Tuesday, October 08, 2019

Payments Which "Look A Lot" Like Dividends Subordinated

In the Fifth Circuit's opinion in French v. Linn Energy, LLC (In re Linn Energy, LLC), 2019 U.S. App. Bankr. LEXIS 26595 (5th Cir. 9/3/19), which can be found here, Judge Edith Brown Clement deftly sums up the case in her first sentence:
In this case we decide that payments owed to a shareholder by a bankrupt debtor, which are not quite dividends but which certainly look a lot like dividends, should be treated like the equity interests of a shareholder and subordinated to claims by creditors of the debtor.
If that's all you wanted to know you can stop reading, but this opinion has a good explanation of how subordination of claims related to securities works.   You  may remember the children's game of chutes and ladders where a party landing on a ladder gets sent to the bottom.  That is an approximation of how subordination works.   

Introduction to Subordination Under the Code

There are three types of subordination recognized by 11 U.S.C. Sec. 510.   Section 510(a) gives force to contractual subordination provisions.   Section 510(c) allows for equitable subordination.   Finally, Sec. 510(b) allows subordination of claims related to securities.   Thus, subsections (a) and (b) provide for automatic subordination while subsection (c) depends on the specific facts and the court retains some discretion in applying it.  
The actual text of Sec. 510(b) is somewhat dense.
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, for damages 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.
There are three types of claims which get subordinated under this provision:
  • a claim arising from rescission of a purchase or sale of a security of the debtor;
  • a claim for damages arising from the purchase or sale of such a security; or
  • a claim for reimbursement or contribution allowed under section 502 on account of such a claim.
According to Judge Brown, "Section 510(b) serves to effectuate one of the general principles of corporate and bankruptcy law: that creditors are entitled to be paid ahead of shareholders in the distribution of corporate assets."   

So far it seems simple.  There are three types of securities-related claims which get subordinated.  Subordination is mandatory.   However, what about a claim that doesn't fit neatly into one of those categories?   According to Judge Brown's opinion, the reach of Section 510(b), as defined by its purpose, is greater than its text.

Usually by now, I would have discussed the facts of the case.  In a typical case, the facts tend to lay out the issue.  However, in this case, you cannot make sense of the facts until you have the statutory background I have set forth above.

A Muddled Factual Mess Requiring Great Simplification and a Recap

 A wealthy man owned a company.  Upon his death in 1930, he placed 250 shares of stock in a company called BPC into a trust for his relatives.  The relatives would receive a percentage of the dividends issued on the stock.   When the junior group of beneficiaries came of age, they had their stock shares issued to them.  However, their elders still had a right to receive a percentage of the income from the stock.   An equitable charge was issued against the stock to ensure that the senior trust beneficiaries received their share of the income.  This meant that although the junior beneficiaries owned the stock, their elders had the right to receive a percentage of the dividends.   

In 1986, BPC went public and had a dispute with one of its shareholders.   The company agreed to buy out the shareholder.  However, the shares to be bought out were subject to the equitable charge.   As a result, retiring the shares would reduce the amount of income paid to the senior beneficiaries from the stock that was placed into trust in 1930.

In 2013,  BPC agreed to a share for share exchange with Linn Energy, LLC.   Linn agreed to honor the deal to pay deemed dividends to the surviving senior beneficiaries of the trust, only one of whom was still alive.  Alas, upon the merger, the payments stopped.

Linn filed a declaratory judgment action asserting that it did not owe anything to Bennett, who was the surviving senior beneficiary.  Bennett counterclaimed.  Then Bennett died and his estate filed an amended counterclaim.    

In May 2016, Linn filed bankruptcy.  Bennett's estate filed a claim of $10 million of deemed dividends.   The Debtor objected to the claim and also sought equitable subordination.  The Bankruptcy Court granted equitable subordination.   

To recap, Bennett, as a senior beneficiary of the trust, was entitled to receive a percentage of the dividends issued by BPC on certain stock.  BPC redeemed some of that stock but agreed to continue to pay the senior beneficiaries as though the stock had not been redeemed.  Linn did a stock exchange with BPC and agreed to honor the deemed dividends but didn't do it.

Equitable Subordination

 The Court described the test as follows but cautioned that a "formulaic check the box approach to subordination under the statute is impossible:"
(1) a claim is for "damages," (2) the claim involves "securities," and (3) the claim "arise[s] from" a "purchase or sale" having a nexus with those securities.
The Court then stated that:
The most important question is this: Does the nature of the Estate's interest make the Estate more like an investor or a creditor? Because we conclude the deemed dividends gave the Estate benefits normally reserved for equity investors, we conclude subordination of all of the Estate's claims was appropriate.
 The opinion goes on for several more pages but that is the gist.  If a claim involves a benefit normally reserved for equity investors, it is subject to being subordinated below the level of unsecured claims.   (Note:  Estate refers to the Bennett Estate, the claimant, and not to the bankruptcy estate).   While this approach does not seem to track with the text of Section 510(b), it does accurately reflect its purpose.

 Hat-Tip:  Thank you to my panel of advisors who helped me decide what to write about this week.  Don't worry.  I will get to alienation of affections next week.

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