Some public employee retirement systems have announced intentions to file lawsuits against Enron Corp. and Global Crossing Ltd. to recover damages for the lost value of investments in those companies' stocks and bonds. Two recent court decisions make it much less likely those pension funds will recover on their claims from the bankrupt companies.
The suits threatened by state pension funds generally argue the company defrauded them into buying, selling or holding the company's stock. These suits are distinct from claims employees of those companies who participated in 401(k) plans may have for violations of securities laws or the Employee Retirement Income Security Act.
Often enough, a company's securities become worthless after it files for bankruptcy protection, as already seems to be happening with Enron and Global Crossing. But pension funds that invested in Enron and Global Crossing apparently will seek to recover the lost value of their holdings by attributing their losses to alleged fraud or breaches of fiduciary duties by Enron, Global Crossing, their respective officers and directors, their auditors or others.
Two new decisions by the U.S. Courts of Appeals for the 3rd and 10th circuits, however, suggest those claims probably will go nowhere. The decisions make it significantly more difficult for investors to recover the value of their investments from a bankrupt company's assets even if they succeed in proving fraud.
At issue is the meaning of Section 510(b) of the U.S. Bankruptcy Code. Under that section, claims for damages arising from the sale or purchase of stock must be paid after claims of other creditors. Bankruptcy courts uniformly have subordinated claims by investors that alleged they were fraudulently induced to purchase stock. But bankruptcy courts have been divided as to whether claims based on conduct occurring after an investor's stock purchase, such as fraud that induced the investor to retain the stock as it declined in value, must be subordinated. In their recent decisions, both the 3rd and 10th circuits decided investor claims based on such postpurchase conduct must also be subordinated under Section 510(b).
The 3rd Circuit ruled Feb. 15 in Baroda Hill Investments Ltd. vs. Telegroup Inc. that shareholders' claims against a bankrupt company must come after the claims of other creditors. The 3rd Circuit acknowledged that Section 510(b) is ambiguous and might be construed as only requiring subordination of claims based on conduct occurring at the time of the stock sale. The court concluded, however, that reading of the section "(does) not (limit) the nexus to claims alleging illegality in the purchase itself."
In its conclusion, the court noted that because shareholders are equity investors seeking compensation for a decline in the value of the stock, the policies underlying Section 510(b) about creditor and equity holder interests "require resolving the textual ambiguity in favor of subordinating their claims."
Similarly, in Allen v. Geneva Steel Co., the 10th Circuit ruled Feb. 27 that a claim of postinvestment fraud that causes an investor (a bondholder) to hold rather than sell a bankrupt company's securities "aris(es) from the purchase or sale" of those securities and, thus, must be subordinated to the claims of other creditors pursuant to Section 510(b). In its decision, the 10th Circuit also relied on the policies underlying Section 510(b), noting that from a creditor point of view, it does not matter whether investors initially buy or subsequently hold the investments as a result of fraud, the former of which is uniformly held to be subject to subordination under Section 510(b). The court concluded the fraudulent retention claim involves a risk that only investors should shoulder, just as the opportunity to sell or hold belongs exclusively to investors. The 10th Circuit also noted that a contrary ruling would weaken a "central feature of American bankruptcy law" known as the absolute priority rule, under which investors are not supposed to receive any distributions until creditors of an insolvent company have first been paid in full.
Notably for investors in Enron and Global Crossing, both the Baroda Hill Investments and the Allen decisions follow the reasoning of the U.S. Bankruptcy Court for the Southern District of New York, which is presiding over those bankruptcies. In its decision in In re Granite Partners LP, the bankruptcy court noted that 20 years earlier, the 2nd Circuit Court of Appeals had "counseled suspicion - with good reason - whenever an investor in an insolvent entity attempts to step up to the level of creditor," and warned that in such instances, the "investor disregards the absolute priority rule." Based on that reasoning, the court subordinated investor claims based on fraudulent misrepresentations that induced them to retain their investments.
These court decisions suggest strongly that the retirement systems and other investors who purchased shares will have a difficult time in obtaining any recovery from the assets of Enron and Global Crossing -even if they succeed in showing the companies defrauded them. Consequently, the cost of such litigation should be weighed against the very real possibility that any claim against a bankrupt company resulting from it will not enjoy higher priority of repayment than the worthless stock upon which the claim was based.
This does not mean investors are totally out of luck. They potentially may recover from other defendants not in bankruptcy, like responsible company officers, directors and auditors, or under insurance policies maintained by those companies if the bankruptcy court does not consider the proceeds to be company assets.
Pension funds and investors who purchased or held stock, however, will not likely recover much from the companies - even if there was fraud - which calls into question the political maelstrom over lawsuits. Those investors should think twice about whether the cost of litigation is really worth it, and what lesson can be learned to avoid this loss in the future.
Kenneth W. Irvin is a partner and William McCarron an associate in the bankruptcy and restructuring practice group at Morrison & Foerster LLP, Washington.