United States: Second Circuit Provides Guidance On Subordination Of Claims Under Section 510(b)

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.

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