Bankruptcy Code section 510(b) provides for mandatory subordination of any claims “arising from,” among other things, the purchase or sale of a security. It is an expansive provision that courts have interpreted broadly, causing some commentators to wonder: “Are there any limits to mandatory subordination under section 510(b)?”

In a decision entered last week in Khan v. Barton (In re Khan), No. 14-1021, 2014 WL 6972785 (B.A.P. 9th Cir. Dec. 9, 2014), the Bankruptcy Appellate Panel of the Ninth Circuit analyzed the objectives and policy considerations underlying mandatory subordination as well as the legislative history of section 510(b), and reaffirmed that subordination is not appropriate for every claim that may, however remotely, “arise from” the purchase or sale of a security. Instead, section 510(b) is meant to effectuate the general principle that creditors are entitled to be paid ahead of shareholders in the distribution of corporate assets.

Background

The story of In re Khan begins in the late 1990s, when the debtors in the two present bankruptcy cases—Zafar Khan and Terrance Tomkow—co-founded start-up companies RPost, Inc. and RPost International, Ltd. with the creditor whose claim they sought to subordinate, Kenneth Barton. The relationship between the co-founders ultimately deteriorated and, after commencing litigation, Barton discovered that his former partners had taken control of his 6,016,500 common stock shares, returned them to the company treasury, and thereby divested him of his equity stake.

In August 2012, a California state court determined that Khan and Tomkow were liable to Barton for, among other things, conversion, fraud, and breach of fiduciary duty in connection with Barton’s loss of his equity stake in the company. On April 14, 2013—the eve of the final hearing on punitive damages—Khan and Tomkow each filed a chapter 13 petition. In June 2013, after the bankruptcy court approved stipulated stay relief that allowed the state court action to continue to finalization of the judgment, the state court entered a judgment awarding Barton compensatory damages in the amount of $2,840,060 (the value of his dispossessed common stock shares), damages for emotional distress, punitive damages, and prejudgment interest. Khan and Tomkow’s appeal of that judgment remains pending.

In the bankruptcy cases, Barton filed proofs of claim and commenced adversary proceedings seeking to deem the state court judgment nondischargeable. Barton also moved to convert both debtors’ chapter 13 cases to chapter 7 based on, among other things, bad faith filings. In response, Khan and Tomkow commenced adversary proceedings seeking mandatory subordination of Barton’s claims, arguing that the plain language of Bankruptcy Code section 510(b) required mandatory subordination of Barton’s claims because they arose from the disposition of a security. After a hearing, the bankruptcy court denied Khan and Tomkow’s efforts to subordinate Barton’s claims. Khan and Tomkow appealed.

Analysis

After determining that ambiguity exists as to whether section 510(b) applies in an individual debtor case, the Panel evaluated policy considerations, the legislative history, and case law. The Panel observed that section 510(b) is premised on two assumptions: (1) creditors and shareholders have “dissimilar risk and return expectations”; and (2) creditors rely on the “equity cushion provided by shareholder investment” when they extend credit. Given those underlying principles, the purpose of section 510(b), as evidenced by the legislative history, is to protect creditors from overreach by shareholders—i.e., “to prevent disappointed shareholders, sometimes the victims of corporate fraud, from recouping their investment in parity with . . . unsecured creditors.”

As the Panel noted, it is “axiomatic” that it is impossible to assert an equity interest in an individual. Therefore, section 510(b) subordination is not relevant or applicable in an individual debtor case. Moreover, the Panel’s review of the case law found no published decision in which section 510(b) was applied in an individual debtor’s case based on an equity position in an affiliate entity.

Accordingly, the Panel ruled that subordination of Barton’s claim was not appropriate. Barton was not—and could not be—an equity owner of the individuals Khan or Tomkow. Rather, he was a judgment creditor who had obtained a state court judgment relating to Khan’s and Tomkow’s actions regarding stock of a non-debtor entity co-owned by the three men. Although it is true that Barton’s claim would not have arisen “but for” his initial equity investment in the company he co-founded, the Panel’s decision makes clear that section 510(b) is not meant to subordinate a claim against individual debtors simply because the claim may relate to stock.