In forming an entity to purchase a company or other investment, investors are typically concerned with how and when they will exit their investment in the company. It is not uncommon to see an agreed buy-out methodology in the documentation that is backed by an arbitration provision governing potential disputes. In such a scenario, the exiting investor has a claim for its buy-out rights, but may no longer have a voice in the management of the investment vehicle. A recent case from the U.S. Court of Appeals for the Ninth Circuit highlights the risk when the investment vehicle itself is the obligor on such a buy-out. In that circumstance, the Ninth Circuit, contrary to the view of decisions from the Second and Third Circuits, has determined that the investor assumes the risk that, should a bankruptcy occur, the investor’s buyout claim would be subordinated to the claims of other creditors.
Section 510(b) of the Bankruptcy Code is the source of this debate as it mandates the subordination of rescission and damage claims “arising from” the purchase and sale of equity interests, such that the claim is assigned the same priority vis à vis creditors as the original equity investment. Other courts have taken into consideration the timing and the nature of the investor’s claim in determining whether the claim falls within the scope of §510(b). For instance, courts may differ as to whether a claim arises from the purchase or sale of an equity interest where a creditor holds a debt claim as of the filing of the bankruptcy petition, but where the origins of the debt claim can be traced back to the purchase or sale of an equity interest. In contrast, at least in the Ninth Circuit, it would appear once an equity holder, always an equity holder.
