1. Mandatory Subordination Under the Bankruptcy Code by David S. Kupetz 333 S. Hope Street, 35th Floor Los Angeles, CA 90071 (213) 617-5274 dkupetz@sulmeyerlaw.com 2407513.1

2. David S. Kupetz specializes in troubled transactions, crisis avoidance consultation, workouts, restructurings, reorganizations, bankruptcies, receiverships, assignments for the benefit of creditors and other non-bankruptcy insolvency proceedings. He represents debtors (in restructurings and workouts and in chapter 11 reorganization cases), secured creditors, unsecured creditors' committees, assignees for the benefit of creditors, buyers/sellers of businesses/assets in distressed circumstances and other entities in insolvency and bankruptcy situations. A sampling of clients represented by Mr. Kupetz includes: Care Enterprises, Inc. (debtor in possession); Ocean Pacific Sunwear, Ltd. (debtor in possession); County of Los Angeles (creditor); General Electric Capital Corporation (secured lender); Litton Industries, Inc. (creditor); Boston West, LLC (Boston Markets) (debtor in possession); ExxonMobil Corporation (creditor); Honda Trading Co. (creditor); CKE Restaurants (creditor); San Diego Television, Inc. (debtor in possession); South Bay Pizza, Inc. (debtor in possession); Transgo Corp. (unsecured creditors committees); Aura Systems, Inc. (out-of-court unsecured creditors committee); Snow Valley, LLC (debtor in possession); Gardenburger, Inc. (debtor in possession); eStyle, Inc. (debtor in possession); American Home (debtor in possession); No Fear Retail Stores, Inc. (debtor in possession); and Ventura Port District (chapter 9 debtor). His many articles on bankruptcy-related subjects have been published in The Business Lawyer, Commercial Law Journal, IDEA: The Journal of Law and Technology, Journal of Bankruptcy Law and Practice, The Annual Survey of Bankruptcy Law, The Urban Lawyer, The Banking Law Journal, Los Angeles Lawyer, California Lawyer, Commercial Law Bulletin, Los Angeles Daily Journal, The Secured Lender, The Journal of Private Equity, The Journal of Corporate Renewal, Public Law Journal, Federal Lawyer and many other publications. Mr. Kupetz served as the author of Collier Commercial Bankruptcy Forms for many years and currently is the author of the Collier Handbook for Creditors' Committees. Mr. Kupetz is a frequent lecturer on reorganization and other insolvency topics. David S. Kupetz Direct Line: 213.617.5274 dkupetz@sulmeyerlaw.com www.sulmeyerlaw.com Los Angeles Office 333 South Hope Street Thirty-Fifth Floor Los Angeles, CA 90071 Voice: 213.626.2311 Fax: 213.629.4520 3. Introduction A basic concept underlying the Bankruptcy Code is that claims of creditors are entitled to distribution ahead of holders of equity interests in the debtor. Bankruptcy Code section 510(b) provides for mandatory subordination of certain claims related to a security of the debtor. Without 510(b), shareholders with a valid claim for damages have the same rights as creditors to recover their investment in the bankrupt firm. 4. Introduction Cont. In O'Donnell v. Tristar Esperanza Properties, LLC (In re Tristar Experanza Properties, LLC), the Bankruptcy Appellate Panel for the Ninth Circuit (the "BAP") carefully examines section 510(b). That provision mandates subordination of claims for "damages arising from the purchase or sale" of a "security" of a debtor. The BAP concluded that section 510(b) encompasses a claim that arose from the withdrawal of a member from an LLC, which withdrawal triggered a repurchasing process whereby the debtor-issuer was to buy back the interest from the investor. 5. Introduction Cont. At its core, the basis for this conclusion is that the claim at issue was so firmly rooted in the holder's equity status that subordination was mandatory. This causal nexus mandated subordination. The purpose and result of such subordination is to adjust the place in line of certain claims related to a security of the debtor in the bankruptcy distribution scheme. 6. Tristar The debtor in Tristar is a California limited liability company. The company is governed by an operating agreement. Jane O'Donnell ("O'Donnell") obtained a membership interest in the company (approximately 14%) through a $100,000 investment. O'Donnell invoked the withdrawal and buy-back provision under the Company's operating agreement. This triggered a process in which Tristar and the withdrawing member would use best efforts to agree upon the fair market value of the subject interest. 7. Tristar Cont. O'Donnell and the company were unable to agree on a fair market value. O'Donnell initiated an arbitration. The arbitrator awarded O'Donnell damages of approximately $400,000. The arbitration award was confirmed by a state court and reduced to a judgment. 8. Tristar Cont. After commencing a chapter 11 case, the debtor in Tristar filed an adversary proceeding against O'Donnell seeking, among other things, mandatory subordination of her claim under section 510(b). While courts have applied section 510(b) to subordinate claims under varying circumstances, the facts of Tristar were novel. 9. Code 510 Subordination demotes a claim from its nominal priority. Section 510 of the Bankruptcy Code provides for three distinct forms of subordination: (1) subordination by agreement; (2) mandatory subordination of certain claims related to a security; and (3) equitable subordination. 10. Code 510 Cont. Bankruptcy Code section 510(b) provides: (b) 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 to 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). 11. Code 510 Cont. Section 510(b) contemplates three types of claims rescission, damages, and reimbursement/contribution that all have a nexus with the purchase or sale of a security. Only the damages clause of section 510(b) was at issue before the BAP in Tristar. 12. Security In order for mandatory subordination under section 510(b) to apply, the claim at issue must have some relation to a "security" of the debtor. The BAP examined the threshold question of whether a membership interest in a limited liability company is a "security" under the Bankruptcy Code. The Bankruptcy Code does not contain a specific definition of the term "security". 13. Security Cont. The statute provides fifteen examples of securities, and 7 examples of what is not a security. These examples do not mention a membership interest in a limited liability company. The BAP analyzed whether an interest in a limited liability company constitutes a "security" for purposes of section 510(b) by comparing that interest to an analogous example of a "security" contained in the Bankruptcy Code. Determining that a membership interest in a limited liability company is a security for purposes of section 510(b), the BAP turned its focus to whether the claim at issue is a claim for "damages." 14. Damages The claimant inTristar asserted that the state court judgment she held confirming an arbitration award did not constitute a claim "for damages" covered by section 510(b). The claimant contended that she held a claim based on a judgment for a "fixed debt" and that her right to payment did not arise from the purchase or sale of securities of the debtor. 15. Damages Cont. The language of 510(b) provides that "damages" requiring subordination must arise from the purchase of sale of the debtor's securities, but does not otherwise purport to describe the nature of the claim for relief or the types of damages that may be recovered. The BAP found no ambiguity in the use of "damages" in section 510(b). 16. Damages Cont. The BAP rejected the claimant's contention that section 510 "damages" require wrongdoing or malfeasance. Given the arbitration award was an order to pay money as a matter of contractual right and achieved the status of a judgment debt once the award was confirmed, the arbitration award and judgment qualify as 510(b) "damages. The BAP next turned to whether the claim for damages that originated from the claimant's membership interest in a limited liability company is a claim that arises from the purchase or sale of a security as that language is used in section 510(b). 17. Arising From Section 510(b) is limited to claims arising from the purchase or sale of a debtor's securities. All Courts of Appeal that have examined the "arising from" language in section 510(b) have found it to be ambiguous. Courts interpreting section 510(b) have examined the legislative history and policy rationales underlying the section, and have reached varying conclusions regarding the scope of mandatory subordination under section 510(b). 18. Arising From Cont. The ambiguity in 510(b) permits competing narrow and broad interpretations. A narrow reading requires that the injury flow from the actual purchase or sale. A broad reading requires that the purchase or sale be part of a causal link even though the injury may flow from a subsequent event. 19. Courts of Appeals have adopted expansive readings of section 510(b) based on the legislative history and policy considerations underlying the section. In Am. Broad. Sys. v. Nugent (In re Betacom), the Ninth Circuit addressed a claim for damages under a merger agreement pursuant to which the target/debtor shareholders should have received stock of the acquirer/debtor but did not and asserted a claim against the acquirer/debtor in jointly administered bankruptcy cases. The Ninth Circuit concluded that section 510(b) is not limited with cases of shareholder fraud, that the subordinated claimant need not actually be a shareholder, and that an actual sale of a security is not required. Arising From Cont. 20. Subsequently, the Ninth Circuit addressed another section 510(b) case. In Racusin v. Am. Wagering, Inc. (In re Am. Wagering, Inc.), the claimant was not a shareholder, but rather was a financial advisor hired in connection with an initial public offering. The financial advisor had merely contracted to be paid for his services on the basis of share price. He sued when he did not receive the compensation promised in his employment agreement. While restating its expansive reading of section 510(b), under these circumstances, the Ninth Circuit declined to subordinate the claim. Arising From Cont. 21. In Allen v. Geneva Steel Co. (In re Geneva Steel Co.), the Tenth Circuit subordinated a shareholder's claim based on fraud by the debtor that caused the shareholder to retain its stock. In Baroda Hill Inv., Inc. v. Telegroup, Inc. (In re Telegroup, Inc.), the Third Circuit subordinated a shareholder's breach of contract claims based on the debtors' failure to use their best efforts to ensure that the stock was registered and freely tradable. Arising From Cont. 22. In Rombro v. Dufrayne (In re Med Diversified, Inc.), the Second Circuit, interpreting section 510(b) subordinated a breach of contract claim by a former employee relating to the debtor's failure to issue shares. In a case involving facts with similarities to Tristar, the Fifth Circuit in SeaQuest Diving, LP v. S&J Diving, Inc. (In re SeaQuest Diving LP), subordinated a claim under section 510(b) based on a state court judgment enforcing a contract requiring the debtor to repurchase partnership interests in the debtor. Arising From Cont. 23. The courts considering the ambiguous "arising from the purchase or sale of" a debtor's security language of section 510(b) have turned to the legislative history. Section 510's legislative history does not reveal an intent to tie mandatory subordination exclusively to securities fraud claims. Legislative History 24. The dissimilar expectations of investors and creditors should be taken into account in setting a standard for mandatory subordination. Shareholders expect to take more risk than creditors in return for the right to participate in firm profits. The creditor only expects repayment of a fixed debt. It is unfair to shift all of the risk to the creditor class since the creditors extend credit in reliance on the cushion of investment provided by the shareholders. Legislative History Cont. 25. The courts interpreting the "arising from" language of section 510(b) carefully considered the policy rationales identified by Slain & Kripke and cited in the legislative history underlying section 510(b). In Betacom, the Ninth Circuit explained that there are two main rationales for mandatory subordination under section 510(b): (1) the dissimilar risk and return expectations of shareholders and equity holders; and (2) the reliance of creditors on the equity cushion provided by shareholder investment. Policy Rationales 26. In Tristar, the BAP carefully considered Ninth Circuit precedent, the Slain and Kripke analysis, and legislative history, and applied the two rationales underpinning section 510(b) to the facts of the case. O'Donnell was in fact an equity holder before she withdrew. During her tenure as a member of Tristar, she enjoyed the potential for profit based on the value of real estate. The confirmed arbitration award is directly linked to her ownership of a membership interest in the debtor. Policy Rationales Cont. 27. By withdrawing as a member and liquidating her interest, O'Donnell altered the Tristar balance sheet by extracting, or, more appropriately, attempting to extract her initial contribution. This would effectively deflate the equity cushion to which trade creditors and the like would look in recovering their claims for fixed debt. Policy Rationales Cont. 28. It takes only the presence of merely one of the dual rationales to require the application of section 510's mandatory subordination. The ultimate test under the broad view adopted by Courts of Appeal is a linking test that looks to whether a causal relationship exists between the claim and an equity interest in the debtor. Simply converting that equity interest to debt will not result in removing the claim from the reach of section 510(b). Policy Rationales Cont. 29. A common strategy of current and former equity holders attempting to insulate a claim from mandatory subordination under section 510(b) is to assert that their claim is a fixed debt. The fact that a current or former equity holder holds a claim does not place them outside the scope of section 510(b). What matters is the type of claim, not the type of claimant. Rejection of the Fixed Debt Argument 30. In Tristar, the claim at issue was directly linked to ownership of an equity interest in the debtor. As a result of this causal relationship, the risk and return expectations of the claimant were viewed as those of equity holders and not transformed into those of a creditor at the time that the judgment was obtained. Rejection of the Fixed Debt Argument Cont. 31. At what point does a conversion of equity into debt become "old and cold"? One line of cases, primarily from the District of Delaware, has held that claims arising out of a promissory note issued prior to the petition date in exchange for stock, are not subject to 510(b) subordination. These promissory note cases seem premised on the issuance of a tangible debt instrument. Rejection of the Fixed Debt Argument Cont. 32. The Delaware district court has expanded the view of certain courts that claims arising out of a promissory note issued prior to the commencement of a bankruptcy case in exchange for equity interests are not subject to mandatory subordination under section 510(b) by applying the reasoning to a prepetition judgment ordering the debtor to repurchase its stock from its shareholder. The Delaware decisions taking a narrower view of section 510(b) are in conflict with the broad view adopted by the Ninth Circuit and other Courts of Appeals. Rejection of the Fixed Debt Argument Cont. 33. The BAP in Tristar rejected the claimant's arguments that the debtor's intent to utilize section 510(b) involved some sort of bad faith and constituted an impermissible collateral attack on a valid state court judgment. The claim was directly linked to the equity interest of the claimant and, was subject to mandatory subordination. Rejection of the Fixed Debt Argument Cont. 34. The misdirected arguments by the appellant in Tristar in an attempt to evade application of section 510(b) miss the point. When a claim, at is core, is simply based upon an equity interest (as in the case of Tristar where the claim is simply the purported value of the equity interest) the broad view of section 510(b) mandates subordination. Rejection of the Fixed Debt Argument Cont. 35. Under the broad view of section 510(b) of the Bankruptcy Code consistently adopted by Courts of Appeals, the determination of whether a claim related to an equity interest must be subordinated is based on a linking test. The linking test looks to whether a causal relationship exists between the claim and an equity interest in the debtor. When that link is unbroken, subordination is mandatory. Conclusion