Court: District Court, S.D. New York; March 30, 2016; Federal District Court
Seven appeals have been filed regarding a November 7, 2014 Order from the United States Bankruptcy Court, which upheld Lehman Brothers Holdings Inc.'s objections to the claims of former employees and reclassified those claims as "equity interests." The Appellants, former senior employees, received substantial compensation packages that included cash and equity through Lehman’s Compensation Plan, which featured restricted stock units (RSUs) for U.S. employees and contingent stock awards for non-U.S. employees. RSUs granted employees a contingent right to ownership of Lehman common stock, vesting after five years contingent on meeting employment conditions. The Compensation Plan aimed to align employee interests with those of stockholders, incentivizing them to enhance the firm’s value. The value of RSUs fluctuated with Lehman’s stock price, and employees received dividend equivalents in the form of additional RSUs, which would also convert into shares after the holding period. The Court affirmed the Bankruptcy Court's well-reasoned decision on the matter.
RSU holders had limited voting rights and, following Lehman's bankruptcy filing on September 15, 2008, RSU claimants, including former Lehman employees, submitted claims for cash equivalent to the value of their unconverted RSUs. From December 7, 2010, to August 24, 2012, Lehman objected to these claims, seeking to reclassify them as equity and subordinate them to general unsecured creditors' claims. For 93% of the RSU claims, Lehman's objections went unopposed, leading to reclassification orders by the Bankruptcy Court in 2011 and 2012.
Appellants contested Lehman’s objections, prompting further responses and omnibus replies from Lehman. During a December 21, 2011 hearing, the Bankruptcy Court asked Appellants to distinguish their claims from those in the Enron case, where similar claims were subordinated under Section 510(b) of the Bankruptcy Code. Appellants argued that they were compelled to accept Lehman's pay structure and did not willingly exchange their labor for RSUs, unlike the Enron claimants. They also contended that their claims involved New York’s wage and labor laws, which were not considered in Enron.
After additional discovery and a three-day evidentiary hearing from April 1-3, 2014, which included witness testimony and exhibit submissions related to Lehman's Compensation Plan, the Bankruptcy Court issued a decision on November 3, 2014. Judge Chapman sustained Lehman's objections, reclassifying the Appellants' claims as equity under Lehman’s Chapter 11 Plan and ruling that, similar to the Enron claims, they were subject to mandatory subordination under Section 510(b).
Judge Chapman determined that the Restricted Stock Units (RSUs) constituted "equity securities" under Section 101(16) of the Bankruptcy Code, leading to the dismissal of Appellants' claims as these interests do not qualify as "claims" under the Code. Following this ruling, a final order was issued on November 7, 2014, and Appellants served Lehman with notices of their intention to appeal later that month. Appeals were filed in early 2015, with Appellants submitting their opening briefs by March 31, 2015, largely reiterating their arguments from the Bankruptcy Court. Lehman opposed these appeals with an omnibus brief on April 29, 2015, and the appeals were fully briefed by May 13, 2015.
The district court has appellate jurisdiction over bankruptcy rulings and reviews legal conclusions de novo and factual findings for clear error. The Appellants challenged the Bankruptcy Court's findings regarding their claims being subject to mandatory subordination under Section 510(b) or being based on equity interests that must be dismissed. Section 510(b) subordinates claims that resemble ownership of securities (both debt and equity) to prevent equity holders from equating their interests with those of general creditors in bankruptcy distributions. This section reflects Congress's intent to address the different risk profiles of shareholders and creditors and to uphold the reliance of creditors on the equity cushion provided by shareholder investments. Section 510(b) is applied broadly to discourage attempts by shareholders to act as creditors in bankruptcy situations.
Section 510(b) of the Bankruptcy Code is interpreted broadly, allowing for a wide range of claims related to the purchase or sale of securities of a debtor. Courts have established that if a shareholder's complaint arises from their investment in the debtor’s securities, it falls within the scope of Section 510(b), regardless of the specific type of damage incurred or the form of the equity interest held. The key principle is that any claim enabling participation in the debtor's profits will be subordinated under this section.
Significantly, the Second Circuit has confirmed that Section 510(b) applies to claims from former employees seeking cash compensation equivalent to their securities-based remuneration. Cases have demonstrated that claims for unpaid bonuses tied to stock options or shares, even in the absence of an actual sale, are subject to subordination under Section 510(b). The claims of appellants for the cash value of their unconverted restricted stock units (RSUs) are similar to those previously subordinated, indicating their claims are appropriately subject to the same treatment. Although not strictly bound by earlier cases like Enron, the reasoning from those decisions, particularly regarding the broad interpretation of Section 510(b), is deemed persuasive by the court.
The bankruptcy court's decision in In re Enron examined the subordination of employee claims related to stock options that were not exercised due to the debtor's fraud. The court determined that Restricted Stock Units (RSUs) qualify as "securities" for subordination under Section 510(b), as seen in prior case law, notably In re Club Ventures Inv. LLC, which recognized unissued membership units as securities due to their equity holder characteristics.
Appellants argued that their acquisition of Lehman RSUs was not voluntary, claiming they were compelled to accept the firm's compensation plan or face termination, thus asserting economic duress. However, the court found that this argument does not differentiate the Appellants’ claims from those in Enron, where similar claims were rejected. The Enron court ruled that even if employees were required to take stock options as part of their compensation, there was still a valid exchange of value, as it was a condition of their employment willingly accepted for their labor.
Consequently, the court applied the same reasoning, maintaining that the Appellants' claims regarding the RSUs arise from the "purchase" of a security and must be subordinated under Section 510(b). The court firmly rejected the notion of economic duress in this context, affirming that accepting RSUs as part of compensation was a voluntary condition of employment.
The Court concurs with the Bankruptcy Court's determination that Appellants accepted as a condition of employment that part of their compensation would consist of Restricted Stock Units (RSUs). Consequently, the Court rules that Appellants' claims for cash based on the value of unconverted RSUs at the time of Lehman's bankruptcy are classified as damages related to the purchase or rescission of securities, thus falling under the broad purview of Section 510(b) and must be subordinated to claims from Lehman’s general unsecured creditors.
Additionally, the Court addresses the Bankruptcy Court's alternative finding that these claims represent interests in "equity securities" under Section 101(16) of the Bankruptcy Code, which do not qualify as "claims" under Section 101(5). While this distinction is largely rendered moot by the ruling on Section 510(b), the Court agrees with the Bankruptcy Court's view that Section 101(16) serves as an alternative basis for dismissing Appellants' claims. Under Federal Rule of Bankruptcy Procedure 3007(d)(7), omnibus objections can target claims that are classified as interests rather than claims.
The distinction between a "claim," defined as a right to payment or equitable remedy, and an "equity security," which includes shares in a corporation or similar securities, is emphasized. Claimants are termed "creditors," whereas those holding equity securities are called "equity security holders." The Bankruptcy Court concluded that the RSUs issued to Appellants qualify as "equity securities" under Section 101(16). Evidence suggests that the RSUs were treated akin to ownership shares in Lehman, carrying similar benefits and risks, despite being subordinate to common stock. The Compensation Plan indicates that RSU holders have rights to dividends and limited voting rights, further supporting their classification as equity interests. Courts assess factors including the nature of the instrument, the parties' intent, and the presence of voting rights in determining the classification of financial instruments.
Appellants argue that Restricted Stock Units (RSUs) differ from common shares, but the Bankruptcy Code defines "equity security" broadly to include various forms of corporate shares. The Court concludes that RSUs are similar enough to common stock to qualify as "equity securities" under Section 101(16)(A). Additionally, even if RSUs do not qualify as "shares," they meet the definition of "rights" under Section 101(16)(C) because they provide non-assignable rights to common stock after a five-year period, without requiring any action from the holders. Appellants’ contention that the RSUs fall under the "right to convert" exclusion fails, as the Compensation Plan does not grant a conversion right; instead, the RSUs automatically convert to common stock after the holding period. Consequently, the Court determines that the RSUs are classified as "equity securities," leading to the dismissal of Appellants’ claims, which are not recognized as "claims" under the Bankruptcy Code. The Court upholds the Bankruptcy Court's decision to reclassify these claims as equity interests within Lehman’s Chapter 11 Plan, affirming the November 7 Order and closing related appeals.
The Bankruptcy Court's November 3 Memorandum and Decision provides a detailed procedural history relevant to the related appeals. This summary focuses on essential facts drawn from the parties' Joint Appendix and other documents submitted during the appeal process. The Court has reviewed Appellants’ briefs, Lehman's omnibus brief opposing the appeals, and the Appellants’ replies, noting any factual disputes or evidentiary challenges.
The parties reached a Stipulation outlining uncontested facts considered by the Bankruptcy Court concerning Lehman’s Omnibus Objections to claims from Appellants and former employees. However, the Stipulation does not imply that these facts are material or relevant to the resolution of the objections, and both parties reserve the right to contest the relevance or weight of cited facts.
Exhibit 3 of the Stipulation discusses Lehman’s 2003 Compensation Plan, including the treatment of Restricted Stock Units (RSUs) and Stock Options. The parties agreed that the terms of the Compensation Plan remained unchanged from 2003 to 2008, the relevant years for this appeal. Even if Appellants can argue economic duress regarding their RSUs, their claims would still fall under Section 510(b), which mandates that claims arising from a rescission of security purchases be subordinated. The Court emphasizes that the Appellants’ claims, linked to fluctuations in the debtor's share price, clearly represent equity interests and thus require subordination under Section 510(b).
