In In re Touch America Holdings Inc., 381 B.R. 95 (Bankr. D. Del. 2008), the U.S. Bankruptcy Court for the District of Delaware was called on to decide whether to subordinate and disallow various reimbursement and indemnification claims filed by former directors and officers of the debtors in connection with two civil actions pending against these directors and officers. On June 19, 2003, Touch America Holdings Inc. et al. (the debtors) filed voluntary petitions seeking bankruptcy relief under Chapter 11 Bankruptcy Code. The debtors' Amended Liquidating Chapter 11 Plan, filed on Aug. 17, 2004, was confirmed by the court Oct. 6, 2004, and a plan trustee was appointed pursuant to the confirmation order.
During the pendency of the debtors' Chapter 11 cases, former directors and officers of the debtors filed proofs of claim in the debtors' cases. The directors and officers had been named as defendants in certain pending civil actions and they, in turn, asserted claims against the debtors for reimbursement, indemnification and contribution to the extent that they might incur costs or be held liable in these civil actions.
On Jan. 27, 2006, the plan trustee filed a motion, pursuant to Bankruptcy Code Sections 510(b) and 502(e)(1)(B) and Bankruptcy Rule 3007, to subordinate or disallow certain indemnification claims filed by the directors and officers. On April 28, 2006, the plan trustee filed a motion for partial summary judgment and, after a series of responses and arguments (as well as a stipulation between the parties), the court was left with two issues: (i) whether indemnification claims arising from certain ERISA litigation arose from the purchase or sale of securities, making them subject to subordination pursuant to 11 U.S.C. Section 510(b); and (ii) whether indemnification claims arising from other litigation (the Edwards litigation) were contingent claims of a co-debtor that should be disallowed pursuant to 11 U.S.C. Section 502(e)(1)(B).
Subordination Under 11 U.S.C. Section 510(b)
The ERISA litigation was a putative class action where the proposed class consisted of all current and former employees who participated in a 401(k) plan (the retirement plan) provided by an entity that, through a restructuring in 2002, came to be a subsidiary of one of the debtors. The subsidiary's employees who participated in the retirement plan received matching contributions exclusively in the subsidiary's stock, and because of certain retirement plan restrictions, such participants were unable to sell certain of their subsidiary shares.
The ERISA litigation plaintiffs alleged that in the late 1990s, the subsidiary's executives initiated a series of steps designed to divest the subsidiary of its energy business and concentrate on telecommunications operations, allegedly making the subsidiary's stock volatile and a risky investment. The plaintiffs further alleged that in spite of declining subsidiary stock prices, the subsidiary continued its transition and opted not to terminate the retirement plan and lift the restrictions on diversification of the subsidiary stock in individual accounts, even though the various individual and corporate defendants in the ERISA litigation had allegedly considered such action.
The ERISA litigation plaintiffs alleged that the defendants knew or should have known that, given the fundamental change in the subsidiary's business strategy, it was not in the best interests of the retirement plan or the participants to continue to use subsidiary stock as a matching employer contribution, or to allow any retirement plan assets to be invested in subsidiary stock. They further claimed that the defendants breached their fiduciary duties by failing to (i) move the retirement plan assets out of subsidiary stock; (ii) lift the restrictions on the participants' ability to transfer the stock; and (iii) cease using subsidiary stock for matching contributions.
The court first enunciated the standard for summary judgment: that the record presents no genuine issue as to any material fact and that the moving party be entitled to judgment as a matter of law. As to the subordination issue, the directors and officers argued that Section 510(b) did not apply to the ERISA litigation because (i) the claims were based upon the directors' and officers' alleged breach of fiduciary duties established by ERISA, and (ii) such claims did not arise from the "purchase or sale" of securities.
The court next looked to the plain language of 11 U.S.C. Section 510(b), which provides that:
"For the purpose of distribution under [the Bankruptcy Code], 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 its analysis, the court focused on the phrase "arising from the purchase or sale of a security."
First, the court had to determine whether the ERISA litigation claims were based upon a "purchase or sale" of securities, as the plaintiffs in the ERISA litigation received their subsidiary stock as a matching contribution under the retirement plan, rather than by purchasing it on the open market. The court found that this logistical difference had no legal relevance: The retirement plan participants' exchanging of value for the subsidiary stock fell under a broad reading of the term "purchase."
Next, the court looked to whether the ERISA litigation claims "[arose] from" the purchase or sale of securities. Case law indicates that subordination under Section 510(b) is warranted where a claimant takes on the "risk and return" expectations of a shareholder (i.e., participation in corporate profits, lower priority of repayment in bankruptcy), rather than a creditor (i.e., no participation in corporate profits, higher priority of repayment in bankruptcy). Without such subordination, dissatisfied equity investors would have claims of the same priority of those of general unsecured creditors in the event of bankruptcy. The court ultimately found that the ERISA litigation claims "[arose] from" the purchase or sale of securities, reasoning that the ERISA litigation plaintiffs took on the "risk and return" expectations of shareholders, and that they sought to recover damages resulting from their purchase and ownership of the subsidiary stock.
Accordingly, the court granted summary judgment in favor of the plan trustee and found that the directors' and officers' indemnification claims for liability and costs associated with the ERISA litigation should be subordinated under Section 510(b).
Disallowance Under Section 502(e)(1)(B)
The Edwards litigation plaintiffs asserted claims of negligence, breach of the implied covenant of good faith and fair dealing, breach of fiduciary duty and fraud against various corporate and individual defendants, including one of the debtors and the subsidiary involved with the ERISA litigation. These plaintiffs alleged that certain of the defendants' directors and officers had misled the Edwards litigation plaintiffs by representing that certain incentive plan amounts would be paid to them upon sale of a subsidiary of the subsidiary to another entity; in reality, only 25 percent of such amounts were paid.
The court noted that the plan trustee would need to demonstrate three elements for disallowance under Section 502(e)(1)(B): (i) the claims must be contingent; (ii) the claims must be for reimbursement or contribution; and (iii) the debtor and the claimant must be co-liable on the claims. The court found that the claims were contingent upon analysis of the merits of the underlying controversy, as indemnification is subject to a good faith analysis.
The court also noted that the concept of reimbursement typically includes indemnity.
The directors' and officers' main defense was that they were not co-liable with the debtors on the underlying claims. The court noted that co-liability requires a finding that should the underlying claims be proven, the debtors would be liable but for the automatic stay. However, the court concluded that, if proven, certain claims asserted in the Edwards litigation could result in co-liability on the part of one of the debtors and certain of the directors and officers. To fully allow the indemnification claims of the Edwards litigation plaintiffs and the directors and officers would violate the purpose behind Section 502(e)(1)(B): to preclude redundant recoveries on identical claims against insolvent estates. Thus, the court concluded that the directors' and officers' indemnification claims should be disallowed.
The court ordered further argument as to whether to allow the portion of the claims seeking attorney fees and expenses. This issue was one of first impression before the court, and though there were opinions on either side of the issue in other jurisdictions, the court ordered additional briefing and argument.
Conclusion
The Touch America Holdings decision is consistent with the rationale behind 11 U.S.C. Section 510(b): Because creditors generally rely on (i) a cushion of equity in making the decision to extend credit, and (ii) having priority over equity in the event of a bankruptcy, a claim for reimbursement or contribution on account of a claim arising out of the purchase or sale of securities must be subordinated to claims of general unsecured creditors. The decision is also consistent with the rationale behind Section 502(e)(1)(B): to prevent competition between a creditor and guarantor for limited proceeds of the estate.
Rudolph J. Di Massa, Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors' rights. He is a member of the American Bankruptcy Institute, the American Bar Association and its business law section, the Commercial Law League of America, the Pennsylvania Bar Association and the business law section of the Philadelphia Bar Association.
Matthew E. Hoffman practices in the area of business reorganization and financial restructuring. Hoffman is admitted to practice in Pennsylvania and New Jersey.
Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.