In re Geneva Steel Co.

• Decision Date: 27 February 2002
• Docket Number: No. 01-4085.,01-4085.
• Citation: 281 F.3d 1173
• Parties: In re GENEVA STEEL COMPANY, Debtor. Richard M. Allen, Appellant, v. Geneva Steel Company, Appellee.
• Court: U.S. Court of Appeals — Tenth Circuit

281 F.3d 1173

In re GENEVA STEEL COMPANY, Debtor.

Richard M. Allen, Appellant, v. Geneva Steel Company, Appellee.

No. 01-4085.

United States Court of Appeals, Tenth Circuit.

February 27, 2002.

Richard M. Allen, pro se.

Ralph R. Mabey, Steven J. McCardell, Joseph M.R. Covey, of LeBoeuf, Lamb, Greene & MacRae, L.L.P., Salt Lake City, UT, and Mark C. Ellenberg of Cadwalader, Wickersham & Taft, Washington, DC, for Appellee.

Before EBEL, KELLY, and BRISCOE, Circuit Judges.

EBEL, Circuit Judge.

After a steel manufacturer sought bankruptcy protection, an investor charged that company fraud deceived him into retaining-rather than selling-his securities. For purposes of distribution priority, the Bankruptcy Code subordinates claims "arising from the purchase or sale" of a debtor's security. This language, courts have universally held, covers claims alleging fraud in the inducement to purchase or sell such a security. In this appeal, we are confronted with the question whether it also reaches claims alleging fraud in the retention of a security. We conclude that it does.¹

I. BACKGROUND

The undisputed facts are set out in the published decision of the Tenth Circuit Bankruptcy Appellate Panel. See Allen v. Geneva Steel Co. (In re Geneva Steel Co.), 260 B.R. 517 (10th Cir.BAP2001). We restate only the relevant points here.

In 1999, Geneva Steel Company filed a petition in bankruptcy court seeking to reorganize under Chapter 11 of the Bankruptcy Code. The petition listed, among other debt, two public bond issues, the first issue coming due in 2001, the second in 2004. Under the terms of Geneva's proposed reorganization plan, all bondholders, regardless of the maturity date of their bonds, were grouped into a single class. Each member of the class would receive common stock in the reorganized company. Classes subordinate to the bondholders would receive nothing.

A trustee for each of the two bond issues submitted proofs of claim for the bondholders, including Richard Allen, who held notes due in 2001. Allen, on his own initiative, filed a $500,000 proof of claim, alleging that company fraud caused him to retain his debt securities. Accompanying his proof of claim was a letter from Allen to Geneva's chief executive officer. It stated that he had retained his notes, much to his detriment, because company officials remained silent in the face of growing financial difficulties.

Geneva moved to disallow Allen's claim as redundant to the claim filed on his behalf by the trustee. Allen objected, asserting that his claim rested on principles of fraud, not upon his ownership of the bonds. The bankruptcy court ruled that: (1) to the extent Allen's claim is based on his bonds, it duplicates the trustee's claim and is therefore disallowed; and (2) to the extent it is based on fraud, it is subordinate to the claims of both bondholders and general goods and services creditors, since it is a claim, under section 510(b) of the Code, "for damages arising from the purchase or sale of[] a security." 11 U.S.C. § 510(b).

Geneva later amended its reorganization plan to create a new class of creditors: those whose claims were subordinated pursuant to section 510 of the Code. Claims in this category, which include only Allen's, receive no distributions.

The Tenth Circuit's Bankruptcy Appellate Panel affirmed the bankruptcy trial court's ruling, and Allen appeals. The order subordinating his claim is a final order. See Adelman v. Fourth Nat'l Bank & Trust Co., N.A. (In re Durability, Inc.), 893 F.2d 264, 265-66 (10th Cir.1990). We exercise jurisdiction under 28 U.S.C. § 158(d).

II. HISTORY AND POLICY BEHIND SECTION 510(b)

A. Early Treatment of Investor Claims in Bankruptcy

"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.

B. The Oppenheimer Decision and Its Criticism

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).

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).

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).

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).

C. The Enactment of Section 510(b)

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.

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:

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.

11 U.S.C. § 510(b).

III. INTERPRETING THE LANGUAGE OF THE STATUTE

Thus, if a claim (usually alleging some sort of securities-related fraud or similar injury) falls within the reach of the statute, it is treated on an inferior or equal basis with the security from which the claim arose. That is, a fraud claim arising from the purchase or sale of a security is treated not as a general unsecured claim but rather as a claim "below or equivalent to the rights afforded by the underlying security." See Stark, 72 Am. Bankr.L.J. at 497 (explaining operation of statute). (In 1984, Congress amended the statute to make clear that fraud claims springing from the purchase or sale of common stock are treated on the same level as common stock. All other claims are subordinated to their underlying security.) This adverse treatment carries...