Dana French v. Linn Energy, L.L.C.

Citation: Not availableDocket: 18-40369

Court: Court of Appeals for the Fifth Circuit; September 3, 2019; Federal Appellate Court

Original Court Document: View Document

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Payments owed to a shareholder by a bankrupt debtor, resembling dividends, are classified as equity interests and subordinated to creditor claims. The case involves Clarence Bennett, who inherited shares in Berry Holding Company (BHC) through a trust established by his deceased uncle in 1930. The trust divided beneficiaries into three groups: A Group, entitled to 37.5% of income; B Group, also receiving 37.5%; and C Group, consisting of minors who would receive the remaining 25% upon reaching age 21. In 1949, the C Group members came of age, and an agreement was made to distribute BHC shares among them, allowing for ongoing income distributions to A and B Groups. An equitable charge was placed on the BHC shares to secure the distributions owed to A and B Group members, granting them the ability to pursue property recovery in case of default by the debtor.

Bennett held a 37.5% interest in B Group dividends from 250 shares and owned 31.5 shares of BHC stock outright. From 1949 to 1986, he received regular dividends until BHC merged into Berry Petroleum Company (BPC) in 1986. Following a dispute with Victory Holding Company (VHC), which owned shares subject to B Group's equitable charge, BPC created the "Victory Trust" to protect B Group members from losing dividend payments due to VHC's share retirement. The trust ensured BPC paid Bennett and other surviving members 37.5% of the dividends VHC would have received—referred to as "deemed dividends"—linked to BPC's actual dividend distributions, though no dividends were required to be issued. From 1986 to 2013, BPC honored these payments. By 2013, Bennett was the last surviving member and continued to receive his share of deemed dividends and direct dividends from BPC.

In 2013, BPC underwent a share-for-share exchange with Linn Energy LLC and LinnCo LLC, becoming Berry Petroleum Company, LLC. Linn allegedly promised to continue payments to Bennett as a condition for his approval of the transaction, but payments ceased post-transaction. The ongoing validity of claims against Linn and BPC is assumed for the appeal. In late 2014, Linn sought a declaration of no obligation to Bennett, who then counterclaimed in January 2015. After Bennett's death in June 2015, his estate added Berry as a defendant and raised six claims, including breach of contract, misrepresentation, elder abuse, and breach of fiduciary duty. In May 2016, Linn, Berry, and related entities filed for bankruptcy in Texas, prompting the estate to file claims for nearly $10 million in unpaid deemed dividends. The Debtors objected, seeking to expunge or subordinate the claims under Section 510(b) of the Bankruptcy Code, arguing Bennett was an investor.

The bankruptcy court partially sustained the Debtors’ objections, subordinating half of the Estate’s claims, which significantly diminished the Estate's chances of recovering any funds due to the Debtors' limited assets. The court permitted the Estate to amend its complaint to clarify claims of misrepresentation and breach of fiduciary duty. Following amendments, the Estate appealed the initial subordination order, which was affirmed by the district court in April 2018, prompting the Estate to appeal to a higher court. After a hearing, the bankruptcy court subordinated the remaining claims and certified this second subordination order for immediate appeal, allowing the Estate to bypass the district court and consolidating both appeals.

The court applies the same standard of review to the bankruptcy court’s findings of fact and conclusions of law as the district court, reviewing factual findings for clear error and legal conclusions de novo. A clear error standard requires reversal only if a definitive mistake is evident from the entire evidence. Section 510(b) of the Bankruptcy Code mandates the subordination of specific claims related to securities transactions, ensuring that creditors are prioritized over shareholders in asset distribution. This section was influenced by the 1973 article by Professors Slain and Kripke, which informed Congress during the enactment of the subordination principle in the Bankruptcy Reform Act of 1978. Their principle highlights that while both investors and creditors face insolvency risks, they do so to varying extents.

Dissimilar expectations between creditors and shareholders shape their roles in a business, with creditors focused on fixed debt repayment and shareholders bearing enhanced risks for potential profits. The absolute priority rule underscores the distinct risk allocation between investors and creditors, which should not be altered. Section 510(b) emphasizes the subordination of claims that seek to recover equity investments, with courts recognizing the complexity in applying this statute due to ambiguous "arising from" language. The Debtors argue for subordination of claims involving damages related to securities transactions, aligning with circuit court interpretations. While the Estate's categorization of claims is not contested, a formulaic approach to subordination is impractical; thus, the statute's policy rationales must inform its application. The crucial inquiry is whether the Estate's interests align more with those of an investor or a creditor. The conclusion favors investor status, warranting subordination of the Estate's claims. The Bankruptcy Code does not define "damages," but courts have interpreted it to encompass claims beyond mere unpaid debts, including those for fraud or breach of contract. The Estate acknowledges its pursuit of damages but argues against their connection to security transactions, despite its characterization leaning toward creditor rights rather than equity interests. Nonetheless, it is universally accepted that the Estate seeks damages as defined under the Bankruptcy Code.

The Estate contends that its claims regarding dividend payments from BHC, later from BPC, do not qualify as a "security" under the Bankruptcy Code. The lengthy definition of security in the Code does not include equitable charges or payments from a trust. The Estate argues that Bennett's interest in these deemed dividends lacked typical characteristics of a security interest, as he could not sell, transfer, or bequeath his life interest, nor did it confer voting rights or a demand for dividends. The Debtors counter that Bennett's interest constitutes a security under the residual clause of the Bankruptcy Code, which encompasses claims not explicitly excluded from the definition. They argue that the Estate's claims stem from securities transactions related to historical stock exchanges and bequests.

The court agrees with the Debtors that the deemed dividend interest is a security under the residual clause, which states that if a claim does not fit a specific example in the Code but is not excluded, it may be considered a security if it is commonly known as such. The court emphasizes the broad nature of this clause, stating that interests are classified as securities if they exhibit characteristics typical of securities. It concludes that Bennett had greater financial expectations than a creditor, as his potential gains from the deemed dividends were substantial and linked to the corporation's success, mirroring risks faced by shareholders.

While Bennett lacked certain rights typical of shareholders, such as voting or management participation, these rights are not essential for classification as a security. The key consideration is whether Bennett had similar risk and benefit expectations as shareholders, which he did. The court’s interpretation aligns with a broad reading of Section 510(b), which recognizes interests tied to a company's overall success as securities.

The Bankruptcy Code defines certain interests as securities, specifically excluding profit-sharing agreements that do not require SEC filings. Bennett’s arrangement with the company does not guarantee profit shares, as he is only entitled to receive a percentage of profits when dividends are issued to other shareholders. Therefore, the Estate’s deemed dividends are classified as securities. For a claim to "arise from" a security transaction, there must be a causal relationship between the claim and the transaction. This interpretation is broad, and in ambiguous cases, the statute's policy goals are significant. Claims seeking recovery of equity investments challenge the absolute priority rule of bankruptcy law, as equity investors accept the risks associated with their investment. The Debtors argue that but-for causation suffices for claims to arise from security transactions. The S&J claim relates to a debt created by rescinding an equity investment, making its subordination consistent with the policies of § 510(b). The Estate's claims stem from multiple transactions, particularly the 2013 deal, which is the most relevant and causally linked to the claims. Thus, the Estate’s claims arise from securities transactions as they are part of the causal chain leading to the alleged injury.

In this circuit, the relevance of claims based on post-issuance conduct is disregarded; both pre- and post-deal actions by the Debtors are connected to the alleged injuries stemming from a 2013 deal. Section 510(b) policies favor subordinating the Estate’s claims, focusing on whether the claims reflect an investor's or a creditor's interest. Here, the claims seek recovery related to equity investments rather than fixed debts, indicating an investor-like interest. Treating the Estate's claims equally with creditors could undermine the equity cushion relied upon by those creditors and violate the Bankruptcy Code’s absolute priority rule. The bankruptcy court's ruling aligns with Section 510(b) principles.

Additionally, the Estate contends that the bankruptcy court's limitation on discovery was erroneous and violated due process. However, such decisions are reviewed for abuse of discretion. The court did not abuse this discretion, as it accepted all of the Estate’s claims as true for its decision-making process. The issues raised by the Estate were either legal matters not requiring further discovery or irrelevant to the case. The court's ruling resembled a Rule 12(b)(6) determination, where additional discovery would not have been beneficial. Thus, the Estate's due process rights were upheld. The court's decision was affirmed.