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One of the fundamental principles of the Bankruptcy Code is that unsecured creditors receive payment in full from a debtor’s bankruptcy estate before equity holders receive anything from the estate. In order to ensure that equity holders do not convert their claims into higher-priority general unsecured claims, Section 510(b) of the code provides that “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.” In Official Committee of Unsecured Creditors v. American Capital Financial Services Inc., Mobile Tool International Inc. and the Official Committee of Unsecured Creditors filed a complaint against individual defendants and their agent seeking, inter alia, to subordinate the defendants’ claims pursuant to Section 510(b). The defendants filed a motion, and the plaintiffs filed a cross-motion, for judgment on the pleadings with respect to the count, seeking subordination. In 1995, the individual defendants and the debtor entered into a stockholder agreement that required the debtor to repurchase its stock from the individual defendants upon notice. After the individual defendants gave notice in November 2001, the debtor and the individual defendants entered into a “put purchase note agreement,” pursuant to which the debtor issued notes to the individual defendants. American Capital Financial Services, as agent for the individual defendants, was granted a security interest in all of the debtor’s assets. Upon the debtor’s filing for bankruptcy protection on Sept. 30, 2002, each of the defendants filed a claim based on the notes issued pursuant to the put purchase note agreement. While the plaintiffs asserted that the defendants’ claims must be subordinated under Section 510(b), the defendants argued that their claims did not arise from the purchase or sale of securities, but rather from the promissory notes. Noting that the 3rd U.S. Circuit Court of Appeals has held that a claim arises from the purchase or sale of a security if there is a nexus or causal connection between the claim and the sale, the court analyzed several cases within the circuit with a similar fact pattern. In Montgomery Ward Holding Corp. v. Schoeberl, which was cited by the defendants, the debtor redeemed shares of its stock from a stockholder prepetition by paying in cash and by issuing promissory notes. When Montgomery Ward filed for bankruptcy protection, the former stockholder filed a claim for amounts due under the promissory notes. In declining to subordinate the claim, the court held that a claim based on a promissory note is not subject to subordination under Section 510(b), as it is only a claim for the recovery of an unpaid debt under the note. Emphasizing that Montgomery Ward was “on all fours with this case,” the court drew a distinction between the cases cited by the plaintiffs and the instant case. For example, unlike the claimants in In re Kaiser Group International Inc., who filed a claim for the failure of the debtor’s stock to reach a certain value outlined in a merger agreement, the defendants in the instant case exchanged their stock for a debt instrument and thus divested themselves of “‘all indicia of ownership.’” Further, in In re International Wireless Communications Holdings Inc., the claim was based on the debtor’s breach of an agreement with the claimants to repurchase its stock that it issued to the claimants if it failed to make an initial public offering by a certain date. In subordinating the claim, the court held that there was a causal connection between the claim and the transaction. However, unlike the instant case, International Wireless did not involve a separate promissory note or a debt instrument. Similarly, in In re Alta+Cast LLC, the claim was based on a judgment entered after the debtor breached an agreement with an employee to repurchase its stock if the employee was terminated for cause. Noting that the employee retained the risk of ownership by holding the stock until his termination, the court subordinated the employee’s claim under Section 510(b). However, as in International Wireless, no separate debt instrument was issued nor did the claimant change his status from owner to creditor. In Baroda Hill Investments Ltd. v. Telegroup Inc., the 3rd Circuit held that even claims “rooted in contract” came within the scope of Section 510(b), whether the conduct giving rise to the claim occurred before or after the stock sale. Specifically, the court of appeals held that a claim for breach of a provision of a stock purchase agreement requiring registration and free transferability of stock “arises from” the purchase of stock for the purposes of Section 510(b). The court in the instant case noted, however, that Baroda-type claims are claims made by a party qua shareholder, not noteholder. The defendants’ claims, on the other hand, were brought after the defendants had relinquished all rights as shareholders; their claims derived solely from any rights that they might assert through the promissory notes. As such, these claims would not fall within the purview of Section 510(b). Thus, following Montgomery Ward, the court held that Section 510(b) does not apply after notes are actually issued in exchange for stock. The court emphasized that the purpose of Section 510(b) is to “prevent stockholders from reaping the benefit of unlimited profits without also fully accepting the inherent risks of ownership.” Stating that the defendants had divested themselves of ownership and that the debtor’s liability became fixed when the promissory notes were issued, the court declined to subordinate the defendants’ claims under Section 510(b).

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