In a case of first impression, the U.S. Court of Appeals for the Second Circuit has held that a claim for damages based on a chapter 11 debtor’s failure to issue shares of its common stock in exchange for a claimant’s stock in another company pursuant to a termination agreement is subject to mandatory subordination.

In Rombro v. Dufrayne (In re Med Diversified, Inc.), 461 F.3d 251 (2d Cir. 2006), the court held that the claim “arose from” the purchase of the debtor’s stock within the meaning and purpose of the Bankruptcy Code’s subordination provision.

David Rombro was an executive employee at Med Diversified, Inc. (the “Debtor”). Following certain disputes, the parties entered into a termination agreement under which the Debtor agreed to issue to Rombro shares of its common stock in exchange for stock that Rombro held in another company. The agreement provided that, except for the stock exchange and minor payments, the Debtor did not owe Rombro any other salary and benefits, and that the parties release any claims, other than a claim for a breach of the agreement itself, arising out of Rombro’s employment and termination.

The stock trade never occurred, and Rombro brought suit for breach of contract and fraudulent inducement.

The Debtor filed for relief under chapter 11 of the Bankruptcy Code, obtaining an automatic stay of Rombro’s lawsuit. Rombro filed a timely proof of claim against the Debtor. The trustee for the Creditors’ Trust filed a complaint against Rombro and, subsequently, moved for summary judgment, seeking a finding that Rombro’s claim was subject to mandatory subordination pursuant to section 510(b) of the Bankruptcy Code. That section provides that “a claim arising from rescission of a purchase or sale of a security of the debtor…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….”

Rombro filed a cross-motion for summary judgment, seeking a determination that his claim was not subject to subordination, but rather was a general unsecured claim for compensation.

The bankruptcy court granted the trustee’s motion for summary judgment and subordinated Rombro’s claim. The judge held that section 510(b) should be construed broadly, such that a claim “arises from” a purchase of a debtor’s stock if that purchase is part of the causal link leading to the injury. Here, the causal link was the Debtor’s alleged failure to issue shares of its stock.

Rombro appealed the decision to the district court, which affirmed the order, holding that even though Rombro never actually received any shares in the Debtor, he had bargained for a position as share holder and all of its resulting benefits and risks. The court found that “[Rombro] cannot expect to both reap a shareholder’s benefits when the Debtor was profitable and then avoid a shareholder’s risks by gaining creditor status when Debtor went bankrupt.” Rombro appealed.

The Second Circuit affirmed the lower courts’ decisions, finding that Rombro’s claim “arose from” the purchase of the Debtor’s stock. In reaching its conclusion, the court looked outside the ambiguous “arising from” language in section 510(b). The court found that the Congressional intent behind mandatory subordination was that: (1) shareholders and general creditors have different risk and return expectations; and (2) creditors rely on the equity cushion provided by shareholder investments.

The Second Circuit found that Rombro’s actions satisfied the first rationale, as he took on the risk and return expectations of a shareholder when he agreed to exchange shares in another company for shares in the Debtor. In the Termination Agreement, Rombro did not bargain for cash, but instead bargained to become a shareholder in the Debtor; by forgoing “the significant cash compensation to which he was otherwise due upon termination, he became bound by the choice he made to trade the relative safety of cash compensation for the upside potential of shareholder status….”

The court’s argument was influenced by decisions in the Third and Ninth Circuits, which addressed similar claims and found that those who bargain to become investors or shareholders should be treated as such. The court stressed, however, that its rationale does not require subordination simply because a claimant happens to be a shareholder, but rather, the claim must also be causally related to the purchase or sale of stock and subordination must further the policies’ underlying section 510(b).