Don’t Go Chasing (Debtor-Affiliate) Waterfalls: Second Circuit Applies 510(b) Subordination to Contribution Claims Arising from the Securities of an Affiliate of a Debtor

Contributed by Adam Lavine
In a decision with significant implications for investors and underwriters alike, the Court of Appeals for the Second Circuit has held that contribution claims arising from the purchase and sale of a security of an affiliate of the debtor can and should be subordinated under section 510(b) of the Bankruptcy Code.  The decision, ANZ Securities, Inc. v. Giddens (In re Lehman Bros. Inc.), stemmed from the liquidation of Lehman Brothers, Inc. (LBI) pursuant to the Securities Investor Protection Act and is one of many precedential bankruptcy decisions arising from the Lehman cases. 
LBI was the lead underwriter for certain notes issues by one of its affiliates, a debtor in a separate chapter 11 case.  The appellants asserted that, as co-underwriters for the notes, they allegedly incurred defense and other costs as a result of lawsuits commenced against them by investors in the notes.  After the appellants filed claims against LBI for reimbursement or contribution of these costs, LBI sought to subordinate those claims pursuant to section 510(b) of the Bankruptcy Code.
Section 510(b) of the Bankruptcy Code requires the subordination of “claim[s] arising from . . . a security of the debtor or of an affiliate of the debtor, or for reimbursement or contribution . . . on account of such claim[s].”  Section 510(b) further provides that such claims “shall be subordinated to all claims or interests that are senior to or equal the claim[s] or interest[s] represented by such security.”
In situations not involving debtor affiliates, section 510(b) generally operates as follows: if a contribution claim is asserted against a debtor on account of a security that entitles an investor to a general unsecured claim, the contribution claim is subordinated to all claims senior or equal to general unsecured claims.  Likewise, if a contribution claim is asserted on account of a subordinated note issued by the debtor, the contribution claim is subordinated to all claims senior or equal to such subordinated note.  In this way, one must assess where a security is located in a debtor’s waterfall to determine the level of subordination for a 510(b) claim asserted on account of that security.
In LBI, the appellants argued that because the relevant securities were issued by an affiliate of LBI and did not fall within LBI’s waterfall, section 510(b) did not apply.  The appellants’ doctrinal hook for this argument was the phrase, “senior to or equal the claim[s] or interest[s] represented by such securit[ies].”  They argued that because there were no claims or interests represented by the relevant securities in LBI’s case, there was nothing to subordinate their contribution claims to.
The Second Circuit’s Decision
The Second Circuit affirmed the decisions of the District Court and the Bankruptcy Court for the Southern District of New York, each of which had subordinated the appellants’ contribution claims.  In its decision, the Second Circuit adopted a reading of section 510(b) that focused on the type of security at issue (e.g., subordinated or unsubordinated), and not on whether claims exist within the case based on that specific security.  Specifically, the Second Circuit stated that:

Claims arising from securities of a debtor’s affiliate should be subordinated in the debtor’s bankruptcy proceeding to all claims or interests senior or equal to claims in the bankruptcy proceeding that are of the same type as the underlying securities (generally, secured debt, unsecured debt, common stock, etc.; and in some circumstances potentially a narrower sub-category).

In support of its holding, the Second Circuit reasoned that its reading of section 510(b) gave meaning to the entire provision by “allowing the statute to operate on claims relating to affiliate securities—which are expressly included.”  In further support of its holding, the court cited, among other things, the legislative history of section 510(b), which revealed a Congressional penchant for broadening the scope of this section over time, and case law from the Second Circuit and elsewhere that has endorsed a broad interpretation of section 510(b).
In the final section of its decision, the Second Circuit observed that “[w]hen a bankruptcy court subordinates claims arising out of securities that were issued by the debtor’s affiliate, it may become somewhat messy to superimpose the capital structure of the affiliate onto that of the debtor . . . .”  Indeed, the Second Circuit noted that the bankruptcy court, as a court of equity, might need to group claims for subordination into narrow subcategories or add tiers to a debtor’s waterfall.  The Second Circuit expressed confidence in the bankruptcy court’s ability to handle such situations, stating that “[b]ankruptcy judges regularly make these types of determinations and they are better suited to do so than we are.”