Claim subordination is the opposite of alchemy. In most bankruptcy cases, creditors might look for ways to improve their treatment. Claim subordination in the bankruptcy code provides a mechanism to force a creditor to receive worse treatment (relative to other non-subordinated claims which is, admittedly, not that great of treatment).
In bankruptcy, there are a few ways for a claim to be subordinated. A claim could be subordinated because you did something bad. A claim could be functionally subordinated by having debt determined to be equity. Or, among others, a claim could arise as a result of a transaction involving the sale of stock of the bankrupt debtor or its affiliate. It is the last one that has come up recently in a Fifth Circuit opinion in a way I thought was interesting because it deals with guaranties.
I. The Underlying Case
The underlying bankruptcy case involves the debtor American Housing Foundation (“AHF”) which, prior to entering bankruptcy, operated to promote and develop low income housing and obtain Low Income Housing Tax Credits (known as “LIHTC”). Each actual housing project was operated out of a specific single purpose entity (“SPE”) which was controlled by AHF.
In the course of its operations, AHF would form limited partnerships with AHF as general partner. AHF would then solicit and obtain investors to put money into the LPs in exchange for limited partnership interests. That money invested into the LP was then supposed to be put into a specific SPE (which actually held the asset) as unsecured debt to cover pre-financing costs.
Other than the opportunity to receive a distribution from the LP, inventors would also be able to claim a LIHTC. But to sweeten the deal even more, AHF provided a guaranty of the money invested into the LP to each investor. Some the guaranty agreements even provided for interest.
To make a long story short, AHF acquired property too quickly and exhausted capital needed for operations of existing projects. This apparently caused AHF to use some new cash to fund operations, pay dividends and fraudulently divert some of the cash to the principal of AHF. This proved untenable and AHF was put into an involuntary bankruptcy case. As is usually the case, after the bankruptcy filing everyone got sued.
II. Guaranty Subordination
Templeton was an investor in several of the LIHTC LPs. As was typical, Templeton received LP interest in exchange for his investment and also received a guaranty from AHF.
While the notion of a guaranty of an investment might not seem too far off mark, the careful lender will recall that a guaranty is a contract for the repayment of debt. In contrast, an equity investment is not debt. The Fifth Circuit touches on this issue in its opinion. However, what is ultimately the legal reason for subordinating the guaranty obligation is section 510(b) of the Bankruptcy Code.
I would commend to you the actual text of 510(b), but the Fifth Circuit summarizes the section as such:
“Accordingly, this provision makes clear that claims arising from equity investments in a debtor’s affiliate should be treated the same as equity investments in the debtor itself–i.e., both are subordinated to the claims of general creditors.”
So, because Templeton’s “guaranty” from AHF arose from the sale of the LP interest, any recovery on account of the guaranty was automatically subordinated to the other creditors of AHF for the purposes of distribution. In this case, Templeton is projected to receive nothing if subordinated as opposed to ~40% as a general unsecured creditor.
III. Things to Consider
Regardless of whether a guaranty of an equity investment is enforceable as such (notwithstanding the lack of actual debt), the guaranty will be subject to mandatory subordination if the guarantor files bankruptcy and the equity company is an affiliate of the guarantor.
This particular type of subordination puts the claim below general unsecured creditors, which puts any chance of recovery in the “very unlikely” category.
By the same token, if you are a lender and your collateral is a lien in such guaranty, then you face the same prospect of subordination as the borrower.
Finally, the opinion discusses other issues of some note, which did not make it into this post because of length. The opinion discusses preference ordinary course defense, and valuation for the purposes of fraudulent transfers.
Templeton v O’Cheskey (In the Matter of: American Housing Foundation), case no. 14-10563, in the United States Court of Appeals for the Fifth Circuit. Opinion revised June 8, 2015.
Opinion is here.