In a recent decision in the Lehman Brothers Inc. (LBI) SIPA proceeding, the bankruptcy court used Bankruptcy Code section 510(b) to subordinate a creditor’s claim – arguably a straight-forward matter of applying the statute’s language to the claim asserted. The statute, however, seems poorly equipped to address the scenario presented by creditor Claren Road and leads to a somewhat baffling result.
Consider the below:
Claren Road has a claim for breach of contract against LBI because LBI failed to buy, in its role as Claren Road’s broker, certain securities.
- When those securities are bonds issued by LBI’s affiliate Lehman Brothers Holdings Inc., Claren Road recovers nothing for its breach of contract claim against LBI because the claim is subject to mandatory subordination under section 510(b).
- When those securities are issued by Apple, Claren Road recovers some of its damages, sharing in distributions as a general unsecured creditor, for its breach of contract claim against LBI.
While the court’s conclusion seems mandated by the language of section 510(b), the result underscores what appears to be an inconsistency between the statute’s language and its underlying policy considerations.
Claren Road maintained a prime brokerage account with LBI, through which it engaged in trading. On September 12, 2008, Claren Road placed an order with LBI, as its broker, to purchase from Claren Road bonds issued by Lehman Brothers Holdings Inc., LBI’s parent, at a set price. Three days later, LBHI filed for bankruptcy. Two days later, the transactions failed when LBI failed to purchase the bonds as required. Two days after that, LBI was placed into a SIPA proceeding. Claren Road filed a proof of claim against LBI in its proceeding seeking recovery of the damages it suffered due to LBI’s breach of its contractual obligation to purchase the bonds.
In October 2013, the LBI SIPA trustee filed a motion seeking to subordinate Claren Road’s claim pursuant to Bankruptcy Code section 510(b), which provides that claims arising from the purchase or sale of securities of the debtor or of its affiliates are to be subordinated. Applying the common meaning of the language of section 510(b), the court granted the SIPA trustee’s motion, subordinating Claren Road’s claim to all general unsecured claims. The practical effect is that Claren Road will recover nothing on its breach of contract claim against LBI. (The court’s decision also granted the SIPA trustee’s requested subordination of reimbursement and contribution claims by a number of junior underwriters. This blog piece focuses only on the court’s analysis of Claren Road’s claim.)
Bankruptcy Code section 510(b) states in relevant part:
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 to the claim or interest represented by such security…. (emphasis added)
Courts in applying section 510(b) have considered the intent of the statute when application of the statute is not straight-forward. As noted by Judge Gonzalez in a decision in the Enron bankruptcy cases, the purpose of section 510(b) is “to prevent disappointed shareholders from recovering their investment loss by using fraud and other securities claims to bootstrap their way to parity with general unsecured claims.” In an article published in 2007, Ted Zink and I also asserted that, based on the legislative history of section 510(b) and its underlying policy considerations, the claims subject to section 510(b)’s required subordination should be limited to (a) those claims seeking to recover the decrease in value of investments in a debtor’s security and (b) those claims where the claimants are seeking to transform residual equity interests into general unsecured claims.
Before one gets to a review of legislative history, however, canons of statutory construction require a court to focus first on the statute’s actual language. If that language is clear, the court must rule in compliance with the statute’s language. Only if there are ambiguities in the language should a court resort to a review of the statute’s legislative history in trying to understand how best to apply the statute to the facts before it.
Here, Claren Road argued that the statute’s language was ambiguous when considering its application to claims relating to securities that were not issued by the debtor. Section 510(b) provides that claims falling within its scope are to be subordinated to all claims that are senior to or equal to the claim represented by “such security.” Claren Road asserted that the securities at issue – bonds issued by LBHI – had no claim against the LBI estate and therefore it made no sense to speak of subordinating its claim against the LBI estate to the claims represented by the LBHI bonds.
The bankruptcy court disagreed, noting that Claren Road’s interpretation would mean that no claim arising from the purchase or sale of an affiliate’s securities would ever fit within the regime for subordination. That result would contradict express provisions of the statute directing that such claims be subordinated. Instead, the court noted that the more reasonable interpretation that gives effect to every word of section 510(b) with respect to an affiliate’s security is as follows: “‘the claim… represented by [the LBHI bonds]’ is not directed to a recovery from LBI on account of the LBHI Bonds but extends to the breach of contract claim asserted by Claren Road against LBI with respect to these bonds.” That claim would be a general unsecured claim, so subordination in this case would require Claren Road’s claim to be subordinated to general unsecured claims against LBI.
The court also was not persuaded by Claren Road’s assertions that subordination of its claim would be inconsistent with the Congressional intent in drafting Bankruptcy Code section 510(b). Some courts adhere to the principle that when a statute’s language is clear, the court must apply the statute was written, not delving into the intent of such language through review of legislative history. Here, the court noted that the statute’s language was clear that claims arising from the purchase or sale of affiliate’s securities are to be subordinated. Accordingly, the court asserted that it was bound to “apply the plain language of the statute even if the holding is beyond the Congressional intent set forth in the legislative history.”
As seen in the Lehman decision, application of Bankruptcy Code section 510(b) in a SIPA proceeding can be problematic when the securities at issue are issued by an affiliate of the broker dealer. Breach of contract claims against a broker for failure to execute trades are not the type of claims that section 510(b) is intended to address, and the subject matter of those trades should not drive the treatment of such breach of contract claims. Add this to the list of quirks that need to be fixed in the Bankruptcy Code’s statutory language.