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Part I – Fraudulent Retention Claims[1]


Equity security holders[2] or investors [3] (“Equity Holders”) in debtor entities are usually

subordinated to creditors’ claims in bankruptcy cases.[4] This need not always be the case.

Two conditions exist where Equity Holders’ claims may be equal or superior to general

unsecured creditors’ claims. The first are claims based on “fraudulent retention” (“Fraudulent
Retention Claims”). The second are claims based on debtors’ post-petition interfering with
Equity Holder’s rights to sell their investment, to benefit the debtors’ reorganization effort
(“Freeze Claims”).

Allowed[5] Fraudulent Retention Claims are treated equally to general unsecured creditors’

claims. Allowed[6] Freeze Claims may receive an administration priority[7] over general unsecured
claims. Allowed Fraudulent Retention Claims get available “bankruptcy dollars[8].” Allowed
Freeze Claims are entitled to full payment, subject to the bankruptcy estate’s resources.[9]

This blogtical is the first of two. It addresses the subordination or not of Fraudulent

Retention Claims. The next blogtical of this series concerns allowing Freeze Claims.

Fraudulent Retention Claims

A Fraudulent Retention Claim is a pre‑petition claim of a debtor’s Equity Holder who is

injured by retaining that debtor’s Equity Interests relying on fraudulent information provided by
that debtor or its management.[10]


Some courts subordinate “Fraudulent Retention Claims” applying Bankruptcy Code §

510(b) (“§ 510(b)”). As discussed In re Granite Partners, L.P.[11] Fraudulent Retention Claims:

“ . . . involve a risk that only the investors should shoulder. In essence, the claim
involves the wrongful manipulation of the information needed to make an
investment decision . . . Just as the opportunity to sell or hold belongs exclusively
to the investors, the risk of illegal deprivation of that opportunity should too. In
this regard, there is no good reason to distinguish between allocating the risks of
fraud in the purchase of a security and post‑investment fraud that adversely affects
the ability to sell (or hold) the investment; both are investment risks that the
investors have assumed.

However, § 510(b)’s terms address claims:

. . . 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.

By its terms, § 510(b) applies to fraud resulting in “damages arising from the purchase or

sale of such” securities. It does not say damages resulting from their “ownership.” Granite
and it progeny effectively interpreted the statute[12] to include ownership. However, the
statute’s terms do not reach that far. Purchase and sale may result in ownership. However, they
may not be the only vehicle.

Expanding § 510(b) beyond its clear terms is inappropriate. As is often stated[13]:

Congress knows how to draft statutes without making them more complicated
than they need to be. Congress “does not, one might say, hide elephants in
mouseholes.” Whitman v. Am. Trucking Ass’ns, Inc., 531 U.S. 457, 468 (2001).
Moreover, courts must forego any invitation to import words into statutes that are
simply not there. See, e.g., Lamie v. U.S. Tr., 540 U.S. 526, 538 (2004) (declining
to enlarge a statute where a plain, non‑absurd meaning is “in view”). “[W]hen the
statute’s language is plain, the sole function of the courts – at least where the
disposition required by the text is not absurd – is to enforce it according to its
terms.” Id., at 534.

Not Subordinating Retention Claims

It’s been said that ‘one’s first response is often the correct one.” Its corollary is Occam’s

Razor[14], “the simplest solution is almost always the best.” Those maxims may apply to § 510(b)
and Retention Clams.

In re Amarex, Inc.,[15] (“Amarex”) addressed Fraudulent Retention Claims in 1987. It held

that § 510(b) does not impact Fraudulent Retention Claims. Amarex’s analysis of § 510(b) was
stated simply:

510(b) reveals a Congressional desire to shift to the shareholders the risk of fraud
in the issuance and sale of a security—no more. The legislative history expressly
focuses on the initial illegality and thus the automatic subordination required by
section 510(b) should extend no farther. The Bankruptcy Court’s expansive
interpretation of section 510(b) ignores the clear language of section 510(b), its
underlying policies and the purposes for which it was enacted. Section 510(b)
pertains only to claims based upon the alleged wrongful issuance and sale of the
security and does not encompass claims based upon conduct by the issuer of the
security which occurred after this event. Such construction gives expression to the
legislative comment that it is the nature of the claim, and not the status of the
claimant, that is significant.[16]

A decade later, In re Angeles Corp.,[17] agreed with Amarex’s application of § 510(b): The


. . . fraud or other wrongful conduct occurring subsequent to the purchase of the
security is not a claim “arising from” the purchase of the security. The District
Court reversed the Bankruptcy Court for holding to the contrary. The District
Court noted the bankruptcy court erred by using a “but for” test as the definition
of “arising from.”[18]

More recently, Stucki v. Orwig,[19] followed Amarex and Angeles stating:

. . . the statute does not state that any claim arising from “ownership” of a security
is subject to mandatory subordination; rather, it states, in relevant part, claims
arising from damages relating to the purchase or sale of a security are subject to
mandatory subordination.[20]

Rejecting “an elephant in a mouse hole” Stucki cited Angeles[21]

If Congress had Angeles wanted to subordinate all claims of security holders to an
equity position, regardless of the source of the claim, Congress would have
worded Section 510(b) to say: ‘All claims made by all security holders, regardless
of the source of claim, shall be subordinated to an equity class . . . ’ However,
Bankruptcy Code Section 510(b) does not say this. Thus, Section 510(b)’s
subordination of claims ‘arising from the sale or purchase of a security’ must
mean subordinating less than every claim of a security holder, regardless of how
that claim arises.”[22]

Similarly, In re Montgomery Ward Holding Corp.,[23] determined that § 510(b)’s “plain

language” meant it, “applies only to a claim that directly concerns the stock transaction itself, i.e.,
the actual purchase and sale of the debtor’s security must give rise to the contested claim.”[24] That
court recognized Granite Partners, but did not follow it. [25]

Scholarship has concluded that the most supportable interpretation § 510(b) rejects

subordinating Fraudulent Retention Claims.[26]

This conclusion is consistent with the rule that forfeitures,[27] like subordination, should be

construed narrowly.[28]

It appears whether a Fraudulent Retention Claim is subordinated depends on where the

issue is litigated. This is frequently the case. Nevertheless, strong and recent arguments exist to
prevent subordination of Fraudulent Retention Claims.

The blogticle on Freeze Claims will follow shortly.

[1] © Wayne Greenwald 2022

[2] See 11 U.S.C. § 101 (16) and (17)

(16) The term “equity security” means—

A)share in a corporation, whether or not transferable or denominated “stock”,
or similar security;
B)interest of a limited partner in a limited partnership; or
C)warrant or right, other than a right to convert, to purchase, sell, or
subscribe to a share, security, or interest of a kind specified in
subparagraph (A) or (B) of this paragraph.

(17) The term “equity security holder” means holder of an equity security of the debtor.

[3] See, In re Montgomery Ward Holding Corp., 272 B.R. 836, 842 (Bkrtcy.D.Del.,2001).

[4] See, 11 U.S.C. § 510(b)(Subordination) and 11 U.S.C. § 1129(b)(2)(B)’s “absolute

priority rule” which “generally requires that all unsecured creditors be paid in full before equity
security holders are allowed to retain any ownership interest in the debtor.” In re Brotby, 303
B.R. 177, 195 (9th Cir.BAP 2003).

[5] Allowed claims give the creditor holding that claim a right to payment of a specified

sum of money pursuant to 11 U.S.C. § 502(b), usually enforceable against the debtor’s
bankruptcy estate. See, In re Ayers Bath (U.S.A.), Co., Ltd., 2021 WL 4317321, at *41
(Bkrtcy.C.D.Cal., 2021). A “claim becomes allowed in one of three ways: first, a proof of claim
is filed or deemed filed and no party objects; second, a claim is allowed by the court after an
objection is filed; and third, a claim is estimated by the Court under the provisions of section
502( c ). In re Rowe, 342 B.R. 341, 348 (Bkrtcy.D.Kan.,2006).

[6] See, Id.
[7] 11 U.S.C. § 503(b).
[8] “ Bankruptcy Dollars ” are the percentage recoveries by creditors holding unsecured

claims. Paying 10¢ on the $ 1.00 is probably above average in most chapter 7 cases.

In re Rappaport, 517 B.R. 518, 538 (Bkrtcy.D.N.J., 2014)

[9] See 11 U.S.C. § 507. Priorities. Regulating the priorities in distributing the bankruptcy

estate’s assets.

[10] See, R.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. at 497

[11] 208 B.R. 332, 342 (Bkrtcy.S.D.N.Y.,1997)(“Granite Partners”), See also, In re Enron

Corp., 341 B.R. 141, 152 (Bkrtcy.S.D.N.Y.,2006)(“Enron”)(“The key issue is the temporal and
conceptual discontinuity between the purchase of the security and the fraudulently induced
retention. These are two separate, if not necessarily distinct, acts, and the alleged injury is
necessarily the direct result of the retention, not the purchase. Nonetheless, the use of the phrase
“arising from” suggests that the injury need not directly result from the purchase. . .”), In re
WorldCom, Inc.
, 329 B.R. 10, 16 (Bkrtcy.S.D.N.Y.,2005)(“WorldCom”), In re Geneva Steel Co.,
260 B.R. 517, 523 (10th Cir.BAP, 2001)(“Geneva Steel ”).

[12] See, Granite Partners at 339, Enron at 152, Geneva Steel at 522–23, WorldCom at 329

B.R. 10, 16 (Bkrtcy.S.D.N.Y.,2005).

[13] Restated recently in In re Ibbott, 2022 WL 697287, at *9 (Bkrtcy.D.Md., 2022).

[14] Attributed to philosopher William of Ockham (1285–1347/49),

[15]78 B.R. 605, 609–10 (W.D.Okl.,1987) .

[16] Id.

[17] 177 B.R. 920, 926–27 (Bkrtcy.C.D.Cal.,1995)(“Angeles”).

[18] Id.

[19] 2013 WL 1499377, at *5 (N.D.Tex.,2013)(“Stucki”).

[20] Id.

[21] At 177 B.R. 927

[22] Id.

[23] 272 B.R. at 842

[24] Id.

[25] Id., at 843.

[26] “Reexamining the Subordination of Investor Fraud Claims in Bankruptcy: a Critical

Study of in re Granite Partners 72 Am. Bankr. L.J. at 524

[27] Forfeit or forfeiture means losing a right, privilege, or property without compensation

as a consequence of violating the law, breaching a legal obligation, failing to perform a
contractual obligation or condition, or neglecting a legal duty.

[28] See. In re Miller, 511 B.R. 621, 630 (Bkrtcy.W.D.Mo.,2014), U.S. v. One Lear Jet

Aircraft, Serial No. 35A‑280,Registration No. YN‑BVO., 808 F.2d 765, 770 (11th Cir. 1987),
Lemmon v. Cedar Point, Inc., 406 F.2d 94, 97 (6th Cir.1969) (narrow construction given to any
provision which authorizes forfeiture of important rights almost earned by rendering of
substantial service), Dahly Tool Co. v. Vermont Tap and Die Co., 561 F.Supp. 600, 600–01
(D.C.Ill.,1982), Willis v. People, 71 V.I. 789, 813, 2019 WL 3291616, at *10, fn.5 (V.I., 2019) fn
5, citing, Western Union Tel. Co. v. Kansas, 216 U.S.1, 44 (1910).