Ninth Circuit Rules Equity Held in a Bankrupt LLC Subject to Mandatory Subordination On April 2, 2015, the Ninth Circuit Court of Appeals upheld a lower court’s decision mandating subordination of a bankrupt LLC owner’s arbitration award under Bankruptcy Code Section 510(b).

In the case — In re Tristar Esperanza Properties, LLC — Jane O’Donnell paid $100,000 in 2005 for a 15 percent membership interest in Tristar Experanza Properties, LLC, a single-asset real estate company. In 2008, she sought to withdraw from the LLC. When O’Donnell and Tristar could not agree on a valuation of her membership interest, O’Donnell filed for arbitration and was subsequently awarded $410,000.

Tristar failed to pay O’Donnell, who then obtained a state court judgment for the debt. Shortly thereafter, Tristar filed for Chapter 11 bankruptcy and O’Donnell filed a proof of claim for the $410,000 debt. Tristar then filed to subordinate her claim under Bankruptcy Code Section 510(b), which provides:

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.

The bankruptcy court granted summary judgment to Tristar and the Bankruptcy Appellate Panel upheld that judgment.

O’Donnell appealed to the Ninth Circuit, arguing that her claim was not for damages or arising from the purchase or sale of the membership interest. The Ninth Circuit disagreed, saying that since her claim arose from a breach of contract claim, it was for damages.

The court also found that although O’Donnell was no longer an equity holder at the time Tristar filed bankruptcy but instead was a judgment creditor, Section 510(b) applies if a creditor claim “arises from the purchase or sale of a security.” The court found that O’Donnell’s claim met the standard of a causal relationship between the claim and the purchase or sale of the security.

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