Restructuring

Contributed by Yvanna Custodio
The United States Court of Appeals for the Second Circuit in In re CIT Group Inc. recently affirmed Judge Allan L. Gropper’s bankruptcy court opinion, which rejected the debtor’s section 510(b) subordination argument.  Section 510(b) of the Bankruptcy Code subordinates claims arising out of certain securities transactions – including claims for damages arising from the purchase or sale of a security.  The debtor, CIT Group Inc., argued that a claim filed by Tyco International Ltd., the debtor’s former indirect parent company, was one for damages arising from the sale of CIT’s securities and, therefore, subject to section 510(b). The bankruptcy court disagreed, and the parties appealed directly to the Second Circuit.
Background
In June 2001, Tyco Capital Holding, Inc. (TCH), a wholly-owned subsidiary of Tyco International, Inc. (Tyco), acquired all of CIT’s common stock for approximately $9.5 billion.  In 2002, as part of a corporate restructuring, Tyco decided to divest itself of its equity in CIT by conducting an initial public offering of all its CIT common stock.  To accomplish the IPO, CIT and Tyco entered into a tax agreement in which the parties agreed that (i) Tyco would indemnify CIT for tax burdens as a result of the merger and (ii) CIT would repay Tyco for tax benefits as a result of CIT’s ability to use TCH’s net operating losses.  Tyco thereafter caused the CIT-TCH merger in which CIT took on TCH’s debts and assets, including $794 million of TCH’s net operating losses.  The offering documents for the IPO provided that Tyco would retain no “direct or indirect equity interest in CIT” after the completion of the sale, which occurred in July 2002.
On November 1, 2009, CIT filed a prepackaged plan of reorganization under chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the Southern District of New York.  On December 8, 2009, a little more than a month later, the bankruptcy court confirmed the plan.  The plan provided that general unsecured creditors would be paid in full, whereas holders of preferred and common stock, as well as subordinated claims, would not be entitled to recovery.  CIT subsequently rejected the tax agreement; Tyco then filed a proof of claim for damages resulting from the rejection.  After Tyco had invoked an arbitration clause in the tax agreement, CIT commenced an adversary proceeding seeking to restrain the arbitration and subordinate the Tyco Claim pursuant to section 510(b).
The debtor hinged its subordination argument on the premise that the tax agreement on which the claim was based was an integral part of the CIT spinoff from Tyco’s corporate group.  In contrast, Tyco argued that its claim was for breach of contract and that, in light of the purpose and intent of the statute, subordination was inappropriate.  In denying CIT’s summary judgment motion and granting Tyco’s cross-motion for summary judgment, the bankruptcy court ruled that the Tyco Claim did not fall within the purview of section 510(b).  On appeal, CIT argued that the bankruptcy court should have subordinated the Tyco Claim because it was “more akin to a shareholder’s claim than a creditor’s claim.”
Analysis
In rejecting the debtor’s subordination argument, the bankruptcy court relied on Rombro v. Dufrayne (In re Med Diversified, Inc.), the leading case and only published Second Circuit decision on section 510(b).  In Med Diversified, the issue was whether “the claim of a former executive employee of the debtor, . . . based on the debtor’s failure to issue its common stock to the executive in exchange for his stock in another company, as provided by a termination agreement” was “a claim . . . for damages arising from the purchase or sale of . . . a security [of the debtor]” and should therefore be subordinated.  Finding that the phrase “arising from” was ambiguous, the Second Circuit in Med Diversified referred to the legislative history of the statute in order to determine its intended meaning.  As stated in Med Diversified and echoed by the bankruptcy court in CIT Group, the policy rationale for mandatory subordination under section 510(b) requires subordination only if the claimant “(1) took on the risk and return expectations of a shareholder, rather than a creditor, or (2) seeks to recover a contribution to the equity pool presumably relied upon by creditors in deciding whether to extend credit to the debtor.”  Notably, in Med Diversified, the Second Circuit affirmed the district court decision, which, in turn had affirmed the bankruptcy order subordinating the former employee’s claim.  The Second Circuit found that the former employee had taken on the “risk and return expectations of a shareholder” by agreeing to the release of claims against the debtor and the exchange of securities in one company for the shares of the debtor.
In CIT Group, although the bankruptcy court acknowledged that the tax agreement had “a nexus to the issuance of the stock in the IPO in that both were agreed to in connection with the spinoff of CIT from Tyco[,]” the court also observed that “the existence of a mere ‘connection’ between the claim and the purchase or sale of a security is not enough to support a finding that the claim ‘arises from’ the purchase or sale and should be subordinated unless the purposes of the statue would be served thereby.”  Reiterating Med Diversified, the bankruptcy court stated that “the real question is whether the claimant bargained for the risks and rewards of a holder of equity rather than a holder of debt.”  (Query whether the policy rationale Congress enunciated with respect to section 510(b) applies only to transactions involving equity securities, as the test would appear inapplicable to transactions in which debt securities are clearly involved.)
In support of its argument that Tyco had assumed or retained the risks of a shareholder, CIT asserted that, under the tax agreement, the payments from CIT to TCH were variable and were dependent on CIT’s future revenues.  (The payments to Tyco would only be triggered if CIT’s profits in a given year rose above CIT’s own NOLS.)  Citing prior cases, the bankruptcy court noted that a fixed or a variable rate of return is not determinative of the risks and rewards that are assumed by a claimant.  According to the court, if the tax agreement were viewed as a whole, it “resemble[d] an exchange as part of a corporate sale with consideration being paid over time and in to-be-determined amounts.”  The bankruptcy court, therefore, declined to subordinate the claim, ruling that the tax agreement did not amount to an equity interest in CIT, which ruling the Second Circuit affirmed on appeal for the reasons stated in the bankruptcy court’s order.
Although Second Circuit rulings by summary order do not have precedential effect, bankruptcy practitioners should consider the implications of the bankruptcy court opinion and Second Circuit summary order in CIT Group when crafting arguments related to section 510(b).  In addition, the practical applications of the policy rationale for section 510(b) are unclear when debt securities are unquestionably involved.