SUPREME COURT REJECTS STRUCTURED DISMISSALS. NOW WHAT? Stuart I. Gordon and Matthew V. Spero

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1 LEXISNEXIS A.S. PRATT JULY/AUGUST 2017 EDITOR S NOTE: A CORNUCOPIA OF CASES Victoria Prussen Spears SUPREME COURT REJECTS STRUCTURED DISMISSALS. NOW WHAT? Stuart I. Gordon and Matthew V. Spero IS PRE-PETITION TERMINATION OF AN EXECUTORY CONTRACT A FRAUDULENT TRANSFER IN THE SEVENTH CIRCUIT? MAYBE MAYBE NOT! Peter C. Blain SIXTH CIRCUIT REJECTS PER SE RULE AUTOMATICALLY MOOTING SALE APPEALS IN THE ABSENCE OF A STAY George R. Howard SECOND CIRCUIT AFFIRMS MANDATORY SUBORDINATION OF EMPLOYEES SECURITIES CLAIMS Michael L. Cook POTENTIAL CONTINUING IMPACT OF THE MARBLEGATE SAGA Eric Sibbitt and Paul Porter FEES, FEES, FEES: BANKRUPTCY COURT QUESTIONS THE ONGOING VALIDITY OF THE BLACKSTONE PROTOCOL FOR INVESTMENT BANKER FEES IN CHAPTER 11 CASES Eli Blechman THE ROAD LESS TRAVELED: SUBSTANTIVE CONSOLIDATION PROVIDES ALTERNATIVE PATH TO ENHANCING CREDITOR RECOVERIES Lindsay M. Weber ITALY CONVERTS INTO LAW AN EMERGENCY DECREE AIMED AT RESCUING TROUBLED BANKS Patrizio Braccioni, Marc-Alexandre Courtejoie, Bruno Cova, Fabio Cozzi, and Eriprando Guerritore

2 Pratt s Journal of Bankruptcy Law VOLUME 13 NUMBER 5 JULY/AUGUST 2017 Editor s Note: A Cornucopia of Cases Victoria Prussen Spears 227 Supreme Court Rejects Structured Dismissals. Now What? Stuart I. Gordon and Matthew V. Spero 230 Is Pre-Petition Termination of an Executory Contract a Fraudulent Transfer in the Seventh Circuit? Maybe... Maybe Not! Peter C. Blain 239 Sixth Circuit Rejects Per Se Rule Automatically Mooting Sale Appeals in the Absence of a Stay George R. Howard 246 Second Circuit Affirms Mandatory Subordination of Employees Securities Claims Michael L. Cook 251 Potential Continuing Impact of the Marblegate Saga Eric Sibbitt and Paul Porter 256 Fees, Fees, Fees: Bankruptcy Court Questions the Ongoing Validity of the Blackstone Protocol for Investment Banker Fees in Chapter 11 Cases Eli Blechman 259 The Road Less Traveled: Substantive Consolidation Provides Alternative Path to Enhancing Creditor Recoveries Lindsay M. Weber 264 Italy Converts into Law an Emergency Decree Aimed at Rescuing Troubled Banks Patrizio Braccioni, Marc-Alexandre Courtejoie, Bruno Cova, Fabio Cozzi, and Eriprando Guerritore 272

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6 MANDATORY SUBORDINATION OF EMPLOYEES SECURITIES CLAIMS Second Circuit Affirms Mandatory Subordination of Employees Securities Claims By Michael L. Cook * The author of this article analyzes a U.S. Court of Appeals for the Second Circuit decision finding that securities claims held by employees of a Chapter 11 debtor must be subordinated under the Bankruptcy Code to the claims of general creditors. Claims held by employees of a Chapter 11 debtor based on restricted stock units ( RSUs )... must be subordinated [under Bankruptcy Code 510(b)] to the claims of general creditors because... (i) RSUs are securities, (ii) the claimants acquired them in a purchase, and (iii) the claims for damages arise from those purchases or the asserted rescissions thereof, held the U.S. Court of Appeals for the Second Circuit on May 4, Affirming the lower courts, the Second Circuit stressed that the claims asserted here... would not have arisen but for the claimants agreement with [the debtor] to receive part of their compensation in the form of RSUs. 2 [C]orporate employers [often] compensate their high-ranking employees not only with cash, but also with equity in the [c]orporation. Such arrangements align the employees financial incentives with those of the company: If the company succeeds, so too do its stakeholding employees; but if the company falters even to and beyond the point of bankruptcy its employees bear some of the loss. 3 The debtor here, had, in fact, adopted this approach, compensating many of its employees in part with [RSUs], which gave them a contingent right to own [the debtor s] common stock at the conclusion of a five-year holding period. The holder of an RSU had risk and return expectations similar to those of a shareholder; he or she would ultimately benefit from any increase in the stock price or suffer from any decline. 4 * Michael L. Cook, of counsel at Schulte Roth & Zabel LLP and a member of the Board of Editors of Pratt s Journal of Bankruptcy Law, has served as a partner in the firm s New York office for 16 years, devoting his practice to business reorganization and creditors rights litigation, including mediation and arbitration. He may be contacted at michael.cook@srz.com. 1 In re Lehman Brothers Holdings, Inc., 855 F.3d 459, 2017 U.S. App. LEXIS 7920, at *6 (2d Cir. May 4, 2017). 2 Id. at *35. 3 Id. at *4. 4 Id. 251

7 PRATT S JOURNAL OF BANKRUPTCY LAW RELEVANCE Courts have broadly interpreted the nature and scope of claims arising from the purchase or sale of a security under Code 510(b). Section 510(b) provides in relevant part that a claim arising from the rescission of a purchase or sale of a security of a debtor or of an affiliate of the debtor, [or] for damages arising from the purchase or sale of such security... shall be subordinated to all claims or interests that are senior or equal to the claim or interest represented by such a security, except that if such security is common stock, such claim has the same priority as common stock. The Code thus mandates subordination of a claim... for damages arising from the purchase or sale of... security [of the debtor]. 5 Courts typically ask whether the claim in question has a nexus with the purchase or sale of a security. 6 As the Second Circuit had previously explained, Section 510(b) is to be construed broadly because it is a remedial statute intended to prevent shareholders from changing their claims into creditors claims. 7 In enacting 510(b), Congress focused on the problem of claims alleging fraud or other violations of law in the issuance of the debtors securities. 8 Section 510(b) thus represents a Congressional judgment that, as between shareholders and general unsecured creditors, it is shareholders who should bear the risk of illegality in the issuance of stock in the event the issuer enters bankruptcy. 9 According to the Second Circuit, appellate courts uniformly subordinate the claims of those who conclude the bargain to become investors or shareholders More recently, the Second Circuit reaffirmed that Code 510(b) confines claims which are in essence claims corresponding to ownership of securities (debt or equity)... to their proper tier of the waterfall Noting that 510(b) should be read broadly, the court affirmed the subordination of 5 In re Med. Diversified, Inc., 461 F.3d 251, 253 (2d Cir. 2006). 6 In re Am Hous. Found., 785 F. 3d 143, 155 (5th Cir. 2015); In re Telegroup Inc., 281 F. 3d 133, 138 (3d Cir. 2002). 7 In re Med. Diversified, Inc., 461 F. 3d at Id. at Id., quoting In re Telegroup Inc., 281 F. 3d at Id. at In re Lehman Brothers Inc., 808 F. 3d 942, 944 (2d Cir. 2015). 252

8 MANDATORY SUBORDINATION OF EMPLOYEES SECURITIES CLAIMS claims arising from securities of the debtor s affiliate. 12 Some courts, however, still struggle with the broad reading of 510(b). For instance, the U.S. Court of Appeals for the Ninth Circuit recently held that a claim based on the debtors conversion of the claimant s stock was not subject to subordination under 510(b). 13 According to the majority in Khan, the claimant s demand for money damages has nothing to do with his investment, other than the fact that he had purchased the now-purloined securities many years earlier. 14 A Delaware district court also held that an employee s contractual claim was not an equity interest subject to subordination under Code 510(b) and affirmed the bankruptcy court s refusal to subordinate it. 15 The creditor was an employee of the debtor who had bought a 1.5 percent membership interest in the debtor LLC. After his employment was terminated in 1999, the debtor was obligated to buy his equity interest at its fair market value under the terms of the debtor s LLC agreement. To determine the fair market value of that equity interest, the parties entered into an arbitration, where the creditor received an award of $1.291 million, which was confirmed by a state court judgment on March 26, The debtor later filed a Chapter 11 petition more than a year later, on April 5, Most important, according to the court, the creditor s equity stake in the [debtor] extinguished pre-petition and with it, [the creditor s] ability to participate in any of the [the debtor s] profits or losses. 16 In short, the employee creditor s former equity interest... has been converted into a fixed debt obligation. 17 The Ninth Circuit also denied a request to subordinate a financial adviser s claim for pre-bankruptcy services when his compensation was tied to the value of the debtor s stock. 18 According to the Ninth Circuit, the financial adviser was never a shareholder. Rather, the debtor s stock value was simply the basis for calculating his compensation Id. at (emphasis added). 13 In re Khan, F.3d 1058 (9th Cir. 2017) (2-1). 14 Id. at In re Cybersight LLC, (Del. 2004). 16 Id. 17 Id. 18 In re Am. Wagering, 493 F. 3d 1067 (9th Cir. 2007). 19 Id. at

9 PRATT S JOURNAL OF BANKRUPTCY LAW ANALYSIS The Second Circuit discarded as unnecessary part of the bankruptcy court s holding in Lehman Brothers that the claimants may assert only proofs of interest not proofs of claim Still affirming the result below, the Court of Appeals narrowed its holding to mandate subordination pursuant to section 510(b). 21 RSUs as Securities According to the court, each RSU is a security under Code 101(49), quoting the bankruptcy court s explanation: a grant of an RSU constitutes a contingent right to participate in, receive [or] purchase [the debtor s] common stock... once certain employment-related conditions have been satisfied. 22 Moreover, reasoned the court, these RSUs bear many of the hallmark characteristics of a security. Like many security holders, the RSU holders had limited voting rights and received any declared dividends in the form of additional RSUs. And of most significance, they had the same risk and benefit expectations as shareholders because the value of their RSUs was tied to the value of [the debtor s] common stock. 23 Unlike a creditor that can only recover its investment, an RSU holder expect[ed] to participate in firm profits. 24 Purchase of Security Because the debtor awarded the claimants the RSUs as compensation for their labor, reasoned the court, they received the RSUs through a purchase or sale, as required by Code 510(b). Indeed, the term purchase in 510(b) is properly construed broadly to include circumstances where a claimant has received equity securities in exchange for labor. 25 Here, the claimants purchased RSUs within the meaning of section 510(b) by agreeing to receive them, in lieu of cash, in exchange for a portion of their labor. 26 By agreeing to work for [the debtor], the claimants voluntarily accepted that [the debtor] U.S. App. LEXIS 7920, at * Id. at * Id. at *26, quoting 519 B.R. at Id. at * Id., quoting Med Diversified at 461 F.3d at Id. at * Id. 254

10 MANDATORY SUBORDINATION OF EMPLOYEES SECURITIES CLAIMS had the discretion to pay part of their total compensation in RSUs. 27 Arising from the Purchase of the Security Because the claims here were claims for damages arising from the purchase of a security, as required by Section 510(b), regardless of how the claimant characterize them, the claims arise... from a securities transaction so long as the transaction is part of the causal link leading to the alleged injury. 28 In other words, these claims only arose because the claimants had agreed with the debtor to receive part of their compensation in the form of RSUs. 29 Claimants Other Arguments The court rejected the claimants various theories opposing subordination. 30 First, as to the argument that the RSUs never vested, the claimants have already been paid the compensation they were due in the form of RSUs and, as a result, have no right to any other mode of performance [e.g., cash] [from the debtor]. 31 As for their restitution claim, the claimants suffered no actual injury merely because the debtor s common stock had no value. 32 COMMENT Lehman Brothers is consistent with Second Circuit precedent broadly construing Code 510(b). It also follows decisions in other circuits subordinating securities damage claims. 27 Id. at * Id. at *34, citing Med Diversified, 461 F.3d at ( 510(b) applies to a claim arising from a failed securities transaction even though the claimant never received shares in the debtor). 29 Id. at * U.S. App. LEXIS 7920, at * Id. at * Id. at *