In In re Linn Energy, LLC, 2019 WL 4149481 (5th Cir. Sept. 3, 2019), the Fifth Circuit recently reminded us that if a debt instrument looks like a security and quacks like a security, it likely is a security for purposes of subordination under section 510(b) of the Bankruptcy Code. The implications of characterizing an instrument as a security under section 510(b) is that any claim arising therefrom is subject to subordination to general unsecured creditors. This is generally the death-knell for any recovery by the subordinated debt holder.
Starting with a trust established in the 1930’s and continuing through a series of subsequent transactions, Clarence Bennett (the “Beneficiary”) was entitled to 37.5% of the income paid as dividends on certain shares of a publicly-traded company, Berry Petroleum Company (“BPC”). In 2013, when the company entered into a share for share exchange with Linn Energy LLC and LinnCo LLC (collectively, “Linn”), BPC became a new entity, but Linn agreed to honor the obligations to pay the Beneficiary what had been structured as “deemed dividends,” which were akin to settlement payments and were based on hypothetical shares in BPC that had been retired.
After the agreement with Linn was entered into, the Beneficiary received no more deemed dividends, and litigation ensued.
In 2016, Linn filed bankruptcy, and the representative of the Beneficiary (who had deceased) filed a $10 million claim for unpaid deemed dividends owed by Linn. Linn objected to the claim on the basis that it should be expunged or subordinated under section 510(b) of the Bankruptcy Code.
The bankruptcy court and district court (on appeal) both agreed that the Beneficiary’s claim should be subordinated. On further appeal, the Fifth Circuit agreed.
Section 510(b) of the Code generally 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 . . . , 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). This provision “serves to effectuate the general principles of corporate and bankruptcy law: that creditors are entitled to be paid ahead of shareholders in the distribution of corporate assets.” In re SeaQuest Diving, LP, 579 F.3d 411, 417 (5th Cir. 2009).
The Fifth Circuit found that while the policy goals of section 510(b) are clear, its application is complicated by the language in the statute. Given the ambiguity in the Code, the Court found that “the policy rational behind [s]ection 510(b) must always guide its interpretation and application to particular facts.” Thus, according to the Court, “[t]he most important question is this: Does the nature of the [claimant’s] interest make the [claimant] more like an investor or a creditor?”
The Fifth Circuit used three elements in applying section 510(b):
- whether the claim is for damages;
- whether the claim involves securities; and
- whether the claim arises from a purchase or sale having a nexus with those securities.
With respect to the first element, the Court noted that “damages” under section 510(b) connotes “some recovery other than the simple recovery of an unpaid debt due upon an instrument.” Thus, claims for fraud or breach of fiduciary duty and claims predicated on post-issuance conduct (including breach of contract) can fall within the purview of section 510(b). Accordingly, the Court reasoned that the Beneficiary’s claim, which included breach of contract, misrepresentation, elder abuse and breach of fiduciary duty, was not a simple claim for unpaid debt and therefore fell within the types of damages covered by section 510(b).
With respect to the second element, the Beneficiary’s representative argued that his claim did not involve securities because the deemed dividends (a) were non-transferrable, (b) did not convey voting or shareholder rights, (c) were non-negotiable and (d) did not give the Beneficiary a right to demand dividend payments, all of which are characteristic of regular stock.
The Fifth Circuit found, however, that the deemed dividends fell within the residual clause of the definition of a “security” under the Bankruptcy Code, which provides that an instrument can be considered a security if it is any “other claim or interest commonly known as a security.” 11 U.S.C. § 101(49)(A)(xiv). In this instance, the Court reasoned that because the Beneficiary had the “same risk and benefit expectations as shareholders,” the deemed dividends bore sufficient hallmarks of a security to be covered by section 510(b).
On the last element–whether the claim arises from the purchase or sale of a security of the debtor–the Fifth Circuit noted that this element is met when there exists some nexus or causal relationship between the claim and the sale. Under this broad reading, “the fact that the claims in the case seek to recover a portion of the claimants’ equity investment is the most important policy rationale.” The Court essentially adopted a “but-for causation” standard, where a claim does not exist but for the purchase or sale of a security.
Utilizing this broad standard, the Court had little trouble finding that the Beneficiary’s claim arose from the 2013 agreement with Linn, where Linn agreed to continue making the deemed dividend payments. According to the Court, “[a] claim (no matter how it is characterized by the claimant) arises from a securities transaction so long as the transaction is part of the causal link leading to the alleged injury.” (quoting In re Lehman Bros. Holdings Inc., 855 F.3d 459, 478 (2d Cir. 2017)). The Court further emphasized that (a) it is irrelevant that some of the claims are predicated on post-issuance conduct and (b) determining the exact transaction where a claim arises–recall, the Beneficiary’s rights arose from a series of transactions–is less important than determining what interest the claimant seeks to recoup.
Given the broad application of section 510(b) in the Fifth Circuit, a claimant whose equity interest has been damaged by the issuing company should be proactive and carefully track the financial condition of the company to determine what type of remedy and settlement it should seek. As was the case in Linn, any settlement that essentially only preserves the economic value of the equity interest will likely be subject to subordination in any subsequent bankruptcy of the issuing company.