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Ronald Silverman is a partner in the financial restructuring group in the New York office of Boston’s Bingham McCutchen, representing financial institutions and commercial enterprises in complex financial and commercial transactions, creditors’ rights matters and litigation throughout the United States and abroad. Scott Seamon is an associate in that group. It sounds all too familiar: Big company makes record profits in the late 1990s; big company’s stock dives amid rumors of financial impropriety; shareholders sue big company for fraud. It may be time to add: In the event of bankruptcy, shareholders win case, but get nothing. In the wake of the Internet bust and the scandals of Enron, Global Crossing, Adelphia, WorldCom and Tyco, class actions have already been filed by individual shareholders and pension funds. Now that the Dow Jones Industrial Average is hovering around 8,000, down from a high of almost 12,000, investors are looking for answers as to where one-third of their portfolios have gone, and often would like their money back. The typical securities class action alleges a laundry list of claims, including breach of fiduciary duty, waste, mismanagement, lack of due care, misrepresentation, violation of federal and state securities laws, fraudulent inducement and fraudulent retention. The thrust of these suits is often that such breaches resulted in artificially inflated stock prices and that when the true state of affairs became known, the stock price crashed, damaging the shareholders, who now are suing for a recovery. However, a little-known section of the U.S. Bankruptcy Code (but well known to the bankruptcy practitioner) may dramatically affect those shareholders who are looking to recoup their life savings. Sec. 510(b), 11 U.S.C. 510(b), may result in shareholders never receiving a dime from companies that enter bankruptcy proceedings. It wasn’t always this way. Case law indicates that courts historically had taken a narrow interpretation of § 510(b), subordinating only claims for fraud in the inducement, until its interpretation was broadened about five years ago. The past year has proved to be explosive, as decisions have taken § 510(b) even further-to the point that it seems that almost all claims remotely related to equity securities may be subordinated. Sec. 510(b) provides as follows: “For the purpose of distribution under this title, a claim arising from rescission of a purchase or sale of a security of the debtor or of an affiliate of the debtor, for damages arising from the purchase or sale of such a security, or for reimbursement or contribution allowed under section 502 on account of such a claim, shall be subordinated to all claims or interests that are senior to or equal the claim or interest represented by such security, except that if such security is common stock, such claim has the same priority as common stock.” The reasoning behind the adoption of Section 510(b) Sec. 510(b) resulted from more than a century-long struggle in both British and American courts between creditors and shareholders of bankrupt companies. In 1937, the U.S. Supreme Court in Oppenheimer v. Harriman Nat’l Bank & Trust Co., 301 U.S. 206 (1937), refused to subordinate a shareholder rescission claim, finding no basis for such a subordination. The initial shift came with the often-cited article written by professors John Slain and Homer Kripke in 1973 entitled “The Interface Between Security Holders and the Issuer’s Creditors,” 48 N.Y.U. L. Rev. 261 (1973). Slain and Kripke argued that any favorable treatment extended to shareholder fraud claims resulted in the “bootstrapping” of equity interests to the priority of that of the general unsecured claimants. Without subordination, equity holders would effectively be unsecured creditors, giving the equity holder the best of both worlds, ability to participate in the upside of the company as a shareholder and the priority of a creditor if the company went bankrupt. The House adopted this position, as it created § 510(b) with the intent to “subordinate in priority of distribution rescission claims to all claims that are senior to the claim or interest on which the rescission claims are based.” H.R. Rep. No. 95-595, at 196 (1977). The question that has been debated by the courts since the enactment of the Bankruptcy Code in 1978 has been the scope of § 510(b). Does “arising from the purchase or sale of a security” include claims based on fraud occurring after the purchase of the security (broad interpretation), as opposed to fraud committed in the context of the sale of the security (narrow interpretation)? In the often-cited In re Amarex, 78 B.R. 605, 610 (W.D. Okla. 1987), the court held that § 510(b) operates to shift to the shareholders the risk of fraud only in the “issuance” and “sale” and would not extend it to common law claims resulting from fraudulent conduct by the issuer after the issuance. In the years that followed Amarex, courts continued to follow a narrow interpretation of § 510(b). See, e.g., In re Stern-Slegman-Prins Co., 86 B.R. 994 (Bankr. W.D. Mo. 1988). The shift began with In re Granite Partners L.P., 208 B.R. 332 (Bankr. S.D.N.Y. 1997), the first case to adopt a wider interpretation of § 510(b)’s “arising from” language. This case involved common law and federal securities claims based on fraudulent retention, as the shareholders argued that they were induced to hang on to their partnership interests instead of selling them. In Granite, the same court in which suits against Enron and Global Crossing were filed held “arising from the purchase or sale” to be ambiguous. It subordinated the claim for misrepresentation of company performance, on the basis that it was in line with the policy behind § 510(b), as “from the creditor’s point of view, it does not matter whether the investors initially buy or subsequently hold on to their investments as a result of fraud . . . .Just as the opportunity to sell or hold belongs exclusively to the investors, the risk of illegal deprivation of that opportunity should too.” Id. at 342. The trend continued , as bankruptcy courts allowed more post-purchase causes of action to be subordinated by § 510(b), including: Subordination of a breach-of-contract and breach-of-fiduciary-duty claim alleging that the debtor failed to exercise its best efforts to register bonds. In re NAL Financial Group Inc., 237 B.R. 225 (Bankr. S.D. Fla. 1999). Subordination of a “put right,” providing a limited partner with the right to require the debtor to purchase his interest for a combination of cash and shares. In re Einstein/Noah Bagel Corp., 257 B.R. 499 (Bankr. D. Ariz. 2000). Subordination despite the plaintiff’s veiled attempt to avoid § 510(b) by imposing a constructive trust instead of a rescission claim. Tekinsight.com Inc. v. Stylesite Marketing Inc., 253 B.R. 503 (Bankr. S.D.N.Y. 2000). In the wake of Granite, the busiest court as far as published § 510(b) decisions are concerned-and also one of the busiest courts in terms of large bankruptcy filings-has been the U.S. Bankruptcy Court for the District of Delaware, which has followed Granite‘s lead by expanding the scope of § 510(b). The court has subordinated claims involving: Fraudulent activities and misrepresentations in connection with a merger. In re Lernout & Hauspie Speech Products N.V., 264 B.R. 336 (Bankr. D. Del. 2001); and In re Kaiser Group International, 260 B.R. 684 (Bankr. D. Del. 2001). Claims for indemnification associated with securities fraud litigation. In re Mid-American Waste Systems Inc., 228 B.R. 816 (Bankr. D. Del. 1999). Securities fraud claims against directors and officers. In re Worldwide Direct Inc., 280 B.R. 819 (Bankr. D. Del. 2002). Federal appeals courts have adopted the broad standard Recently, U.S. circuit courts of appeals have joined the party, just in time for the boom in shareholder litigation that has resulted from the downturn in the economy. To date, the 3d U.S. Circuit Court of Appeals, as well as the 9th and 10th circuits, have issued opinions adopting a broad interpretation of § 510(b). The 9th Circuit was the first circuit to opine on § 510(b) in American Broadcasting Systems Inc. v. Nugent (In re Betacom of Phoenix Inc.), 240 F.3d 823 (9th Cir. 2001), a case that subordinated fraud, breach-of-fiduciary-duty and breach-of-contract claims associated with obligations under a merger agreement. The 10th Circuit, in In re Geneva Steel Co., 281 F.3d 1173 (10th Cir. 2002), expressly abrogated Amarex. The court held that post-investment fraud-in the form of the company remaining silent even though experiencing financial difficulty-that caused investors to retain securities “arose” from the purchase or sale of securities. “Put simply, ‘creditors stand ahead of the investors on the receiving line’ ” Id. at 1179. The 3d Circuit, on the heels of many of these Delaware decisions, subordinated claims alleging the breach of an agreement to use best efforts to ensure that stock became registered. Baroda Hill Investments Ltd. v. Telegroup Inc. (In re Telegroup Inc.), 281 F.3d 133 (3d Cir. 2002). The court did stop short of saying that all claims by equity holders will be subordinated: It stated that there must be some kind of nexus or causal relationship to the purchase or sale of a security. Id. at 138, 144, n.2. Two recent decisions in the 3d Circuit applied the Telegroup precedent. See In re Response U.S.A. Inc., 2003 WL 169938 (D.N.J. 2003); and In re Int’l Wireless Communications Holdings Inc., 279 B.R. 463 (D. Del. 2002). What these cases indicate is that many of the class actions currently filling up the courts’ dockets and incurring fees at a substantial rate may prove to be fruitless. While a jury may find that a company fraudulently caused a shareholder to retain stock by failing to disclose accurate financials, and award a multimillion-dollar verdict, when it comes time to collect on those claims, the shareholders will likely be subordinated to the claims of creditors. Given that creditors are rarely paid in full in bankruptcy cases, shareholder litigants’ victories may well prove pyrrhic.

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