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).