Claims to Dividends Originating From Stock Trust Subordinated Under Section 510(b) of the Bankruptcy Code

Section 510(b) of the Bankruptcy Code provides a mechanism designed to preserve the creditor/shareholder risk allocation paradigm by categorically subordinating most types of claims asserted against a debtor by equity holders. However, courts do not always agree on the scope of the provision in attempting to implement its underlying policy objectives. The U.S. Court of Appeals for the Fifth Circuit recently examined the broad reach of section 510(b) in In re Linn Energy, 936 F.3d 334 (5th Cir. 2019). The court ruled that, even though the beneficiary of a stock trust did "not fit perfectly in the investor box," his claims should be subordinated under section 510(b) because his entitlement to "deemed dividends" originally arising from the trust "was certainly more like an investor's interest than a creditor's interest."

Subordination in Bankruptcy

The concept of claim, debt, or lien subordination is well recognized under federal bankruptcy law. A bankruptcy court's ability to reorder the relative priority of claims or debts under appropriate circumstances is part and parcel of its broad powers as a court of equity. The statutory vehicle for applying these powers in bankruptcy is section 510 of the Bankruptcy Code.

Section 510(a) makes a valid contractual subordination agreement enforceable in a bankruptcy case to the same extent that it would be enforceable outside bankruptcy.

Section 510(b) generally subordinates claims arising from the purchase or sale of a security of the debtor or an affiliate of the debtor to all claims that are senior or equal to the claim or interest represented by the security.

Finally, misconduct that results in injury to creditors can warrant the "equitable" subordination of a claim under section 510(c).

Subordination of Shareholder Claims Under Section 510(b)

Section 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 purpose of section 510(b), consistent with the Bankruptcy Code's "absolute priority" rule, is to prevent the bootstrapping of equity interests into claims that are on a par with other creditor claims. According to this rule, unless creditors are paid in full or agree otherwise, shareholders cannot receive any distribution from a bankruptcy estate.

Shareholders have resorted to a wide array of devices and/or legal arguments in an effort to overcome this basic legal premise, including contractual provisions purporting to entitle them to damages upon the issuer's breach of a stock purchase agreement and alternative theories of recovery, such as unjust enrichment and constructive trust. See generally Stucki v. Orwig, 2013 WL 1499377 (N.D. Tex. Apr. 12, 2013) (discussing case law).

Some courts have decided cases under section 510(b) by reviewing the traditional allocation of risk between a company's shareholders and its creditors. Under this policy-based analysis, shareholders are deemed to undertake more risk in exchange for the potential to participate in the profits of the company, whereas creditors can expect only repayment of their fixed debts. Accordingly, shareholders, and not creditors, assume the risk of a wrongful or unlawful purchase or sale of securities. This risk allocation model is sometimes referred to as the "Slain/Kripke theory of risk allocation," as described in a 1973 law review article written by Professors John J. Slain and Homer Kripke entitled The Interface Between Securities Regulation and Bankruptcy—Allocating the Risk of Illegal Securities Issuance Between Securityholders and the Issuer's Creditors, 48 N.Y.U. L. Rev. 261 (1973). See In re SeaQuest Diving LP, 579 F.3d 411, 420 (5th Cir. 2009); In re Betacom of Phoenix, Inc., 240 F.3d 823, 829 (9th Cir. 2001); In re Granite Partners, L.P., 208 B.R. 332, 336 (Bankr. S.D.N.Y. 1997).

Because of the parties' differing expectations for risk and return, it is perceived as unfair to allow a shareholder to recover from the limited assets of a debtor as a creditor by "converting" its equity stake into a claim through the prosecution of a successful securities lawsuit. The method by which such a conversion is thwarted is subordination of the shareholder's claim under section 510(b).

Many courts have found the language of section 510(b) to be ambiguous. See SeaQuest, 579 F.3d at 421. In In re Am. Hous. Found., 785 F.3d 143 (5th Cir. 2015), the Fifth Circuit concluded that a claim should be subordinated under section 510(b) if: (i) the claim is for "damages"; (ii) the claim involves "securities"; and (iii) the claim "arise[s] from" a "purchase or sale." With respect to the third element, the court explained, "[f]or a claim to 'arise from' the purchase or sale of a security, there must be some nexus or causal relationship between the claim and the sale." Id. at 156 (quoting SeaQuest, 579 F.3d at 421) (internal quotation marks omitted). The Second Circuit applied a slightly different formulation of the test in In re Lehman Bros. Holdings Inc., 855 F.3d 459, 472-78 (2d Cir. 2017), where it examined whether: (1) the claimant owns a security; (2) the claimant acquired the security by means of a purchase or sale; and (3) the claimant's damages arose from the purchase or sale of the security or the rescission of such a purchase or sale.

Section 101(49) of the Bankruptcy Code defines the term "security" broadly to "include" notes, stock, treasury stock, bonds, debentures and an extensive catalogue of other investments. In addition, the definition contains a broad residual clause providing that a security also includes "any other claim or interest commonly known as [a] "'security.'" The scope of the residual clause is broad. See SeaQuest, 579 F.3d at 418.

The statutory definition also expressly excludes a number of items, including, among other things, currency, checks, drafts, bills of exchange, bank letters of credit, commodity futures contracts, forward contracts, options and warrants.

Section 101(16) of the Bankruptcy Code defines an "equity security" to mean shares in a corporation or any "similar security," limited partnership interests, and certain warrants or rights.

In Lehman Brothers, the Second Circuit noted that "some interests will not perfectly match any of the specific examples in [the Bankruptcy Code's definition of security]," and that, should this be the case, it is of "most significance" that a claimant "ha[s] the same risk and benefit expectations as shareholders." Lehman Brothers, 855 F.3d at 473-74; accord In re WorldCom, Inc., 2006 WL 3782712, at*6 (Bankr. S.D.N.Y. Dec. 21, 2006) ("The form in which the equity interest is held is ultimately irrelevant. So long as the claimant's interest enabled him to participate in the success of the enterprise and the distribution of profits, the claim will be subordinated pursuant to section 510(b).").

The Bankruptcy Code does not define "damages." However, many courts have reasoned that "the concept of damages under Section 510(b) has the connotation of some recovery other than the simple recovery of an unpaid debt due on an instrument." American Housing, 785 F.3d at 153-54 (citing cases and ruling that claims seeking compensation for fraud or breach of fiduciary duty are claims for damages under section 510(b) as well as claims "predicated on post-issuance conduct," including breach of contract claims).

Linn Energy

Under a trust created in 1931, Clarence Bennett ("Bennett"): (i) had an interest in income paid as dividends on shares of stock in Berry Holding Company ("BHC"); and (ii) owned certain BHC stock outright. Bennett received regular dividend payments until 1986, when BHC merged with Berry Petroleum Company ("BPC"). BPC later proposed to retire what was formerly the BHC stock, but this would have eliminated the interests of Bennett and the other trust beneficiaries in the dividend income of the stock. However, Bennett would receive shares in BPC upon retirement of the BHC stock.

To overcome the objections of the trust beneficiaries, BPC created a "victory trust" that would continue to pay the original trust beneficiaries what would have been their interests in the BHC stock dividends. However, because the BHC stock was being retired, the payments were only "deemed dividends" akin to settlement payments. Moreover, the trust required BPC to pay Bennett and the other beneficiaries income only when dividends were issued on BPC stock—if no dividends were declared, the beneficiaries were not entitled to any payments.

In 2013, BPC merged with Linn Energy and an affiliate (collectively, "Linn") to become Berry Petroleum Company, LLC ("Berry"). At that time, Bennett was the only surviving beneficiary of the victory trust. To get Bennett's approval for the merger, Linn agreed to continue paying him the deemed dividends under the trust.

In 2014, Linn sued Bennett in federal district court seeking a declaration that it owed Bennett nothing. Bennett (and later his estate) countersued Linn and added Berry as a defendant, alleging breach of contract, tortious conduct, misrepresentation, elder abuse and breach of fiduciary duty.

In May 2016, Linn, Berry and various affiliates (collectively, the "debtors") filed for chapter 11 protection in the Southern District of Texas. Bennett filed proofs of claim for approximately $10 million in unpaid dividends. The debtors objected to the claims, arguing that they should be expunged or subordinated under section 510(b). The bankruptcy court subordinated Bennett's claims in whole or in part in two separate rulings, the first of which the district court affirmed, after which Bennett appealed to the Fifth Circuit. The bankruptcy court certified a direct appeal of its second subordination ruling to the Fifth Circuit, which consolidated the appeals.

The Fifth Circuit's Ruling

The Fifth Circuit affirmed the bankruptcy court's rulings subordinating Bennett's claims under section 510(b).

Judge Edith Brown Clement began by examining the policy rationale underpinning section 510(b). She wrote that "[t]he most important question is this: Does the nature of [Bennett's] interest make [Bennett] more like an investor or a creditor?"

She noted that all parties agreed that Bennett was seeking "damages," within the meaning of section 510(b), which she found "surprising" because a theme throughout Bennett's submissions was that his interest under the victory trust was "more akin to a creditor's contractual right to payment than the equity interest of an investor." Bennett argued, however, that the damages did not arise from the purchase or sale of a security.

Consistent with the Fifth Circuit's previous ruling in SeaQuest that the residual clause of section 101(49) is broad in scope, Judge Clement concluded that the deemed dividend interest owned by Bennett was a security interest under the residual clause:

Bennett held greater financial expectations than that of a creditor during his lifetime. The upside of his deemed dividend payments was theoretically limitless, as it tracked the value of the corporation. Further, because he risked receiving nothing at all if the corporation went bankrupt or if the corporation chose not to issue dividends, Bennett faced many of the same risks as a traditional shareholder. True, Bennett did not have the right to vote or participate in corporate management, or to sell or bequeath his deemed dividend payments to someone else. But even traditional shareholders do not always enjoy all these rights. . . . The most fundamental consideration is whether Bennett had "the same risk and benefit expectations as shareholders." Lehman Bros., 855 F.3d at 475. The deemed dividends plainly gave him such expectations. Treating them as securities comports with the broad reading courts have given Section 510(b). Id. at 474 ("Several courts have similarly defined 'security' in section 510(b) in terms of an interest tied to a firm's overall success.").

Judge Clement rejected Bennett's argument that his interest was more akin to a profit-sharing agreement, which is expressly excluded from the definition of "security." She wrote that "nothing guaranteed Bennett a share of the profits." Instead, Bennett was entitled to payments of deemed dividends only when other shareholders were paid dividends.

Finally, Judge Clement concluded that Bennett's claims arose from the purchase or sale of the debtor's securities. Adopting a broad "but for causation standard," Judge Clement explained that, but for the 1931 stock bequest in the original trust, the 1986 victory trust, or the 2013 deemed dividend agreement, Bennett would not have a right to demand the deemed dividends in the bankruptcy cases. Accordingly, the judge wrote, "[e]ach of those transactions counts as a purchase or sale—or, in the case of the 1986 transaction—the rescission of a purchase or sale—of securities of the Debtors."

However, Judge Clement focused on the 2013 deemed dividend agreement because it was nearest in time and "the transaction most directly responsible for [Bennett's] claims." Quoting Lehman Brothers, Judge Clement explained that a claim, regardless of how it is characterized by the claimant, arises from a securities transaction "so long as the transaction is part of the causal link leading to the alleged injury" (quoting Lehman Brothers, 855 F.3d at 478). Because the 2013 deemed dividend agreement was "part of the causal link leading to [Bennett's] alleged injuries," Judge Clement ruled that Bennett's claims arose from the purchase or sale of the debtors' securities and must be subordinated under section 510(b).

According to Judge Clement, the policies underlying section 510(b) supported subordination of Bennett's claims. First, the interest held by Bennett in BHC, BPC and then in Linn or Berry "was certainly more like an investor's interest than a creditor's interest." Second, permitting Bennett's claims to be treated pari passu with the claims of creditors "would upset the equity cushion those creditors relied on when extending credit," in addition to undermining the absolute priority rule.


Linn Energy reinforces the broad scope of section 510(b), consistent with its underlying policy objective of preventing interest holders from transforming their rights as shareholders to claims with priority on a par with the claims of creditors. The ruling illustrates that, regardless of how a particular claim is characterized by the claimant, the court will closely examine the nature of the asserted claim and the relationship between the claimant and the debtor to ascertain whether the claimant is truly a creditor rather or an investor.

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