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Close Enough: Fifth Circuit Holds That Section 510(B) of the Bankruptcy Code Requires Subordination of Payments That “Look a Lot like” Dividends

In 1930, Clarence Bennett’s wealthy uncle died. He left behind shares in Berry Holding Company ("BHC") that were subdivided into three groups. Bennett was the beneficiary of dividends paid out of one of these groups and, for many years, received his share of dividends from BHC. In 1986, BHC became Berry Petroleum Company ("BPC"), a publicly traded company, and Bennett’s interest changed. In order to preserve the intent of the wealthy uncle’s bequest, that his heirs receive income on the shares of his company, and because of an unrelated dispute with a third-party that resulted in certain of the shares being retired, BPC agreed to pay Bennett “deemed dividends” each time BPC paid an actual dividend to its shareholders. 

This arrangement continued until 2013, when BPC entered into a share exchange with Linn Energy LLC and LinnCo LLC (collectively, "Linn") as a result of which BPC became Berry Petroleum Company, LLC ("Berry"). Despite assurances from Linn that it would undertake BPC’s obligation to pay Bennett the deemed dividends, the payments stopped once the share exchange was completed. Litigation ensued, but before it concluded, Linn and Berry filed voluntary bankruptcy petitions in the United States Bankruptcy Court for the Southern District of Texas. Bennett’s estate (he died in 2015) filed a claim for just under $10 million for the amounts it claimed were owed under the “deemed dividend” arrangement and for misrepresentation and breach of fiduciary duty. The debtors argued that the claim should be expunged or subordinated pursuant to Section 510(b) of the Bankruptcy Code. The Bankruptcy Court agreed and subordinated all of Bennett’s claims. The Fifth Circuit affirmed.[1] 

Section 510(b) of the Bankruptcy Code provides:

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.

11 U.S.C. § 510(b). Based on the language of the statute – which the Fifth Circuit characterized as “ambiguous” insofar as the “arising from” language is concerned – the debtors argued that a court should subordinate where: “(1) a claim is for ‘damages,’ (2) the claim involves ‘securities,’ and (3) the claim ‘arise[s] from’ a ‘purchase or sale’ having a nexus with those securities.”[2] The Court did not entirely reject this approach, but noted that “a formulaic check-the-box approach to subordination under the statute is impossible. Given its ambiguity, the policy rationales behind Section 510(b) must always guide its interpretation and application to particular facts. The most important question is this: Does the nature of the Estate's interest make the Estate more like an investor or a creditor? Because we conclude the deemed dividends gave the Estate benefits normally reserved for equity investors, we conclude subordination of all of the Estate's claims was appropriate.”[3] 

In reaching this conclusion, the Fifth Circuit focused on the aspects of Bennett’s interest that were “like a security.”

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. The deemed dividends plainly gave him such expectations. Treating them as securities comports with the broad reading courts have given Section 510(b).[4]

The Fifth Circuit even acknowledged that Bennett’s interest was something of a hybrid, and that “the deemed dividend payments do not fit perfectly in the investor box.” Nevertheless, the Court held that “the interest [Bennett] enjoyed in BHC, BPC, and then in Linn or Berry was certainly more like an investor's interest than a creditor's interest.” Moreover, “[a]llowing [Bennett] to be treated pari passu with creditors would upset the equity cushion those creditors relied on when extending credit and would undermine the Bankruptcy Code's absolute priority rule. Subordinating [Bennett’s] claims is consistent with the central policy underlying Section 510(b).”[5]


[1] French v. Linn Energy, L.L.C. (In re Linn Energy, LLC), 936 F.3d 334 (5th Cir. 2019).

[2] Id. at *10-11. 

[3] Id

[4] Id. at 15-16 (internal citations and quotations omitted).

[5] Id. at 20-21 (internal citations and quotations omitted).