Contributed by Adam Lavine
In a decision with broad and significant implications for many investors, the Court of Appeals for the Fifth Circuit has held that claims arising under a guarantee of a security issued by an affiliate can be subject to mandatory subordination pursuant to section 510(b) of the Bankruptcy Code. While the decision may come as a surprise to some investors who assume that guarantee claims, unlike claims for securities fraud, are not subject to mandatory subordination, the decision serves as a critical reminder of the breadth of section 510(b) of the Bankruptcy Code.
The case of In re American Housing Foundation, is significant not only for its ultimate holding regarding the subordination of guarantee claims, but also for its analysis of the Bankruptcy Code’s definition of “affiliate.” Such analysis is in tension with Bankruptcy Court decisions from the District of Delaware and elsewhere.
In American Housing, the debtor was a nonprofit developer of low-income housing. To fund many of its developments, the debtor created various single-purpose limited partnerships (LPs). Interests in these LPs were sold to investors and guaranteed by the debtor. The debtor (or its wholly-owned subsidiaries) served as the LPs’ general partners.
The principal amount of an investor’s investment was supposed to cover a housing development’s “soft costs,” such as painting expenses and costs related to obtaining Low Income Housing Tax Credits. In practice, an investor’s principal was often fraudulently diverted to fund the debtor’s general operations and to personally benefit the debtor’s president.
In American Housing, an investor filed claims against the debtor based on the debtor-issued guarantees in amounts that roughly equaled the amounts of his investments. According to the chapter 11 trustee (and each of the lower courts), the guarantee claims were required to be subordinated as a result of section 510(b) of the Bankruptcy Code. The investor disagreed and appealed the matter all the way to the Fifth Circuit.
The Fifth Circuit’s Analysis of the Guarantee Claims
Section 510(b) of the Bankruptcy Code requires the subordination of claims for, among other things, “damages arising from the purchase or sale of [a security of the debtor or an affiliate of the debtor] . . . .” 11 U.S.C. § 510(b). In analyzing whether the investor’s claims fell within this section of the Bankruptcy Code, the Fifth Circuit considered whether the claims were (a) for damages, (b) arising from the purchase or sale of a security, and (c) of an affiliate of the debtor.
Damages. The Fifth Circuit noted that whether the guarantee claims constituted claims for “damages” was a “difficult question” because some courts have held that “damages” under section 510(b) must be for something other than the simple recovery of an unpaid investment. To understand the distinction referenced by the court, consider a typical bondholder. Upon a bankruptcy filing, a typical bondholder has a claim for the principal amount of the investment plus any accrued but unpaid interest. To the extent the bondholder additionally asserts a claim for securities fraud, such claim is considered a claim for “damages” under section 510(b). The Fifth Circuit implied that this is because such claim is for something “other than the simple recovery of the unpaid investment.”
In American Housing, the Fifth Circuit noted that the guarantee claims were essentially breach of contract claims and that such breach claims were distinct from the underlying claims against the issuer for the investments themselves. Accordingly, the court held that the guarantee claims were for “damages” under section 510(b). In so holding, the court implicitly likened a guarantee claim to a typical securities fraud claim insofar as both are for something other than the recovery from the issuer of the investment itself.
Arising from the purchase or sale of a security. Some investors might assume that guarantee claims, such as those at issue in American Housing, can never arise from the purchase of securities because they necessarily arise from the independent contractual obligations contained in the guarantees. In American Housing, the Fifth Circuit disagreed with this assumption. Specifically, the court held that, under the facts of the case, there was a sufficiently close nexus between the guarantee claims and the purchase of the securities for the guarantee claims to qualify as having arisen from the purchase of the securities. In particular, the court relied upon the bankruptcy court’s findings that, among other things, the guarantees were “intimately intertwined with” and could not “be considered apart from the other transactions that arose in connection with the investment.”
Of an affiliate of the debtor. Finally, the Fifth Circuit held that the LPs were “affiliates” of the debtor and, therefore, the LP interests were securities “of an affiliate of the debtor.” Section 101(2)(C) of the Bankruptcy Code defines “affiliate,” in relevant part, as follows:
[a partnership] whose business is operated under a lease or operating agreement by a debtor. . . .
The Fifth Circuit noted that this definition is susceptible to two constructions. First, the phrase “by a debtor” could modify the word “operated,” and thus a debtor must have operated the partnership to be considered an affiliate of the partnership. Second, and alternatively, the phrase “by a debtor” could modify the term “operating agreement,” and thus the operating agreement must be an agreement of the debtor for the debtor to be considered an affiliate of the partnership.
The Fifth Circuit held that the LPs were affiliates of the debtor under either construction. Based on the record developed by the Bankruptcy Court, it was clear to the Fifth Circuit that (i) the debtor operated the LPs either as the general partner or the direct parent of the general partner and (ii) the operating agreements were agreements of the debtor, even though the debtors were not parties to them.
This holding is in tension with bankruptcy court decisions from the District of Delaware and elsewhere. For example, in SemCrude, the debtor wholly owned the general partner of the LP issuer, just like the debtor in some of the corporate structures considered by the Fifth Circuit in American Housing. The SemCrude court, however, noted that such ownership and control could not make the LP an “affiliate” of the debtor because the debtor was not alleged to be a party to the LP agreement. The Fifth Circuit rejected this holding, reasoning that
[courts have applied] unduly strict interpretations of the phrase “agreement by a debtor,” ignoring that an agreement may functionally be “by” the debtor even where the debtor is not a party to the agreement. We see no reason why the existence of a shell conduit between a debtor and an entity—which in no way inhibits the debtor’s ability to control and operate that entity—should preclude a finding of affiliate status.
Should Investors Be Worried?
It is quite common for a corporate family to raise capital by offering securities guaranteed by the corporate parent or one or more of the parent’s subsidiaries. After American Housing, should investors be worried that, in the event of the guarantor’s bankruptcy, such guarantees might be only as valuable as the paper they’re written on? The answer is: it depends.
Among other things, it depends on the particulars of the corporate family involved and the jurisdiction of the dispute, as exemplified by the disparate holdings of SemCrude and American Housing. Under the Fifth Circuit’s reasoning, the nature of the particular investment and guarantee may also be relevant. Indeed, the Fifth Circuit relied heavily on a factual record developed during a 25-day trial conducted by the Bankruptcy Court. The trial revealed, among other things, that (i) the guarantees were “intimately intertwined with the LP agreements,” (ii) the guarantees could not be “considered apart from the other transactions that arose in connection with the investments” and (iii) the guarantees, at least in part, induced the claimant to make his investment.
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