A business consultant who contracted to receive a percentage of a company’s shares in exchange for helping the company go public—but never actually received those shares and obtained a money judgment against the company instead—was not a holder of equity for purposes of subordination under the Bankruptcy Code, the U.S. Court of Appeals for the Ninth Circuit has determined.

The ruling in Racusin v. American Wagering, Inc. (In re American Wagering, Inc.), 465 F.3d 1048 (9th Cir. 2006) reverses a decision by a bankruptcy appellate panel, and is in line with an oral decision issued by the bankruptcy court to allow the business consultant’s claim.

The Ninth Circuit’s decision follows nearly a decade of litigation between the parties. In 1994, Leroy’s Horse and Sports Place hired Racusin as a financial advisor to assist it with an initial public offering. Leroy’s became a subsidiary of OverturnedAmerican Wagering, Inc., which would become the publicly owned entity after the IPO. The agreement between Racusin and Leroy’s called for Racusin to be paid a commission of 4 percent of the final evaluation in the form of common stock and $150,000 in cash.

In 1996, while the IPO was pending, Leroy’s sued Racusin, seeking a determination that the contract was unenforceable.

Racusin removed the case to federal court and counterclaimed for breach of contract. After obtaining an initial judgment of just more than $700,000, he appealed on the ground that he was entitled to a jury trial and won. In a subsequent jury trial, Racusin was awarded stock worth more than $2.03 million.

Racusin again appealed, claiming the court should not have awarded specific performance when he sought money damages. The Ninth Circuit agreed and remanded the case for the district court to calculate the monetary value of the shares awarded. On remand, Racusin was awarded $2.3 million.

Shortly after Racusin was awarded the damages, but six years after he first had obtained a judgment against Leroy’s, the latter and American Wagering each filed for chapter 11 bankruptcy protection. Racusin filed a claim for $2.28 million, which included a set-off for cash received. The debtors brought an adversary proceeding alleging that Racusin’s claim should be subordinated under 11 U.S.C. § 510(b), which mandates subordination of “a claim…for damages arising from the purchase or sale of…a security.”

In an oral ruling, the bankruptcy court granted summary judgment to Racusin. The bankruptcy appellate panel reversed and held the claim should be subordinated.

‘Arising From’ Securities Sales

The Ninth Circuit reversed the BAP, concluding that Racusin’s claim should not be subordinated because it was not one “for damages arising from the purchase or sale of a security.” The court based its decision on the fact that the stock never was tendered to Racusin, resulting in a lawsuit for breach of contract seeking damages based on the value of the stock.

“Racusin received a money judgment for the breach and initiated legal action to receive that award long before the bankruptcy proceeding at issue here commenced,” noted the court. “Accordingly, his claim in the bankruptcy proceeding is more akin to that of a creditor than an investor....”

The court specified that not all suits for breach of contract automatically qualify as debts that survive a subordination challenge.

“That the claim is for breach of contract is not sufficient alone to prevent subordination,” the court stated. “[A] number of courts, including this one, have held that breach of contract claims may be subordinated under section 510(b) where there exists ‘some nexus or causal relationship between the claim and the purchase of the securities....’”

“[B]ut we also made clear that a claim should only be subordinated when it will accomplish the purpose of section 510(b),” the court explained. The purpose of 510(b) was to distinguish shareholders, who are expected to bear the risks of their investments, from creditors, who are entitled to be paid ahead of shareholders.

The court distinguished Racusin from cases in which breach of contract claims had been subordinated because Racusin never was offered the shares due him under the agreement.

“His potential opportunity for profit as a shareholder was eliminated long before the bankruptcy,” the court wrote. “The lengthy time period between Racusin’s first favorable judicial ruling and the filing of the bankruptcy petition distinguish this case from others with much shorter time frames….”