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Stock repurchase agreements and equitable subordination.

It is common practice for closely held corporations, those corporations whose shares are held by a single shareholder or a closely knit group of shareholders, to repurchase their stock upon the death or retirement of a principal shareholder. Frequently, these transactions are structured so that the corporation delivers a promissory note which provides for payments over time to the principal for the purchase of its stock. Principals find these transactions attractive as the promissory note acts as an annuity.

A bankruptcy court in Massachusetts recently faced such a transaction and ruled that an unsecured claim based on the balance due on a promissory note asserted against a bankruptcy estate by the principal shareholders' assignees could be subordinated to general unsecured creditors. The bankruptcy court found the bankruptcy policy of a fair distribution to unsecured creditors was furthered by subordination, notwithstanding the fact that the transaction was entered into seven years prior to the corporation's bankruptcy filing, and the corporation was solvent at the time of the transaction -- indeed, the corporation was valued as having a net worth of $3 million. The court's ruling provides a powerful weapon for unsecured creditors, who would otherwise be in parity with a redeeming shareholder, and sends a message to principals that their repurchase agreements may be subject to attack even if the corporation was solvent, and even if the transaction was entered into years before the bankruptcy. The doctrine of equitable subordination, which is only available under the Bankruptcy Code, has significance, as state law generally will invalidate such transactions only where the corporation was insolvent at the time of the transaction or where the transaction impaired the corporation's capital.

In May 1982, a closely held corporation ("Debtor") and the claimant ("Claimant"), a charitable trust controlled by the Debtor's shareholders, officers and directors, entered into an agreement wherein the Debtor agreed to purchase preferred and common stock owned by the Claimant for approximately $650,000. In exchange, the Debtor issued an unsecured promissory note, with a term of 15 years, payable in equal monthly installments, bearing interest at the rate of 12 percent. The Debtor's certified financial statements reflected a net worth of approximately $3 million, a net profit of $433,000, and current assets in excess of current liability at $3,150,000 shortly after the stock repurchase. In April 1989 the Debtor filed a Chapter 11 petition which was later converted to Chapter 7 liquidation. The Claimant filed an unsecured claim in the amount of $542,246, representing the balance due on the promissory note. The official creditors' committee objected to the claim, requesting the claim be equitably subordinated below the unsecured creditor class.

Three-Part Test

Equitable subordination is a doctrine unique to bankruptcy law. The Bankruptcy Code expressly recognizes the right to equitably subordinate certain claims. A majority of courts interpreting the subordination provision of the Bankruptcy Code adopt a three-part test:

(1) the claimant has engaged in inequitable conduct; (2) the misconduct results in injury to competing claimants; and (3) the subordination is not inconsistent with bankruptcy law. Here, however, the creditors' committee did not contend that the Claimant acted inequitably. Instead, the creditors' committee's objection was based on the origin of the claim, the repurchase of stock, which in effect was a claim to a shareholder distribution. The court looked at the substance of the transaction and noted: "[a] corporation's redemption of its own stock is in essence a dividend for which the corporation receives no consideration." Yet the court rejected the proposition that a fraudulent conveyance claim could be mounted to unwind the stock redemption. Rather, the court looked to equitable principles and found that as creditors are the presumptive owners of an insolvent corporation, creditors are entitled to payment prior to shareholders, and as redemption debt is equivalent to a stock dividend claim, equitable subordination was appropriate.

The court surveyed state law to determine whether the stock repurchase agreement was valid. Under California and Delaware corporate law, for instance, a corporation is prohibited from purchasing its own shares only when the purchase would make it insolvent or the purchase would not impair the capital of the corporation. Likewise, under the Model Business Corporation Act, under which most states have modeled their corporate statutory schemes, redemption is prohibited only where the corporation is rendered insolvent. Here, the stock repurchase agreement did not render the Debtor insolvent nor did the repurchase impair the capital of the corporation. Thus, under state law, the transaction was permissible and the Claimant would be placed on a parity with other unsecured claims.

However, the court found that because of the supremacy clause of the U.S. Constitution, the Bankruptcy Code, a federal statute, preempted state corporate law. The subordination provision of the Bankruptcy Code was in direct conflict with state law here as (1) the Bankruptcy Code required subordination of the claim while state law provided for parity; and (2) bankruptcy policy promotes a fair distribution to unsecured creditors while state law does not consider such issues. As the court was not imposing liability upon directors who authorized the stock repurchase agreement but instead was subordinating a claim based essentially on a dividend when the corporation is insolvent, there was nothing fundamentally unfair with the court's ruling.

Redeeming shareholders in closely held corporations may now face legal challenges from creditors attempting to unwind stock repurchases on two fronts: (1) If a corporation makes a distribution while insolvent, or the distribution impairs its capital, the transaction may be attacked under state law; and (2) Where a stock redemption provides for delivery of a promissory note by the corporation, the balance owing on the promissory note may be equitably subordinated later -- even years later -- should the corporation file bankruptcy, notwithstanding the corporation was solvent at the time of the stock repurchase.

Scott E. Blakeley practices bankruptcy and creditors' rights law in the Los Angeles office of Bronson, Bronson & McKinnon.
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Author:Blakeley, Scott E.
Publication:Business Credit
Date:Jan 1, 1995
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