In Brief: Second Circuit Reaffirms Broad Scope Of Bankruptcy Code's Subordination Of Shareholder Claims

Section 510(b) of the Bankruptcy Code provides a mechanism designed to preserve the creditor/shareholder risk allocation paradigm by categorically subordinating most types of claims asserted against a debtor by equityholders in respect of their equity holdings. However, courts do not always agree on the scope of this provision in attempting to implement its underlying policy objectives. In In re Lehman Brothers Holdings Inc., 2017 WL 1718438 (2d Cir. May 4, 2017), the Second Circuit reaffirmed the broad scope of section 510(b), ruling that breach of contract claims asserted by employees who were awarded restricted stock units entitling them to common stock were properly subordinated under section 510(b).

Subordination in Bankruptcy

The concept of claim, debt, or lien subordination is well recognized under federal bankruptcy law. A bankruptcy court's ability to reorder the relative priority of claims or debts under appropriate circumstances is part and parcel of its broad powers as a court of equity. The statutory vehicle for applying these powers in bankruptcy is section 510 of the Bankruptcy Code.

Section 510(a) makes a valid contractual subordination agreement enforceable in a bankruptcy case to the same extent that it would be enforceable outside bankruptcy.

Section 510(b) subordinates claims arising from the purchase or sale of a security of the debtor or an affiliate of the debtor to "all claims or interests that are senior to or equal the claim or interest represented by the security, except that if such security is common stock, such claim has the same priority as common stock."

Finally, misconduct that results in injury to creditors can warrant the "equitable" subordination of a claim under section 510(c).

A related but distinct remedy is "recharacterization," whereby a court orders an asserted claim to be treated as if it were an interest. Because the Bankruptcy Code does not expressly empower a bankruptcy court to recharacterize debt as equity, some courts disagree as to whether they have the authority to do so and, if so, the source of such authority.

To date, seven circuit courts of appeal have held that a bankruptcy court's power to recharacterize debt derives either from the court's broad equitable powers, including those set forth in section 105(a) of the Bankruptcy Code, which provides that "[t]he court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of [the Bankruptcy...