1. Mandatory Subordination Under
the Bankruptcy Code
by David S. Kupetz
333 S. Hope Street, 35th Floor
Los Angeles, CA 90071
(213) 617-5274
dkupetz@sulmeyerlaw.com
2407513.1

2. David S. Kupetz specializes in troubled transactions, crisis avoidance consultation, workouts,
restructurings, reorganizations, bankruptcies, receiverships, assignments for the benefit of
creditors and other non-bankruptcy insolvency proceedings. He represents debtors (in
restructurings and workouts and in chapter 11 reorganization cases), secured creditors,
unsecured creditors' committees, assignees for the benefit of creditors, buyers/sellers of
businesses/assets in distressed circumstances and other entities in insolvency and bankruptcy
situations.
A sampling of clients represented by Mr. Kupetz includes: Care Enterprises, Inc. (debtor in
possession); Ocean Pacific Sunwear, Ltd. (debtor in possession); County of Los Angeles
(creditor); General Electric Capital Corporation (secured lender); Litton Industries, Inc. (creditor);
Boston West, LLC (Boston Markets) (debtor in possession); ExxonMobil Corporation (creditor);
Honda Trading Co. (creditor); CKE Restaurants (creditor); San Diego Television, Inc. (debtor in
possession); South Bay Pizza, Inc. (debtor in possession); Transgo Corp. (unsecured creditors’
committees); Aura Systems, Inc. (out-of-court unsecured creditors’ committee); Snow Valley, LLC
(debtor in possession); Gardenburger, Inc. (debtor in possession); eStyle, Inc. (debtor in
possession); American Home (debtor in possession); No Fear Retail Stores, Inc. (debtor in
possession); and Ventura Port District (chapter 9 debtor).
His many articles on bankruptcy-related subjects have been published in The Business Lawyer,
Commercial Law Journal, IDEA: The Journal of Law and Technology, Journal of Bankruptcy Law
and Practice, The Annual Survey of Bankruptcy Law, The Urban Lawyer, The Banking Law
Journal, Los Angeles Lawyer, California Lawyer, Commercial Law Bulletin, Los Angeles Daily
Journal, The Secured Lender, The Journal of Private Equity, The Journal of Corporate Renewal,
Public Law Journal, Federal Lawyer and many other publications. Mr. Kupetz served as the
author of Collier Commercial Bankruptcy Forms for many years and currently is the author of the
Collier Handbook for Creditors' Committees.
Mr. Kupetz is a frequent lecturer on reorganization and other insolvency topics.
David S. Kupetz
Direct Line: 213.617.5274
dkupetz@sulmeyerlaw.com
www.sulmeyerlaw.com
Los Angeles Office
333 South Hope Street
Thirty-Fifth Floor
Los Angeles, CA 90071
Voice: 213.626.2311
Fax: 213.629.4520

3. Introduction
 A basic concept underlying the Bankruptcy Code is
that claims of creditors are entitled to distribution
ahead of holders of equity interests in the debtor.
 Bankruptcy Code section 510(b) provides for
mandatory subordination of certain claims related to
a security of the debtor.
 Without § 510(b), shareholders with a valid claim for
damages have the same rights as creditors to
recover their investment in the bankrupt firm.

4. Introduction Cont.
 In O'Donnell v. Tristar Esperanza Properties, LLC (In re
Tristar Experanza Properties, LLC), the Bankruptcy Appellate
Panel for the Ninth Circuit (the "BAP") carefully examines
section 510(b).
 That provision mandates subordination of claims for
"damages arising from the purchase or sale" of a "security" of
a debtor.
 The BAP concluded that section 510(b) encompasses a
claim that arose from the withdrawal of a member from an
LLC, which withdrawal triggered a repurchasing process
whereby the debtor-issuer was to buy back the interest from
the investor.

5. Introduction Cont.
 At its core, the basis for this conclusion is that the
claim at issue was so firmly rooted in the holder's
equity status that subordination was mandatory.
 This causal nexus mandated subordination.
 The purpose and result of such subordination is to
adjust the place in line of certain claims related to a
security of the debtor in the bankruptcy distribution
scheme.

6. Tristar
 The debtor in Tristar is a California limited liability
company. The company is governed by an operating
agreement. Jane O'Donnell ("O'Donnell") obtained a
membership interest in the company (approximately
14%) through a $100,000 investment.
 O'Donnell invoked the withdrawal and buy-back
provision under the Company's operating agreement.
 This triggered a process in which Tristar and the
withdrawing member would use best efforts to agree
upon the fair market value of the subject interest.

7. Tristar Cont.
 O'Donnell and the company were unable to
agree on a fair market value.
 O'Donnell initiated an arbitration. The arbitrator
awarded O'Donnell damages of approximately
$400,000.
 The arbitration award was confirmed by a state
court and reduced to a judgment.

8. Tristar Cont.
 After commencing a chapter 11 case, the debtor
in Tristar filed an adversary proceeding against
O'Donnell seeking, among other things,
mandatory subordination of her claim under
section 510(b).
 While courts have applied section 510(b) to
subordinate claims under varying circumstances,
the facts of Tristar were novel.

9. Code § 510
 Subordination demotes a claim from its nominal
priority.
 Section 510 of the Bankruptcy Code provides for
three distinct forms of subordination:
(1) subordination by agreement;
(2) mandatory subordination of certain claims
related to a security; and
(3) equitable subordination.

10. Code § 510 Cont.
 Bankruptcy Code section 510(b) provides:
 (b) 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, 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 to the claim or interest represented by such
security, except that if such security is common stock,
such claim has the same priority as common stock. 11
U.S.C. § 510(b).

11. Code § 510 Cont.
 Section 510(b) contemplates three types of
claims – rescission, damages, and
reimbursement/contribution – that all have a
nexus with the purchase or sale of a security.
 Only the damages clause of section 510(b) was
at issue before the BAP in Tristar.

12. Security
 In order for mandatory subordination under
section 510(b) to apply, the claim at issue must
have some relation to a "security" of the debtor.
 The BAP examined the threshold question of
whether a membership interest in a limited
liability company is a "security" under the
Bankruptcy Code.
 The Bankruptcy Code does not contain a specific
definition of the term "security".

13. Security Cont.
 The statute provides fifteen examples of securities, and 7
examples of what is not a security.
 These examples do not mention a membership interest in
a limited liability company.
 The BAP analyzed whether an interest in a limited liability
company constitutes a "security" for purposes of section
510(b) by comparing that interest to an analogous
example of a "security" contained in the Bankruptcy
Code.
 Determining that a membership interest in a limited
liability company is a security for purposes of section
510(b), the BAP turned its focus to whether the claim at
issue is a claim for "damages."

14. Damages
 The claimant inTristar asserted that the state
court judgment she held confirming an
arbitration award did not constitute a claim
"for damages" covered by section 510(b).
 The claimant contended that she held a claim
based on a judgment for a "fixed debt" and
that her right to payment did not arise from
the purchase or sale of securities of the
debtor.

15. Damages Cont.
 The language of § 510(b) provides that
"damages" requiring subordination must arise
from the purchase of sale of the debtor's
securities, but does not otherwise purport to
describe the nature of the claim for relief or
the types of damages that may be recovered.
 The BAP found no ambiguity in the use of
"damages" in section 510(b).

16. Damages Cont.
 The BAP rejected the claimant's contention that
section 510 "damages" require wrongdoing or
malfeasance.
 Given the arbitration award was an order to pay
money as a matter of contractual right and achieved
the status of a judgment debt once the award was
confirmed, the arbitration award and judgment
qualify as § 510(b) "damages.“
 The BAP next turned to whether the claim for
damages that originated from the claimant's
membership interest in a limited liability company is
a claim that arises from the purchase or sale of a
security as that language is used in section 510(b).

17. Arising From
 Section 510(b) is limited to claims arising from
the purchase or sale of a debtor's securities.
 All Courts of Appeal that have examined the
"arising from" language in section 510(b) have
found it to be ambiguous.
 Courts interpreting section 510(b) have
examined the legislative history and policy
rationales underlying the section, and have
reached varying conclusions regarding the scope
of mandatory subordination under section
510(b).

18. Arising From Cont.
 The ambiguity in § 510(b) permits competing
narrow and broad interpretations.
 A narrow reading requires that the injury flow
from the actual purchase or sale.
 A broad reading requires that the purchase or
sale be part of a causal link even though the
injury may flow from a subsequent event.

19.  Courts of Appeals have adopted expansive readings of section
510(b) based on the legislative history and policy
considerations underlying the section.
 In Am. Broad. Sys. v. Nugent (In re Betacom), the Ninth Circuit
addressed a claim for damages under a merger agreement
pursuant to which the target/debtor shareholders should have
received stock of the acquirer/debtor but did not and asserted
a claim against the acquirer/debtor in jointly administered
bankruptcy cases.
 The Ninth Circuit concluded that section 510(b) is not limited
with cases of shareholder fraud, that the subordinated
claimant need not actually be a shareholder, and that an
actual sale of a security is not required.
Arising From Cont.

20.  Subsequently, the Ninth Circuit addressed another section
510(b) case. In Racusin v. Am. Wagering, Inc. (In re Am.
Wagering, Inc.), the claimant was not a shareholder, but rather
was a financial advisor hired in connection with an initial public
offering.
 The financial advisor had merely contracted to be paid for his
services on the basis of share price.
 He sued when he did not receive the compensation promised
in his employment agreement.
 While restating its expansive reading of section 510(b), under
these circumstances, the Ninth Circuit declined to subordinate
the claim.
Arising From Cont.

21.  In Allen v. Geneva Steel Co. (In re Geneva Steel
Co.), the Tenth Circuit subordinated a
shareholder's claim based on fraud by the debtor
that caused the shareholder to retain its stock.
 In Baroda Hill Inv., Inc. v. Telegroup, Inc. (In re
Telegroup, Inc.), the Third Circuit subordinated a
shareholder's breach of contract claims based on
the debtors' failure to use their best efforts to
ensure that the stock was registered and freely
tradable.
Arising From Cont.

22.  In Rombro v. Dufrayne (In re Med Diversified, Inc.), the
Second Circuit, interpreting section 510(b) subordinated
a breach of contract claim by a former employee relating
to the debtor's failure to issue shares.
 In a case involving facts with similarities to Tristar, the
Fifth Circuit in SeaQuest Diving, LP v. S&J Diving, Inc. (In
re SeaQuest Diving LP), subordinated a claim under
section 510(b) based on a state court judgment enforcing
a contract requiring the debtor to repurchase partnership
interests in the debtor.
Arising From Cont.

23.  The courts considering the ambiguous "arising
from the purchase or sale of" a debtor's security
language of section 510(b) have turned to the
legislative history.
 Section 510's legislative history does not reveal
an intent to tie mandatory subordination
exclusively to securities fraud claims.
Legislative History

24.  The dissimilar expectations of investors and creditors
should be taken into account in setting a standard for
mandatory subordination.
 Shareholders expect to take more risk than creditors
in return for the right to participate in firm profits.
 The creditor only expects repayment of a fixed debt.
 It is unfair to shift all of the risk to the creditor class
since the creditors extend credit in reliance on the
cushion of investment provided by the shareholders.
Legislative History Cont.

25.  The courts interpreting the "arising from" language of
section 510(b) carefully considered the policy
rationales identified by Slain & Kripke and cited in
the legislative history underlying section 510(b).
 In Betacom, the Ninth Circuit explained that there
are two main rationales for mandatory subordination
under section 510(b): (1) the dissimilar risk and
return expectations of shareholders and equity
holders; and (2) the reliance of creditors on the
equity cushion provided by shareholder investment.
Policy Rationales

26.  In Tristar, the BAP carefully considered Ninth Circuit
precedent, the Slain and Kripke analysis, and legislative
history, and applied the two rationales underpinning
section 510(b) to the facts of the case.
 O'Donnell was in fact an equity holder before she
withdrew.
 During her tenure as a member of Tristar, she enjoyed
the potential for profit based on the value of real estate.
 The confirmed arbitration award is directly linked to her
ownership of a membership interest in the debtor.
Policy Rationales Cont.

27.  By withdrawing as a member and liquidating her
interest, O'Donnell altered the Tristar balance
sheet by extracting, or, more appropriately,
attempting to extract her initial contribution.
 This would effectively deflate the equity cushion
to which trade creditors and the like would look in
recovering their claims for fixed debt.
Policy Rationales Cont.

28.  It takes only the presence of merely one of the dual
rationales to require the application of section 510's
mandatory subordination.
 The ultimate test under the broad view adopted by
Courts of Appeal is a linking test that looks to
whether a causal relationship exists between the
claim and an equity interest in the debtor.
 Simply converting that equity interest to debt will not
result in removing the claim from the reach of section
510(b).
Policy Rationales Cont.

29.  A common strategy of current and former equity
holders attempting to insulate a claim from
mandatory subordination under section 510(b) is
to assert that their claim is a “fixed debt”.
 The fact that a current or former equity holder
holds a claim does not place them outside the
scope of section 510(b).
 What matters is the type of claim, not the type of
claimant.
Rejection of the “Fixed Debt” Argument

30.  In Tristar, the claim at issue was directly linked to
ownership of an equity interest in the debtor.
 As a result of this causal relationship, the risk
and return expectations of the claimant were
viewed as those of equity holders and not
transformed into those of a creditor at the time
that the judgment was obtained.
Rejection of the “Fixed Debt” Argument Cont.

31.  At what point does a conversion of equity into debt
become "old and cold"?
 One line of cases, primarily from the District of
Delaware, has held that claims arising out of a
promissory note issued prior to the petition date in
exchange for stock, are not subject to § 510(b)
subordination.
 These promissory note cases seem premised on the
issuance of a tangible debt instrument.
Rejection of the “Fixed Debt” Argument Cont.

32.  The Delaware district court has expanded the view of
certain courts that claims arising out of a promissory note
issued prior to the commencement of a bankruptcy case
in exchange for equity interests are not subject to
mandatory subordination under section 510(b) by
applying the reasoning to a prepetition judgment ordering
the debtor to repurchase its stock from its shareholder.
 The Delaware decisions taking a narrower view of
section 510(b) are in conflict with the broad view adopted
by the Ninth Circuit and other Courts of Appeals.
Rejection of the “Fixed Debt” Argument Cont.

33.  The BAP in Tristar rejected the claimant's
arguments that the debtor's intent to utilize
section 510(b) involved some sort of bad faith
and constituted an impermissible collateral attack
on a valid state court judgment.
 The claim was directly linked to the equity
interest of the claimant and, was subject to
mandatory subordination.
Rejection of the “Fixed Debt” Argument Cont.

34.  The misdirected arguments by the appellant in
Tristar in an attempt to evade application of
section 510(b) miss the point.
 When a claim, at is core, is simply based upon
an equity interest (as in the case of Tristar where
the claim is simply the purported value of the
equity interest) the broad view of section 510(b)
mandates subordination.
Rejection of the “Fixed Debt” Argument Cont.

35.  Under the broad view of section 510(b) of the
Bankruptcy Code consistently adopted by Courts
of Appeals, the determination of whether a claim
related to an equity interest must be
subordinated is based on a linking test.
 The linking test looks to whether a causal
relationship exists between the claim and an
equity interest in the debtor.
 When that link is unbroken, subordination is
mandatory.
Conclusion