Relying on assurances from the firm that all regulations have been followed will not be sufficient to protect a company if a court determines that more investigation was needed.

In a recent opinion providing guidance to bankruptcy courts on a developing issue of law, the Second Circuit affirmed a decision of the District Court for the Southern District of New York subordinating contribution claims pursuant to section 510(b) of the Bankruptcy Code because they arose from the purchase or sale of a security of an affiliate of the debtor.  In its decision, the Second Circuit expressly recognized the equitable powers of the bankruptcy courts to determine the appropriate level of subordination.

In ANZ Securities, Inc., et al. v. Giddens (In re Lehman Bros. Inc.), the trustee for the liquidation of Lehman Brothers Inc. (LBI) under the Securities Investor Protection Act of 1970 (SIPA) had moved the Bankruptcy Court in 2013 to subordinate claims by various underwriters seeking contribution from LBI as co-underwriter for securities issued by Lehman Brothers Holdings Inc. (LBHI), LBI’s parent. A group of underwriters asserted that approximately $78 million in settlements and legal fees incurred in defending claims by investors in the LBHI securities should be reimbursed by LBI under the underwriting agreements.

In his motion, the trustee relied on section 510(b), which provides that “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.” 11 U.S.C. § 510(b) (emphasis added). The trustee argued that, under the plain language of the statute, these claims must be subordinated because they sought reimbursement or contribution and arose from the purchase or sale of securities issued by an affiliate of LBI. The underwriters argued that § 510(b) did not apply because the LBHI securities do not represent any claims or interests in the LBI SIPA proceeding.

As we previously covered, on January 30, 2014, the Bankruptcy Court for the Southern District of New York granted LBI’s motion and subordinated the underwriters’ claims to the claims of general unsecured creditors, reasoning that “the claims represented by such security are the claims of the []Underwriters for reimbursement and contribution.”   In re Lehman Bros, Inc., 503 B.R. 778, 787 (Bankr. S.D.N.Y. 2014) (Peck, J.).  After an appeal, on September 5, 2014, the District Court affirmed the Bankruptcy Court’s Order, but applied a different interpretation of the portion of § 510(b) that governs the level to which the claims must be subordinated. Specifically, the District Court focused on the type of security rather than the type of claim involved, and explained that, “a straightforward and practical application of section 510(b) recognizes that unsecured, non-equity securities represent unsecured claims, meaning that claims involving such securities must be subordinated to general unsecured claims.” In re Lehman Bros. Inc., 519 B.R. 434, 451 (S.D.N.Y. 2014) (Scheindlin, J.).

After further appeal, on December 14, 2015, the Second Circuit affirmed the District Court’s decision and adopted Judge Scheindlin’s construction of § 510(b). The court held that, “in the affiliate securities context, ‘the claim or interest represented by such security’ means a claim or interest of the same type as the affiliate security.” ANZ Securities, Inc. v. Giddens (In re Lehman Bros., Inc.), No. 14-3686, 2015 WL 8593604, at *3 (2d Cir. Dec. 14, 2015) (Jacobs, Walker, Livingston, JJ.). Accordingly, “claims arising from securities of a debtor’s affiliate should be subordinated in the debtor’s bankruptcy proceeding to all claims or interests senior or equal to claims in the bankruptcy proceeding that are of the same type as the underlying securities (generally, secured debt, unsecured debt, common stock, etc.; and in some circumstances potentially a narrower sub‐category).” Id. Relying mainly on textual principles, in addition to legislative history and policy rationales for the statute, the court explained that this construction allowed the statute to apply to claims related to affiliate securities, which were expressly included in the provision. The court rejected the underwriters’ narrow construction which would limit the affiliate securities provision to two hypothetical scenarios (i.e. when the debtor has guaranteed payment of its affiliate’s securities, or when the estates of the debtor and its affiliate are substantively consolidated), citing Second Circuit precedent construing the statute broadly. The court also made clear that the text of § 510(b) applies to claims for contribution or reimbursement.

With its instruction to subordinate claims based on the type of the underlying securities, the Second Circuit explained that bankruptcy courts, as courts of equity, might need to group claims for subordination into narrow sub-categories, or add tiers if priority levels among the affiliate’s securities are not mirrored in the debtor’s estate, but also noted that the bankruptcy courts are well-suited to do so. The court emphasized that “bankruptcy judges regularly make these determinations, and they are better situated to do so” than appellate courts. ANZ Securities, 2015 WL 8593604, at *7. As a practical matter, the court noted that “it may become somewhat messy to superimpose the capital structure of the affiliate onto that of the debtor,” but found that this approach “preserves flexibility needed by the bankruptcy court.” Id., at *6. In the LBI SIPA proceeding, the issue is straightforward because there is no need for the bankruptcy court to make any further determinations once the claims are subordinated below the level of general creditor claims.

Prior to this decision, only a handful of courts had addressed the question of whether and how to subordinate claims based on affiliate securities. Though every such court has found that subordination is required in this situation – at least when the debtor was a corporate entity – these decisions each had varying interpretations of § 510(b). The recent Court of Appeals’ decision in ANZ Securities v. Giddens provides a clear and thorough interpretation of the statute’s affiliate clause that will guide lower courts within the Second Circuit and likely in other jurisdictions as well. The decision makes clear that the text of § 510(b) is to be construed broadly, such that claims arising from the securities of an affiliate of the debtor, including contribution or reimbursement claims by non-investors such as underwriters, must be subordinated. Importantly, the Second Circuit also makes clear that, as a specialized court with equitable powers, the bankruptcy court has the ability to sort out the potentially complex issues involved in determining priority levels for subordination.

On June 1, 2015, the U.S. Supreme Court issued its decision in Bank of America v. Caulkett.[1] The Court’s unanimous opinion, which was written by Justice Thomas, established that junior mortgage lienholders maintain a “secured” claim against a bankrupt debtor even where the junior mortgage lien is completely underwater. Further, an underwater junior mortgage lien cannot be voided if the lien is an “allowed” claim within the meaning of the section 502(a) of the Bankruptcy Code.  In the wake of the foreclosure crisis, the decision constitutes a significant victory for the many banks that issued second mortgages on homes owned by individuals who filed for bankruptcy at a time when the amount owed on their first mortgage exceeded the actual value of their homes.

For background, in Bank of America v. Caulkett, the respondents, two individuals, each owned homes with junior liens held by Bank of America.[2] The amount each respondent owed on his primary mortgage was greater than the respective value of each home.[3] Accordingly, Bank of America’s junior lien was completely “underwater” in both instances.[4] Each respondent filed for bankruptcy and sought to void the junior lien held by Bank of America pursuant to Bankruptcy Code section 506(d), which voids liens that do not constitute “allowed secured claims” against a debtor.[5] The Bankruptcy Court permitted voiding of the liens.[6] Bank of America appealed, and both the District Court and the Eleventh Circuit affirmed the Bankruptcy Court’s ruling.[7] The Supreme Court then decided the case on certiorari.

Both parties agreed that Bank of America’s claim against the debtors was an “allowed” claim within the meaning of section 502. The major issue before the Court was whether Bank of America’s underwater junior lien constituted a “secured claim” within the meaning of section 506(d), thus preventing Bank of America’s claim from being voided.[8]

The respondents argued that the claim was unsecured, and therefore could be voided, relying on Bankruptcy Code section 506(a)(1) which states that “[a]n allowed claim of a creditor secured by a lien on property…is a secured claim to the extent of the value of the creditor’s interest…in such property” and “an unsecured claim to the extent that the value of such creditor’s interest…is less than the amount of such allowed claim.”[9] A plain reading of the text suggests that an underwater junior lien is unsecured and voidable.

Nevertheless, the Court relied on its previous decision in Dewsnup v. Timm[10] to find that an underwater junior lien is a secured claim. In Dewsnup, the Court held that if a claim “has been ‘allowed’ pursuant to § 502 of the Code and is secured by a lien with recourse to the underlying collateral, it does not come within the scope of 506(d).”[11] The Caulkett Court, therefore, found that under Dewnsup, a secured claim is “a claim supported by a security interest in property, regardless of whether the value of the property would be sufficient to cover the claim.”[12] Although the claim at issue in Dewsnup involved a partially underwater lien, the Caulkett Court held that the definition of “secured claim” includes claims involving liens that are wholly underwater—that is, where after taking into account the money owed on the first mortgage, the value of the junior lienholder’s interest in the property would be zero. The Court found no reason to limit its holding in Dewsnup to claims backed by collateral with some value, noting that imposing this proposed limitation could lead to “arbitrary results” in light of the “constantly shifting value of real property.”[13] Accordingly, the Court found that wholly underwater junior liens, such as those held by Bank of America were allowed secured claims that could not be voided under section 506(d).

Bank of America v. Caulkett’s implications for underwater junior lienholders is significant. By establishing that the issuer of a second mortgage can maintain a secured claim against a debtor that cannot be voided, Caulkett means that underwater junior lienholders may have a shot at recovery where they otherwise would not. However, the overall reach of Caulkett may be limited to the chapter 7 context. Lien allowance and avoidance in the chapter 11 context is determined by the application of other code sections including 111(b), 1123(b)(5) and the cram down provisions of the Bankruptcy Code. This, along with the fact that the Court did not discuss the broader application of its ruling, indicates that it is unlikely that Caulkett will have any impact on the treatment of underwater junior liens in the chapter 11 context.

[1] Bank of America v. Caulkett, 135 S.Ct. 1995 (2015).

[2] Id. at 1998.

[3] Id.

[4] Id.

[5] Id.

[6] Id.

[7] Id.

[8] Id.

[9] Id. at 1998-99.

[10] Dewsnup v. Timm, 112 S.Ct. 773 (1992).

[11] Id. at 777.

[12] Id. at 1999.

[13] Id. at 2000-01.

Mandatory subordination pursuant to section 510(b) of the Bankruptcy Code is commonly applied where claims arise from the purchase or sale of securities that were issued by the debtor.  Less common is the situation where a debtor seeks subordination of claims that arise from a transaction involving securities of an affiliate of the debtor.  This fact pattern was addressed by U.S. Bankruptcy Court Judge James M. Peck of the Southern District of New York in a decision in which the court upheld the subordination of such claims by the trustee overseeing the liquidation of Lehman Brothers Inc. (LBI) under the Securities Investor Protection Act of 1970 (SIPA).

Section 510(b) of the Bankruptcy Code states that claims shall be subordinated when “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.”

In 2013, the LBI trustee filed two separate motions seeking, among other things, to subordinate unsecured general creditor claims in reliance on the “affiliate of the debtor” language of section 510(b).  The claims subject to the motions involved securities that were issued by Lehman Brothers Holdings Inc. (LBHI), the former parent and an undisputed affiliate of LBI.

The first motion concerned claims by various underwriters of LBHI securities who alleged that they were entitled to indemnification, contribution, or reimbursement from LBI as co-underwriter for those securities.  These underwriter claimants asserted that they had incurred more than $300 million in settlements and legal fees as a result of defending claims brought against them by investors of the LBHI securities.  The trustee argued that these claims were subject to subordination under the plain language of the statute because they sought reimbursement or contribution and arose from the purchase or sale of securities issued by LBI’s parent.  (The question of whether claims for contribution by underwriters of a debtor’s securities are subject to section 510(b) was undisputed, as it had already been answered in the affirmative in In re Jacom Computer Servs., Inc., 280 B.R. 570 (Bankr. S.D.N.Y. 2002)).

The underwriter claimants argued in favor of a narrow reading of section 510(b), focusing on the language of the statute which states that applicable claims “shall be subordinated to all claims or interests that are senior to or equal the claim or interest represented by such security.” (emphasis added).   The claimants argued that because no claims or interests represented by LBHI securities were present in the SIPA proceeding, there were no claims or interests to which the underwriters’ claims could be subordinated.

The second motion was filed by a former prime brokerage customer seeking damages arising from the failure of LBI to complete an agreement to buy LBHI bonds the last trading day before LBHI went bankrupt.  The trustee argued that this claim should be subordinated pursuant to section 510(b) because it arose from the failure by LBI to purchase securities that were issued by LBI’s parent.  The claimant argued that the language of section 510(b) was ambiguous as applied to these facts because the underlying securities, issued by an affiliate of the debtor, were not themselves valid claims against the debtor.   As such, the claimant argued, its claim could not be subordinated to a claim “represented by such security.”

Judge Peck agreed with the trustee that the plain language of section 510(b) applied to the claims, and found it unnecessary to consider the legislative history of this provision or the theories and public policy behind subordination.  Though the underlying securities were of an affiliate in a different bankruptcy proceeding and not part of LBI’s capital structure, the claims nevertheless fit within the statutory framework and were properly subject to subordination under section 510(b) to all claims that are senior or equal to the general unsecured claims against LBI.  The court held that the claims were based on the LBHI securities from which they arose.  Judge Peck noted that “[a]lthough claimants have been creative in their attempts to portray the language of section 510(b) as unclear and inapplicable to their claims, the statute is clear in requiring subordination” because ultimately “[i]n both of these circumstances, the bonds were issued by an affiliate of LBI and the claims made against LBI arise out of and are based upon transactions that relate to these bonds.”[1]  The matter is now on appeal to the district court.


[1].     In re Lehman Brothers Inc., No. 08-01420 (JMP), 2014 WL 288571, at *1 (Bankr. S.D.N.Y. Jan. 27, 2014).