Once a Shareholder, Always a Shareholder: Subordination of Appraisal Rights under Section 510(b)

Should a claim for appraisal rights brought by a former shareholder of a Chapter 11 debtor be subordinated under Section 510(b) of the Bankruptcy Code? According to the Bankruptcy Court for the District of Delaware, the answer is yes. See In re: RTI Holding Co., LLC, No. 20-12456, 2021 WL 3409802 (Bankr. D. Del. Aug. 4, 2021).

Background

Ruby Tuesday Operations LLC (“RTO”), a successor-in-interest to Ruby Tuesday, Inc. (“RTI”) — a foodservice retailer and reorganized Chapter 11 debtor — objected to claims brought by former shareholders of RTI. The claims were based on the appraisal rights of the former shareholders, who dissented from a 2017 merger of RTI with one of its subsidiaries. Because the shareholders rejected the proposed merger consideration, an appraisal action was commenced under the applicable Georgia law seeking a judgment for the value of shares as appraised by the court. The merger closed and, as mandated by Georgia law, the dissenters’ shares were canceled as of the closing date.

In October 2020, while the appraisal action was still pending, RTI filed for Chapter 11 bankruptcy and the appraisal action was automatically stayed. The dissenting former shareholders filed proofs of claim for their appraisal rights, asserting nonpriority general unsecured claims in the amount claimed by them to be the “real” value of their shares as asserted in the appraisal action. Under the debtors’ plan of reorganization, however, the dissenters’ claims were classified as subordinated under Section 510(b) of the Bankruptcy Code and were not entitled to any distribution. That section provides in relevant part that “[f]or purposes of distribution..., 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...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.”

Accordingly, RTO objected to the former shareholders’ proofs of claim, arguing that they are subordinated under Section 510(b) and not entitled to any distribution. The claimants, in turn, argued that since their shares were canceled, they were no longer shareholders and were instead entitled to the statutory right provided by the appraisal statute, which right is not affected by Section 510(b).

Causal Nexus, the “But For” Test, and the Policy Considerations behind Section 510(b)

Relying on the Third Circuit’s opinion in In re Telegroup, Inc., 281 F.3d 133 (3d Cir. 2002), the Court sustained RTO’s objections based on the nexus between the claimants’ appraisal rights and their status as former shareholders. The Court explained that, under Third Circuit precedent, for a claim to “arise from” the purchase or sale of a security under Section 510(b), there must be a clear nexus or causal relationship between the claim asserted and the sale of the security. To determine whether the necessary casual nexus exists, the Court explained, a “but for” test should be applied. Such test examines whether the claim would not exist “but for” claimant’s purchase of the debtor’s stock.

Applying this test here, the Court found that the necessary causal nexus was present. It explained that the claims arise under a provision of the Georgia corporate code that provides relief to dissenting stockholders, and claimants’ right to assert a claim under that statute was one that is only given to those who have purchased shares. Therefore, the Court found, the claims would not exist but for claimants’ status as shareholders.

The Court acknowledged, however, that Section 510(b)’s statutory text is ambiguous and provides little guidance in delineating the precise scope of the required nexus. Therefore, in determining whether subordination is warranted, the court must also ensure that subordination furthers the policy goals of the statute. Citing the legislative history, the Court explained that Section 510(b) aims to prevent shareholders from recovering their equity investment by neutralizing or minimizing the risk of enterprise failure.

The Court rejected the argument that the dissenters ceased being shareholders altogether when the merger closed. While they no longer owned the stock, the appraisal statute is clear that the amount to be awarded in an appraisal action represents the value of the stock.

The Court also explained that to rule that the claims are not subordinated would effectively remove the business failure risk associated with equity holding and allow the claimants to recover their investment in parity with general unsecured creditors. When the dissenters opted into the appraisal action, they were hoping to enjoy the upside benefits of equity should the court rule that the fair value of the stock was higher than the merger price; but they also took a downside risk as the court could have ruled that the fair value was below the merger consideration. Thus, a ruling that dissenters are unsecured creditors would distort the risks and incentives inherent to an equity investment, by allowing shareholders to enjoy the upside associated with their stock without absorbing the downside.

Based on this analysis, the Court concluded that subordination of the appraisal rights claims in this case was both (1) warranted based on the nexus between the claims and the claimants’ status as shareholders; and (2) appropriate under the policy considerations underlying Section 510(b). Because the applicable class under the plan did not and will not receive any distribution, claimants’ were not entitled to any recovery on their claims.

Takeaways

While we are not necessarily persuaded by the upside/downside reasoning in the opinion, the RTI Holding Court’s analysis that shareholders assume the risk of business failure by investing in equity rather than debt and are therefore subordinated, is solid. Congress enacted Section 510(b) to prevent disappointed shareholders from recovering the value of their investment by filing bankruptcy claims that would neutralize or minimize such assumed risk. Holders of appraisal rights that arise from an equity position should be aware of the risk of subordination under Section 510(b) in the event of bankruptcy, even if they are no longer shareholders at the time they file their claim in the bankruptcy case. Presumably, the RTI Holding analysis applies in equal force even to a judgment obtained in an appraisal action. Therefore, dissenting shareholders in a distressed company should evaluate the potential upside of an appraisal judgment with the risk of bankruptcy subordination.

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