Gavel IsolatedSection 510(b) of the Bankruptcy Code permits the subordination of certain claims to all claims or interests senior or equal to the security on which the claim is based. A recent Fifth Circuit opinion delineates the scope of mandatory subordination under Section 510(b).

Robert Templeton invested as a limited partner in certain limited partnerships formed under the auspices of American Housing Foundation (AHF), which was in the business of developing low-income housing projects. AHF guaranteed repayment of Templeton’s investments in the partnerships, often unconditionally, and sometimes with interest. Ultimately AHF filed for Chapter 11 bankruptcy.

Templeton filed proofs of claims against AHF based on the guaranties, and later AHF’s bankruptcy trustee objected to the claims. The bankruptcy court entered a judgment subordinating those claims “pursuant to the provisions of 11 U.S.C. [section] 510(b).” The bankruptcy court’s reasoning was premised on a recharacterization of those guaranties as equity interests in AHF pursuant to 11 U.S.C § 502(b). Section 502(b) authorizes the bankruptcy court to allow or disallow a claim, although it does not address the relative priority of the claim.

On appeal, the Fifth Circuit affirmed the subordination of Templeton’s claim, albeit on an entirely different basis. Instead of focusing on Section 502(b), the Fifth Circuit relied on Section 510(b) of the Bankruptcy Code, which provides:

For the purpose of distribution under this title, a claim arising from rescission of a purchase or sale of a security of the debtor or of an affiliate of the debtor [emphasis added], for damages [emphasis added] arising from the purchase or sale of such a security, or for reimbursement or contribution allowed under section 502 on account of such a claim, 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 Fifth Circuit noted that “Section 510(b) applies whether the securities were issued by the debtor or by an affiliate of the debtor.” The Court then applied a step-by-step analysis in order to determine whether Templeton’s claim should be subordinated.

The Court first concluded that Templeton’s claims against AHF fell within the category of “damages”. The unpaid debt owed by the partnerships was considered an equity investment. Although Templeton’s claims against AHF were for the breach of its guaranties of his LP interests (rather than suing directly for repayment of his equity investments in the LPs), the Court considered such distinction as an elevation of form over substance   Templeton’s guaranty claims were considered essentially breach of contract claims that may be characterized as claims for “damages.”

Second, the Fifth Circuit reasoned that the LP interests Templeton purchased constituted “securities” within the meaning of Section 510(b), and that the partnership interests acquired by Templeton were securities “of an affiliate of [AHF].” With respect to the LPs for which AHF served as a general partner, because AHF was a party to those LP agreements, the Court concluded that Templeton’s claims easily fell within the securities “of an affiliate of the debtor” clause. With respect to those LPs in which a wholly-owned subsidiary of AHF served as a general partner, the Fifth Circuit concluded that, although AHF was not a direct party to those agreements, AHF had complete control over these LPs. The Court thus held that these agreements were operating agreements “by” AHF, as the wholly-owned subsidiaries were only shell entities and, in the words of the Bankruptcy Court, “conduit[s]” through which AHF acted noting: “[w]e see no reason why the existence of a shell conduit between a debtor and an entity—which in no way inhibits the debtor’s ability to control and operate that entity—should preclude a finding of affiliate status.”

Based upon the AHF decision, claims arising from the purchase of securities of entities over which a debtor exercises sufficient control, such as entities which qualify as affiliates under the Bankruptcy Code, may be treated no differently than claims arising from the purchase of securities of the debtor itself. Any claims arising from equity investments in a debtor’s affiliate will likely have the same ranking as an equity investment in the debtor itself—i.e., both are subordinated to the claims of general creditors. The AHF opinion significantly adds to our jurisprudence explaining the broad scope of mandatory subordination under Section 510(b) of the Bankruptcy Code.