Sometimes the interpretation of the Bankruptcy Code leads to unexpected results. In a recent case, the US Bankruptcy Appellate Panel of the Ninth Circuit (BAP) has ruled that section 510(b) of the Bankruptcy Code requires the subordination of certain claims against a debtor to all equity interests in the debtor, even though such subordination may mean that the holders of the claims will receive nothing on the claims.

In In re USA Commercial Mortgage Co.,1 certain investors had purchased membership interests in debtor USA Capital Diversified Trust Deed Fund, LLC, a limited liability company, before the debtor filed for bankruptcy. After the debtor filed for bankruptcy, the investors filed proofs of interest relating to their membership interests with the court. In addition, the investors filed proofs of claim for alleged breaches of contract and fraud relating to their purchases of the membership interests.2 Although the proofs of claim and of interest were each filed for the same amount ($592,825.45 plus interest), the investors were not seeking a double recovery — they acknowledged that, to the extent they received any amounts on the proofs of claim, the amounts due on the proofs of interest would be reduced accordingly. 

Objection to Claims

The Official Committee of Equity Security Holders objected to the investors' proofs of claim on the basis that they were duplicative of the proofs of interest, and the Committee asserted that such claims should in any event be subordinated pursuant to section 510(b) of the Bankruptcy Code.

This Code section provides that claims arising from the purchase or sale of a security of a debtor or its affiliate must 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." Noting that the proofs of interest and proofs of claim were duplicative and that, if they were allowed to recover on both, the investors could potentially be treated better than other holders of membership interests who had filed only proofs of interest, the bankruptcy court sustained the Committee's objection and disallowed the investors' claims, thereby limiting the investor's potential recovery solely to their membership interests, pro rata with the other holders of membership interests in the debtor.

Holding on Appeal

On appeal, the BAP held that the bankruptcy court had erred in its determination that the investors' proofs of claim were duplicative of their proofs of interests. Indicating that "a proof of claim is based on a right to payment," the BAP held that, as the investors' proofs of interest were based merely on their ownership of their equity interests in the debtor, while their proofs of claim were based on the fraud and breach of contract claims against the debtor (i.e., something "more than mere ownership"), the investors were clearly entitled to assert both their proofs of claim and their proofs of interest, even though they could not receive a double recovery.

The BAP then addressed the issue of subordination, even though the bankruptcy court had not ruled on the subordination issue. It noted first that there appeared to be no dispute among the parties that section 510(b) could be applied to subordinate the investors' claims, so that the dispute at issue was limited to what level the investors' claims could be subordinated. In that regard, the BAP rejected the investors' assertions that claims "should only be subordinated when it will accomplish the purpose of section 510(b)," and that the purpose of section 510(b) is to protect creditors from equity holders' trying to dilute the claim pool by claiming creditor status, not to protect other equity holders. In so doing, the BAP opted for a "plain reading" of the statute.

Based on its plain reading of section 510(b), the BAP held that, for purposes of distribution, the investors' claims, which arose from the purchase of membership interests in the debtor, could be subordinated below all such membership interests, and not simply below other claims (as argued by the investors) or to the level of the membership interests. The BAP looked in particular to the language of section 510(b) that states that claims arising from the purchase of 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" (emphasis added). Relying on the principal of expression unius est exlusio alterius (the express mention of one thing excludes all others), the BAP held that, since the 1984 amendments to section 510(b) added express language regarding the priority of claims arising from the purchase or sale of common stock (and not of any other type of security), "it can be inferred that Congress did not intend for § 510(b) to subordinate claims based on securities other than common stock (i.e., limited partnership interests) to a level on par with those securities."

Assuming that the membership interests in the debtor are the lowest class of equity interests, and therefore that the holders of the membership interests are entitled to receive all residual distributions from the debtor's estate, the effect of the BAP's opinion is that, if the bankruptcy court subordinates the investors' breach of contract and fraud claims, the investors will receive nothing from those claims.

The BAP's opinion is significant. Based on its construction of the statute, any claim arising from the purchase or sale of an equity interest that is not common stock will be subordinated not only to all other claims, but also to all equity interests with the same or higher priority as that of the equity interests from which such claim arose. If the claim arises from the purchase or sale of the lowest class of equity interest in a debtor, the creditor will receive nothing from the claim. A creditor holding such a claim may be surprised that, through the mechanism of "subordination," its claim may effectively be extinguished entirely.

Follow these links for additional articles from the March 2008 Insolvency Notes:

Court Relies on Market Capitalization to Determine Solvency of Debtor Prior to Bankruptcy

Claims Denominated in Foreign Currency Must Be Converted into US Dollars as of Petition Date