In In re Lehman Brothers Holdings Inc., the U.S. Court of Appeals for the Second Circuit recently affirmed that claims filed by Lehman employees on account of restricted stock units (“RSUs”) are subject to subordination under section 510(b) of the Bankruptcy Code.

When Lehman filed its chapter 11 case, thousands of its employees held RSUs, which are compensatory awards giving employees the contingent right to own Lehman common stock following a five year holding period. Many of those employees filed proofs of claim seeking cash payments for the face value of their RSUs. The debtors objected to such claims on the basis that the claims must be subordinated under section 510(b). The bankruptcy court sustained the objection, and the district court affirmed. Certain of the employees appealed to the Second Circuit.

Section 510(b) of the Bankruptcy Code provides as follows:

[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, except that if such security is common stock, such claim has the same priority as common stock.

The purpose of section 510(b) is to safeguard the absolute priority rule, which generally results in creditors being entitled to payment before shareholders with respect to the distribution of the debtor’s assets. Section 510(b) prevents shareholders from inappropriately elevating their equity interests to the priority of unsecured claims, which may occur if shareholders bootstrap the value lost in their equity interests into a breach of contract or fraud claim.

After reviewing the statutory language, the Second Circuit concluded that RSUs must be subordinated pursuant to section 510(b) if (i) they are “securities,” (ii) the employees acquired them in a “purchase,” and (iii) the claims for damages arise from that purchase or a rescission of it.

The court had no difficulty concluding that RSUs are securities because of their hallmark characteristics: the holders of the RSUs had voting rights, received declared dividends, and had the risk and benefit expectations of shareholders because the value of the RSUs was tied to the value of Lehman common stock.

The court also determined that the employees “purchased” the RSUs because the employees agreed to receive them in exchange for their labor. A subset of the employees argued that when their employer, Neuberger Berman, was acquired by Lehman, the employees had no choice but to continue employment with Lehman because not doing so would require them to forfeit their previously earned equity in Neuberger Berman and to abandon their careers in light of non-compete covenants imposed by Neuberger Berman. The court rejected this argument, reasoning that such employees had the choice to quit after the merger, but chose not to do so out of rational self-interest.

Finally, the court concluded that the employees’ claims arise from the purchase or rescission of a securities transaction because, no matter the characterization by a claimant, a claim arises from a securities transaction so long as the transaction is part of the casual link leading to the alleged injury.