Opinion ID: 162082
Heading Depth: 1
Heading Rank: 2

Heading: HISTORY AND POLICY BEHIND SECTION 510(b)

Text: 8
9 In adopting section 510(b) Congress did not write on a clean slate. Kenneth B. Davis, Jr., The Status of Defrauded Securityholders in Corporate Bankruptcy, 1983 Duke L.J. 1, 4. American and British courts have struggled for more than a century to referee battles between a bankrupt's creditors and its defrauded investors. Id. Early cases in both countries tended to side with the creditors, supported by the theory that a company's capital reserves represented a `trust fund' for payment of corporate debts. Id. at 5. By the early 1900s, courts began questioning the trust fund theory in favor of one that focused more narrowly on creditor reliance. Under this view, only creditors who could show actual reliance on a particular shareholder contribution warranted a superior claim to the capital invested by that shareholder. Id. at 5-6. By the 1930s, American courts routinely allowed investors to rescind their equity purchases, allowing investors not only to litigate their fraud claims but arming them, as well, with various procedural devices to ensure that creditors could not move ahead in the distribution line. Id. at 6-7. 10
11 In 1937, the United States Supreme Court put its weight behind the rule allowing investor participation on a par with general creditors. Called upon to review the liquidation of a depression-era bank, which had fallen into receivership, the lower court had rejected a shareholder rescission claim. It ruled that the shareholder could not receive any distribution until after all creditors were paid in full. The Supreme Court reversed, finding no statutory basis to support the appellate court's priority scheme; hence the Court refused to subordinate the shareholder's claim. Oppenheimer v. Harriman Nat'l Bank & Trust Co., 301 U.S. 206, 215, 57 S.Ct. 719, 81 L.Ed. 1042 (1937). 12 Although Oppenheimer was not, strictly speaking, a bankruptcy case, the high court subsequently declined to review two cases challenging whether its ruling applied in bankruptcy. See Robert J. Stark, Reexamining The Subordination of Investor Fraud Claims in Bankruptcy: A Critical Study of In re Granite Partners, L.P., 72 Am. Bankr.L.J. 497, 503 (1998) (discussing Oppenheimer and the Court's refusal to decide whether its principle extended to bankruptcy cases). For their part, lower courts relied on Oppenheimer in continuing to treat defrauded investors in bankruptcy cases no differently from general creditors. Id. at 503-04 (discussing cases). 13 This tropism toward shareholder participation came to a dramatic halt in 1973 with the release of a report authored by the Commission on the Bankruptcy Laws, a blue ribbon panel created by Congress to recommend comprehensive changes to the Bankruptcy Code. See Davis, 1983 Duke L.J. at 10. The commission's report in turn embraced an influential article written by law professors John Slain and Homer Kripke. See John Slain & Homer Kripke, 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). 14 Slain and Kripke criticized the favorable treatment that bankruptcy courts were extending to shareholder fraud claims. Their argument rested on the bargain and reliance interests formed by creditors and equity-holders. They pointed out that allowing equity-holders to become effectively creditors-by treating these two classes as though they were one — gives investors the best of both worlds: a claim to the upside in the event the company prospers and participation with creditors if it fails. It also dilutes the capital reserves available to repay general creditors, who rely on investment equity for satisfaction of their claims. Giving shareholder claims the same priority as creditor claims, reasoned Slain and Kripke, eliminates this safety cushion. Id. at 286-91; see also Stark, 72 Am. Bankr.L.J. at 504 (discussing the Slain/Kripke position).
15 In enacting the Bankruptcy Code of 1978, Congress found the Slain and Kripke position compelling. As the report accompanying the House version of the bill noted, Congress generally adopt[ed] the Slain/Kripke position tailoring section 510(b) in a manner that it considered administratively more workable. H.R.Rep. No. 95-595, at 196 (1977), reprinted in 1978 U.S.S.C.A.N. 5963, 6156. Its intent was to subordinate[] in priority of distribution rescission claims to all claims that are senior to the claim or interest on which the rescission claims are based. Id., reprinted in 1978 U.S.S.C.A.N. 5963, 6156-57. 16 Effective November 1978, the Bankruptcy Reform Act inserted the subordination principle first articulated by Slain and Kripke into bankruptcy law. The language of the statute, altered only slightly since its enactment, reads: 17 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. 18 11 U.S.C. § 510(b).