Rich Uncles, Poor Nephew: Investor Claims Subject to Mandatory Subordination
By: NallyAnn Scaturro
St. John’s University School of Law
American Bankruptcy Institute Law Review Staff Member
The mandatory subordination provision of title 11 of the United States Code (the “Bankruptcy Code”) ensures that creditors are paid ahead of shareholders when corporate assets are divided in a bankruptcy case. In the Matter of Linn Energy, LLC, the United States Court of Appeals for the Fifth Circuit held that a claimant’s right to receive a percentage of a bankrupt company’s profits is subject to mandatory subordination if the right is in the nature of a security.[i] Clarence Bennett had an uncle whose will created a trust for his relatives.[ii] “The will placed 250 shares of the uncle’s company, Berry Holding Company (“BHC”), into the trust and divided the trust beneficiaries into classes.”[iii] Bennett outlived the other members within his class and inherited their shares in accordance with the will.[iv] In 1986, BHC underwent a merger subsequently followed by a dispute with Victory Holding Company, which resulted in the new company agreeing to pay the group members, including Bennett, an amount equal to 37.5% of the dividends they would have received prior to the merger.[v] These payments were labeled “deemed dividends,” because no actual dividends were issued and group members only had a right to 37.5% of the income when and if the company chose to issue dividends.[vi] In 2013, the company entered into a share-for-share exchange with Linn, which promised to continue to pay Bennett, as the last surviving member of his group in his uncle’s will, the deemed dividends.[vii] In late 2014, Linn filed suit in the Eastern District of California seeking a declaration that it owed Bennett nothing.[viii] Bennett filed a counterclaim in January 2015, then died in June 2015, and his estate filed an amended counterclaim.[ix] In May 2016, Linn, Berry, and other associated entities filed a voluntary Chapter 11 bankruptcy petition, which greatly decreased Bennett’s estate’s chances of recouping the $10 million. [x] Bennett’s estate filed claims for almost $10 million in unpaid deemed dividends in the bankruptcy case. [xi] The Debtors objected, claiming Bennett was an investor, and thus his claims should be expunged. [xii] The bankruptcy court subordinated half of the estate’s claims, which, because of the Debtor’s limited assets, effectively destroyed the estate’s chances of recovering any money.[xiii] Thereafter, the estate appealed the district court’s decision to the Fifth Circuit. [xiv] The Fifth Circuit affirmed the district court’s order finding that because “the deemed dividends gave the Estate benefits normally reserved for equity investors . . . subordination of all of the Estate’s claims was appropriate.” [xv] Thus, even though the Estate argued that its interest did not count as a security because Bennett could not sell, bequeath, or transfer his interests, vote, or demand dividends the court found that it was in fact a security interest under the residual clause because Bennett “had the same risk and benefit expectations as shareholders.” [xvi]
Subordination upholds a basic tenet of bankruptcy law – creditors are entitled to be paid before shareholders when corporate assets are distributed.[xvii] Because investors and creditors accept different amounts of risk, they are entitled to different priority when a company becomes insolvent. Subordination is equitable because creditors never anticipate more than the repayment of their debts whereas shareholders take part in the company’s profits. [xviii] Thus, the primary inquiry is “[d]oes the nature of the interest make the [party] more like an investor or a creditor?”[xix] Here, the court found that Bennett’s interest was more akin to that of a shareholder than a creditor because of his rights and obligations and, therefore, allowing his Estate to recoup the “deemed dividends” would have been inappropriate because it would upset the delicate equity cushion the company’s creditors relied on when they extended credit.[xx]
Following the long-established principle that even when an interest does not perfectly align with the Bankruptcy Code’s precise definition of a security, the Fifth Circuit found that the most significant factor in making that determination are the risks and benefits associated with that interests. [xxi] Because the claimant elected to take an equity stake in the debtor, he (and his estate) became bound by the choice to trade the safety of a fixed return for the potential of shareholder status. Therefore, his estate or any other assignee could not seek to recover ahead of equity holders as a creditor. Importantly, because Bennett’s interest allowed him to partake in the successes of the company, rather than fixed payment on a loan, his claim had to be subordinated. Even where parties believe they are creating unique categories, such as “deemed dividends” with their own cited determined purpose, if this new imagined category is truly a security interest in disguise, bankruptcy law will not hesitate to enforce it as such. This is true even when the parties have set explicitly out to determine otherwise. Ultimately, if it operates like a security interest, it is a security interest.
[i] See Matter of Linn Energy., LLC, 936 F.3d 334, 338 (5th Cir. 2019).
[ii] See id.
[iv] See id. at 339.
[v] See id.
[vi] See id.
[vii] See id.
[viii] See id.
[ix] See id.
[x] See id.
[xi] See id.
[xii] See id.
[xiii] See id. at 340.
[xiv] See id.
[xv] See id. at 341.
[xvi] See id. at 343.
[xvii] See 11 U.S.C. § 510(b) (2011) (“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 . . . shall be subordinated to all claims or interests that are senior to or equal the claim or interest represented by such security”).
[xviii] See In re Granite Partners, L.P., 208 B.R. 332, 336 (Bankr. S.D.N.Y 1997) (enumerating that the most important policy rationale behind this section is that claims seeking to recover equity investments should be subordinated).
[xix] See Matter of Linn Energy., 936 F.3d at 341.
[xx] See generally id.