The dispute arose from formation of Seaquest Diving, L.P. S & J Diving, L.P. contributed assets valued at $6 million in exchange for Class A shares, while three individuals received Class B shares in return for sweat equity and industry contacts. Litigation ensued within two months of the venture's formation. After two settlement agreements failed to close, a judgment was entered in favor of S & J in the amount of $2,742,014. Six days later, Seaquest filed for chapter 11.
Seaquest sought to subordinate the S & J judgment based on Sec. 510(b). The Bankruptcy Court agreed, finding that the state court judgment was an adjudication of recission of the LP and LLC agreements and that therefore, the claim must be subordinated pursuant to 11 U.S.C. Sec. 510(b).
Under Sec. 510(b), "a claim arising from recission of a purchase or sale of a security of the debtor or of an affilate 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 . . . ." While equitable subordination, requires a finding of wrongdoing by a creditor, mandatory subordination enforces the principle that "creditors are entitled to be paid ahead of shareholders in the distribution of corporate assets." Thus, an equityholder cannot be elevated to the level of an unsecured creditor by virtue of an unwinding of the securities transaction.
After an extensive analysis, the Fifth Circuit held that the state court judgment was in fact a recission claim. Judge DeMoss wrote:
For purposes of § 510(b), we may “look behind” the state court judgment to determine whether the S&J claim “arises from” the rescission of a purchase or sale of a security of SeaQuest. (citation omitted). The Supreme Court has approved of this practice when construing other provisions of the bankruptcy code. (citation omitted). We reject S&J’s argument that “the equitable nature of a claim is lost once it is converted to a . . . judgment.” If the court could not look behind the judgment, then subordination of a rescission or tort claim based on securities fraud (which clearly falls within the purview of § 510(b)) would depend upon whether the claimant obtained a pre-petition judgment on the claim. We doubt that Congress intended such a result, which is contrary to the text and legislative history of the statute. For purposes of § 510(b), a “claim” includes a judgment. (citation omitted). The fact that a claim has been reduced to a judgment does not deprive the court of the ability to look behind that judgment to determine whether it “arises from” a rescission of a security of the debtor.
The pre-petition judgment in this case was based on breach of the October 3 Settlement Agreement. This agreement stated that “the asset contribution and transaction agreement [ACTA] will be rescinded such that Sea[Q]uest and S&J Diving will retain all of its [contributed] assets,” S&J will no longer be a limited partner of SeaQuest LP, and Jones will no longer be a member of SeaQuest LLC. The $3,100,000 “asset sales agreement,” which was never consummated, was dependent upon the return of these contributed assets, and the payment of $2,300,000 in overhead expenses was characterized as a “reimbursement” of S&J’s capital contribution. By structuring the transaction as a rescission rather than a redemption, S&J immediately realized the benefit of recouping a significant portion of its capital contribution rather than sharing those assets pari passu with other unsecured creditors during SeaQuest’s bankruptcy.
Opinion, pp. 19-20.
In this case, the fact that the parties described the transaction as a recission and that it was a recission in substance meant that the judgment claim enjoyed no greater priority than held by an equity holder.