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The Ninth Circuit Continues to Broadly Interpret § 510 (b)

By: James M. Kerins

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

          In Pensco Trust Co. v. Tristar Esperanza Props., LLC (In re Tristar Esperanza Props., LLC),[1] the U.S. Court of Appeals for the Ninth Circuit held that a creditors claim, based upon a debtor’s failure to pay an arbitration award, must be subordinated pursuant to section 510 (b) of the Bankruptcy Code.[2]  In Tristar, Jane O'Donnell purchased a minority membership interest in Tristar, a limited liability company. Three years after the purchase, she and exercised her right to withdraw her membership interest.[3] When she and the company could not agree on a price, O’Donnell brought an arbitration action, and won an award of approximately $400,000, later converted into a state court judgment.[4] Subsequently, debtor filed a chapter 11 bankruptcy petition, O'Donnell filed a proof of claim, and commenced an adversary proceeding against O'Donnell seeking to subordinate her claims under section 510 (b) of the Bankruptcy Code.[5]  O'Donnell insisted that section 510 (b) of the Bankruptcy Code did not apply because the claim was “not for damages, but for a fixed, admitted debt.”[6] Additionally, O'Donnell claimed that section 510 (b) should not apply because the claim “does not arise from the purchase or sale of securities” because she converted her equity interest to a debt claim before debtor filed its bankruptcy petition.[7]  The bankruptcy court rejected O'Donnell’s arguments and held that the subordination clause of section 510 (b) “sweeps broadly.”[8] Consequently, the bankruptcy court “broadly interpreted”[9] the phrase “arises from”[10] to mandate subordination whenever there is a “causal relationship between the claim and the purchase” or sale of securities.[11]  Furthermore, although O'Donnell did not “enjoy the benefits of equity ownership on the date of the petition,”[12] according to the bankruptcy court, since O'Donnell bargained for an equity position she therefore, “embraced the risks that position entails.”[13]  On appeal, the Bankruptcy Appellate Panel for the Ninth Circuit[14] and the United States Court of Appeals for the Ninth Circuit both affirmed.[15]

          Courts have long held that subordination under section 510 (b) is to be broadly applied.  For example, in Am. Broad. Sys. v. Nugent (In re Betacom of Phx., Inc.),[16] the Ninth Circuit stated that the subordination clause extends beyond the securities fraud claim that the House of Representatives explicitly discussed in its report.[17]  Additionally, in Leroy's Horse & Sports Place v. Am. Wagering, Inc. (In re Am. Wagering),[18] the Ninth Circuit stated that the subordination clause of section 510 (b) can even reach an ordinary breach of contract when there is a sufficient nexus between the claims and the purchase of securities.[19]  Similarly, in Tristar, the Ninth Circuit relied, in part on its Am. Broad. Sys. and  Leroy's Horse & Sports Place opinions, in reaching its decision to broadly interpret the subordination clause of section 510 (b).[20]  According to the Ninth Circuit, the critical question in a section 510 (b) analysis is whether or not the claim arises from the purchase or sale of a security.[21]  Following its ruling in Am. Wagering, the Ninth Circuit held that a claim must be subordinated if there is a sufficient “nexus or causal relationship between the claim and the purchase” or sale of securities.[22]

          The holding in Tristar is of significant value. If a court were to exclude fixed and admitted debts from “damages,” most judgments would be insulated from subordination because once a final judgment is issued the damages are fixed. This would go directly against Congress’s intent of section 510 (b). A Law review article,[23] which Congress relied on heavily when enacting Section 510 (b), stated the need for mandatory subordination best.[24] The absolute priority rule was created to reflect “the different degree to which each party assumes a risk of enterprise insolvency; no obvious reason exists for reallocating that risk.”[25] If the courts were to narrowly interpret Section 510 (b), the current priority given to preferred creditors would be eliminated. As a result, the risks for general creditors would increase because they would be forced to not only bear the risk of debtor insolvency, but also to the investment of the rescinding shareholder.[26] This would go directly against Congress’ intent. Thus, it is hardly surprising that courts reject to narrowly interpret section 510 (b).



[1] Pensco Tr. Co. v. Tristar Esperanza Props., LLC (In re Tristar Esperanza Props., LLC), 782 F.3d 492 (9th Cir. 2015).

[2] See id. at 497-98.

[3] See id. at 494.

[4] Id.

[5] Id.

[6] See id. at 495.

[7] Id.

[8] Id.

[9] See id at 497

[10] Id.

[11]  See id. (quoting Leroy's Horse & Sports Place v. Am. Wagering, Inc. (In re Am. Wagering), 493 F.3d 1067, 1072 (9th Cir. 2007)).

[12] In re Tristar Esperanza Props., LLC, 782 F.3d at 497.

[13] See id. at 498.

[14] O'Donnell v. Tristar Esperanza Props., LLC (In re Tristar Esperanza Props., LLC), 488 B.R. 394 (B.A.P. 9th Cir. 2013).

[15] In re Tristar Esperanza Props., LLC, 782 F.3d at 498.

[16] Am. Broad. Sys. v. Nugent (In re Betacom of Phx., Inc.), 240 F.3d 823 (9th Cir. 2001).

[17] See id. at 829.

[18] Leroy's Horse & Sports Place v. Am. Wagering, Inc. (In re Am. Wagering), 493 F.3d 1067 (9th Cir. 2007).

[19] See id. at 1072.

[20] See In re Tristar Esperanza Props., LLC, 782 F.3d at 495.

[21] See In re Tristar Esperanza Props., LLC, 782 F.3d at 497.

[22] See id. (quoting Leroy's Horse & Sports Place v. Am. Wagering, Inc. (In re Am. Wagering), 493 F.3d 1067, 1072 (9th Cir. 2007)).

[23] Professors John J. Slain and Homer Kripke — The Interface Between Securities Regulation and Bankruptcy — Allocating the Risk of Illegal Securities Issuance Between Security holders and the Issuer’s Creditors, 48 N.Y.U. L. REV. 261 (1973).

[24] See In re Betacom of Phoenix, Inc. 240 F.3d 823, 829 (9th Cir. 2001)(“Congress relied heavily on the analysis of two law professors in crafting the statute.”); In re Granite Partners, L.P., 208 B.R. at 336 (“Any discussion of section 510 (b) must begin with the 1973 law review article authored by Professors John J. Slain and Homer Kripke...”).

[25] Slain & Kripke, supra note 23, at 287.

[26] Slain & Kripke, supra note 23, at 288.