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One of the fundamental goals of the Bankruptcy Code is the fair and equitable distribution of a debtor’s estate among the debtor’s creditors. Subordination of a claim, which is codified at 11 U.S.C. � 510, alters the priority of a claim so that in most cases, the claim receives a distribution only after all other creditors have been paid. There are three types of subordination: (1) subordination by agreement; (2) mandatory subordination of certain claims arising out of securities transactions; and (3) equitable subordination. In re Alta+Cast, 2003 WL 22429694 (Bankr. D. Del. Oct. 24, 2003) addresses the first two. Alta+Cast, the debtor, was a start up company that provided information technology to healthcare providers. In November 1996, they and ACS Development Group entered into a licensing agreement that provided, inter alia, that Mark Hays, the owner of ACS, would receive 15 percent of the total equity in the debtor. In November 1997, Hays, ACS and the debtors entered into an assignment agreement pursuant to which the debtor guaranteed Hays’ employment for a minimum of two years and was to execute an employment agreement with Hays. Although Hays did not sign the employment agreement that was dated Oct. 23, 1997 and prepared for his signature, he did sign an amendment thereto dated Aug. 27, 1998. In any event, the parties did not dispute the relevant terms of the employment agreement. In particular, the employment agreement provided that if Hays’ employment were terminated for cause, the debtor would repurchase Hays’ ownership interest in the debtor. By the fall of 1998, the debtor had generated less than $850,000 in total revenue and had incurred expenses of approximately $14.8 million. Hays asserted that the debtor terminated his employment on May 5, 1999. The debtor, on the other hand, claimed that it had not terminated Hays’ employment; rather, it had only attempted to renegotiate certain aspects of the employment agreement. On Aug. 17, 1999, in what would be called the Idaho Action, Hays sued the debtor in U.S. District Court for the District of Idaho claiming breach of the employment agreement and seeking damages in excess of $12 million. On Oct. 10, 2002, the debtor filed for Chapter 11 bankruptcy protection in Delaware. Hays was granted relief from the stay to conclude the Idaho Action. After trial, the jury in the Idaho Action returned a special verdict in which it determined that Hays’ employment was terminated for just cause and thus, pursuant to the employment agreement, the debtor was obligated to repurchase Hays’ ownership interest in the debtor. This interest was valued at $2.26 million plus interest. Hays’ $2.26 million claim was registered in the debtor’s bankruptcy case as an unsecured claim. The debtor sought to subordinate Hays’ claim to the claims of all other creditors pursuant to � 510(a) or (b) of the Bankruptcy Code. Section 510(a) of the code provides that “[a] subordination agreement is enforceable in a case under this title to the same extent such agreement is enforceable under applicable non-bankruptcy law.” Pursuant to the employment agreement, the debtor’s obligation to repurchase Hays’ membership interest upon termination for cause was to be evidenced by a promissory note issued by the debtor. Additionally, the employment agreement provided that this note was to be subordinated to any debt owed by the debtor to any banks or trade creditors. While the debtor contended — and Hays did not dispute — that this language evidenced an intent to subordinate any obligation to repurchase Hays’ ownership interest to all other claims against the debtor, Hays asserted that the employment agreement’s subordination provision did not govern because the note was never issued. In her opinion, Bankruptcy Judge Mary Walrath noted that Hays’ claim would have been subordinated had the debtor issued the note. She also pointed out that Hays’ argument ignored the fact that Hays’ claim was based upon the jury’s finding that the debtor had breached the employment agreement not by firing Hays, but by failing to issue the note. In determining that the true measure of Hays’ damages applicable in the Idaho Action was that which would put Hays in the position he would find himself absent the debtor’s breach, Walrath held that Hays could not be put into a better position because of the debtor’s breach than he would have been had the debtor performed its obligations under the employment agreement. Thus, the court concluded that Hays’ claim had to be subordinated pursuant to the employment agreement and 11 U.S.C. � 510(a). The court also held that Hays’ claim was subordinated under 11 U.S.C. � 510(b), which provides that “[A] claim arising from rescission of a purchase or sale of a security of the debtor or an affiliate of the debtor, for damages arising from the purchase or sale of such 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 to 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.” Hays asserted that his claim was for breach of the employment agreement, pursuant to which he sought damages, and that even though the damages were measured by the value of his ownership interest in the debtor, there was no causal connection between his claim and the purchase of that ownership interest. The bankruptcy court disagreed. Reasoning that � 510(b) represented Congress’ judgment that claims by shareholders arising from their purchase or sale of stock, whether at the time of issuance or after issuance, must be subordinated to the claims of “real” creditors, the court agreed with the 3rd Circuit’s holding in In re Telegroup, Inc., 281 F.3d 133, 141 (3d Cir. 2002) that a shareholder should not be allowed to avoid subordination under � 510(b) simply by characterizing his claim as a breach of contract claim. The court further found that because the jury in the Idaho Action found that the debtor’s breach of the employment agreement was not the debtor’s termination of Hays’ employment, but rather its failure to repurchase Hays’ stock, Hays’ claim must be characterized as one arising from the sale or purchase of a security of the debtor subject to subordination under � 510(b). If you are interested in submitting an article to law.com, please click here for our submission guidelines.

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