In re Lehman Bros. Holdings Inc., 513 B.R. 624 (Bankr. S.D.N.Y. 2014) –

A purchaser of residential mortgage-backed securities filed proofs of claim based on alleged misrepresentations by the debtors in offering materials distributed in connection with sale of the securities. The debtors objected and sought to subordinate the claims as claims arising from securities “of” the debtors.

As generally described by the court, the securitization process for mortgage-backed securities (MBS) starts with origination (or purchase) of a large number of mortgage loans that are grouped into a collateral pool. The originator sells the loans to a trust, which in turn sells bonds (usually referred to as certificates) to investors. The trust pays the originator from the proceeds of the sale of certificates to the investors, and the trust becomes the owner of the pool of mortgages. A certificate entitles the holder to a portion of the cash flow from the mortgages in the pool.

In this case the MBS were “packaged, ‘issued,’ marketed, and sold” by the debtors through a process in which one debtor (LBHI) assembled the mortgage loans and then transferred the pool of mortgages to another debtor (SASCO). SASCO sold certificates to investors through an affiliate that served as underwriter (LBI). Ultimately the mortgages were deposited in non-debtor securitization trusts.

Under securities laws the trusts were considered “issuing entities.” The trusts actually issued the certificates, but were solely vehicles with no reporting obligations, employees, officers or directors. The trusts provided MBS certificates to SASCO, which served as a “depositor” for the MBS and also was considered an “issuer” for purposes of federal securities laws.

A purchaser (FHLB) filed claims against both LBHI and SASCO seeking damages from alleged misrepresentations and omissions in the offering documents used in connection with marketing the MBS in violation of various securities laws.

Section 510(b) of the Bankruptcy Code provides:

For the purpose of distribution under this title, a claim arising from rescission of a purchase or sale of the 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 for 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.

This section was motivated by a law review article that argued there should be mandatory subordination of claims arising from issuance of the debtor’s securities. An investor in equity gets the benefit of the potential upside if the company is profitable. So it should also expect to bear the risk of a company’s failure.

Allowing fraud claims to be asserted as unsecured damage claims would provide a potential windfall to investors. Congress concurred and Section 510(b) reflects its judgment that shareholders should bear the risk of illegality in the issuance of stock in the context of a bankruptcy since it would be inequitable to shift the loss to general creditors.

The debtors argued that Section 510(b) was applicable to FHLB’s claims since they (1) involved a security, (2) were for damages arising from the sale of a security, and (3) involved a security “of the debtor or of an affiliate of the debtor.”

The primary dispute was whether the MBS were securities “of” one of the debtors. The debtors argued that since SASCO is considered an issuer under securities law, the certificates must be securities of SASCO. Alternatively, if they are considered securities of the trusts, the trusts are affiliates and again Section 510 should be applicable. Considering the purpose of Section 510(b), since all FHLB bargained for was recovery from the pool of segregated mortgaged loans, it should not be given parity with general unsecured creditors and allowed to recover from the debtors unsegregated assets.

In response FHLB argued that the MBS should be treated as debt and not equity, and to the extent that they were considered debt securities, they were debt securities issued by the trust and “products” marketed by the debtors.

The court concluded that while the MBS were debt securities, they were not securities “of the debtor or of an affiliate of the debtor” within the meaning of Section 510(b).

The MBS represent claims to the cash flows from the pools of mortgage loans. The risk is tied to the borrowers on the loans, not any of the debtors. The stream of payments does not originate from any debtor but rather from the borrowers, and the trusts were merely conduits.

The pool of mortgages was packaged, marketed and sold by the debtors, but legally owned by the trusts. Payment was not owed and did not come from the business or assets of any of the debtors. In fact, the prospectus specifically stated that “certificates will represent interests in the issuing entity only [i.e. the trust] and will not represent interests in or obligations of the sponsor, the depositor or any of their affiliates or any other party.”

In essence the debtors created and sold a product, and the court viewed the MBS purchasers as similar to other parties asserting breach of contract claims or tort claims arising from the sale of faulty products sold by a debtor. Although the product happened to be a financial product and a “security,” “its unique characteristics and lack of relationship to the Debtors’ capital structure lead the Court to conclude that the MBS should not be considered a security ‘of’ the debtor as such phrase is used in section 510(b).”

The court did not equate the word “of” to “issued by.” And from a policy prospective, since the goal of Section 510(b) is to ensure that shareholders who bargain to receive the profits of the company should not elevate their claims for illegality when the company fails, the purpose would not be served by application in this case. FHLB was not entitle to receive benefits from the profits of any debtor, took no risk from purchase of stock of the debtors and was not an equity holder. The MBS were not tied to performance of any debtor but rather to the underlying loans. So application of Section 510(b) to this case was contrary to both the plain language and the purpose of the Section.

It is easy to forget that the financial markets looked very different in 1978 when the Bankruptcy Code was adopted: “The court cannot overemphasize the challenge inherent in applying a statutory provision to complex financial products that were barely in existence at the time of enactment of the provision.” At the time the law review article advocating subordination was written “‘securities’ were decidedly more boring: stocks and bonds, rather than ABS, CDOs, CDO-squareds, MBS, and CMOs, to name a few of the tens of trillions of dollars of securitized projects that exist today.”