The Ninth Circuit recently held that a judgment arising from the sale of a member’s interest in a limited liability company may be subordinated as a claim arising from rescission of a purchase or sale of a security of a debtor and, therefore, is to be subordinated to claims of unsecured creditors pursuant to § 510(b) of the Bankruptcy Code.  In Pensco Trust Company et al v. Tristar Esperanze Properties, LLC (In re Tristar Esperanza Properties, LLC), 2015 WL 1474990 (9th Cir. 2015), Jane O’Donnell, a member of Tristar, acquired her interest in the debtor in 2005 for a price of $100,000.  In 2008, O’Donnell exercised her right under the operating agreement to withdraw from the LLC, and Tristar elected under the operating agreement to purchase her interest.  When they could not agree on a price, the dispute was submitted to an arbitrator O’Donnell a “net award of damages,” including the value of her interest in Tristar plus fees, costs and interest.  When the Tristar failed to pay, O’Donnell sought and obtained a state court judgment against Tristar for the amount awarded by the arbitrator.

Tristar subsequently filed bankruptcy and brought an adversary proceeding against O’Donnell seeking to subordinate her claim under 11 U.S.C. § 510(b) as a “claim . . . for damages arising from the purchase or sale of a security” in the debtor.  O’Donnell asserted that her judgment was not a claim for damages, arguing that the concept of damages requires some sort of wrongdoing or compensation for an injury, whereas her claim consisted only of the unpaid purchase price of her member interest in the debtor.  The Ninth Circuit disagreed with O’Donnell and affirmed the BAP’s decision that her claim was subject to subordination under § 510(b).

The Ninth Circuit began its analysis by looking at the plain language of § 510(b), which states in relevant part:  “a claim arising from rescission of a purchase or sale of a security of the debtor . . . [or] 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.”  The court reiterated a previous holding that § 510(b) “sweeps broadly” and “extends beyond the securities fraud claims” discussed in the report issued by the House of Representatives. 

O’Donnell first asserted that her claim was not a claim for damages but merely a fixing of the amount due under the operating agreement for Tristar’s purchase of her member interest.  The court rejected the argument, first because the arbitration award was explicitly an award of damages on which O’Donnell had obtained a judgment, and second because it found no Congressional intent to treat a judgment fixing a purchase price for a security differently from non-judgment claims arising from the purchase and sale of securities in the debtor. 

O’Donnell also argued that her claim, by reduction to judgment, had been converted from an equity claim in the debtor to a debtor claim against the debtor.  Admittedly, for the three years following the issuance of her judgment, O’Donnell had not been a member of the debtor and did not enjoy the rights and privileges of a member as of the date of the bankruptcy filing. There was no dispute that, on the date of the bankruptcy filing, she was a creditor and not an equity holder of the debtor.  While noting opinions from other courts agreeing with O’Donnell’s position, the Ninth Circuit disagreed, stating that “the critical question for purposes of § 510(b) . . . is not whether the claim is debt or equity at the time of the petition, but rather whether the claim arises fromthe purchase or sale of a security.”  The court held that such a claim must be subordinated, even if the claimant was not an equity holder as of the petition date, “if there is a sufficient ‘nexus or causal relationship between the claim and the purchase’ or sale of securities.”  In short, the focus is not to be on what the claim is, but rather what the claim arises from.  Because O’Donnell’s claim arose from an award for the purchase and sale of a security, it was to be subordinated under § 510(b).