Search
 
 

Practices

 

Search

FILTERS

  • Please search to find attorneys
Close Btn

Alerts

April 2022

Sellers Beware (Of The Section 510(b) Trap) In A Corporate Divorce

Whether the product of a business entity’s consensual separation agreement or knock down litigation over years of mistrust and differences, a structured buyout over time of one partner’s equity interest in the erstwhile business partnership, with the payout secured by the business assets, has hidden dangers. The United States Bankruptcy Appellate Panel of the Ninth Circuit on March 22, 2022, in a case captioned In re Bruce Elieff, BAP # CC-21-1081-SFL, rendered an Opinion on one such hidden danger: A seller’s claim for damages arising from his former partner’s purchase of his equity interest in their business partnership would be, upon the buyer’s default on the payment terms of the buyout, subordinated to the unsecured claims in the buyer’s subsequent affiliated bankruptcies under Section 510(b) of the Bankruptcy Code. Moreover, the Court ruled the judgment lien obtained by the seller against the debtor’s business assets also was subordinated to unsecured creditors of the business.

The Facts

The short, edited version of the facts is that two equal partners in a business venture that invested in multiple, separate real estate deals and development projects, each utilizing jointly owned separate, limited LLCs and partnerships, had a falling out that resulted in messy litigation after ten years of business together. The litigation was resolved by a Settlement Agreement whereby one partner (the “Seller”) transferred his equity interests in the businesses to his former partner (the “Buyer”) in exchange for certain indemnification obligations and $48.8 Million payable in four installments and secured principally by the business assets. Three years of contentious and protracted litigation followed Buyer’s default on the third payment installment, and eventually Seller reduced his claim in state court to a judgment lien against the Buyer and two of the business entities for $ 35 Million. The Buyer and two business entities each subsequently filed separate Chapter 11 bankruptcies.

The Bankruptcy And Appellate Decisions

The Buyer, now as a Chapter 11 Debtor, commenced in Bankruptcy Court an adversary proceeding under section 510 (b) of the Code to subordinate Seller’s $ 35 Million claim AND its judgment lien in the same amount. As the Bankruptcy Judge noted, “… the undisputed fact remains that the crux of the Settlement Agreement required [Seller] to transfer his interests in the [Joint Entities] in exchange for Settlement Payments.” Soon after, Buyer’s bankruptcy was converted to a Chapter 7 liquidation and a Trustee defended the Seller’s appeal of the Bankruptcy Court’s decision. The Bankruptcy Appellate Panel of the Ninth Circuit affirmed the Bankruptcy Court, stating matter-of-factly that Section 510(b) “…mandates the subordination of damages claims arising from the purchase or sale of a security." The rational for Section 510(b) was articulated on appeal as “Its principal purpose is to ensure that creditors of the debtor are paid before disappointed equity interest holders who bargain for the potential for a greater return in exchange for a greater risk of loss.” The Appellate Court addressed multiple issues on appeal, but as to Section 510(b)’s subordination of both the claim and the judgment lien to unsecured creditors, it was bluntly succinct: “Section 510(b) mandates the subordination of the “claim” for damages arising from the sale of securities. This necessarily encompasses the entirety of [the Seller’s] “right to payment” whether personal or in rem…The Court noted the [Seller] retains his secured claim. Subordination simply rendered it junior to the interests of the unsecured creditors.” That clarification in bankruptcy is likely meaningless.

The Takeaway

To some extent In re Bruce Elieff may be limited in other jurisdictions by its complicated set of facts, the application of California law concerning underlying property rights and arguably the reputation of the United States Bankruptcy Appellate Panel of the Ninth Circuit. But the reasoning behind subordination under Section 510(b), of both the claim for damages from a failed sale of securities and a subsequent judgement lien arising from the sale itself, appears sound. The Opinion also addressed but ultimately rejected the notion that the parties arguably could have allocated value in the Settlement Agreement to other consideration in support of the settlement. If that consideration was not related to or directly arising from the value of the securities sold, arguably the value of the “other” consideration would not implicate Section 510(b) and, therefore, that amount should be bifurcated and not subject to subordination. That “open door” warrants further consideration in the drafting stage of a settlement following a breach, but, more importantly, in drafting the original buyout agreement of a partner’s securities.

For further insight and analysis, please contact your CSG Law attorney or one of the authors listed below.