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).

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.

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).