Opinion
No. 73 Civ. 2332
October 17, 1979
Securities Investor Protection Act — Subordination Agreements — Scope
A lender who entered into a subordination agreement with a broker thus enabling the broker to comply with regulatory net capital rules could not be relieved of the subordination until all claims held by other creditors of the insolvent broker had been satisfied. However, cash and regular stock dividends were not covered by the agreement. See SIP A Sec. 6 at ¶ 6406.
[Digest of Opinion]
The dispute arose from the liquidation of Weis Securities, Inc. pursuant to the regime of the Securities Investor Protection Act of 1970. The claimant was an investor who had entered into a subordination agreement with Weis. At approximately the same time he entered into his subordination agreement with the debtor broker, the investor also filed an application with the New York Stock Exchange to become a subordinated lender of Weis. The subordination agreement and the investor's application for subordinated lender status were approved by the exchange. These approvals permitted the broker to list the property in the investor's account as capital in computing its net capital ratio so that it could comply with Exchange Rule 325 and thereby remain in business as a broker-dealer. On November 30, 1972, the subordination agreement was terminated. After the May, 1973 filing date of the SIPA liquidation proceeding, the lender sought the return of his stock. He was unsuccessful since the trustee took the position that under the subordination agreement the debtor was entitled to retain the stock to pay the claims of creditors arising out of matters occurring before the termination of the agreement.The court first noted that parties claiming rights to participate in a bankrupt's assets must do so in accordance with such contractual rights against the debtor that they may have purchased or acquired. Among such acquired contractual rights are those springing from subordination agreements. The investor argued that termination of the subordination agreement was the equivalent of withdrawal of the property from the subordinated account. Thus, he contended that a withdrawal occurred on the termination date, November 30, 1972. However, the court observed that termination of an irrevocable subordination agreement is not the equivalent of a withdrawal of property. The facts showed that the investor entered into an irrevocable subordination agreement at arms-length and for a substantial benefit. The termination of this agreement could not extinguish subordination in favor of claims arising out of transactions before the termination date. At best, the termination can only result in prospective relinquishment of liability on new claims arising after the termination date.
The court also concluded that the investor's interpretation was inconsistent with the public policy of assuring investors a stable securities market. All the property within the purview of the subordination agreement was treated as unencumbered property readily available to satisfy the claims of creditors. Allowing compliance with the net capital rules of the SEC and NYSE, the subordination agreement permitted the broker to deal with the public. Thus, to accept a narrow interpretation of the subordination agreement would clearly frustrate the protection that both the broker and its subordinated lenders were compelled to extend in favor of those who relied on the subordination agreements. The court concluded that the lender must stand by his commitment.
The trustee had counterclaimed for postfiling date distributions which had accrued on the securities claimed by the investor. Specifically, the counterclaim consists of a two-for-one stock split of the underlying shares, cash dividends and stock dividends. The court decided that the stock split was, in reality, part of the principal of the loan made to the broker. The mere fortuity of the stock split should not deprive the debtor-broker of half the value it was entitled to under the agreement. Thus, the stock split was covered by the subordination agreement. However, the cash and stock dividends were never covered by the subordination agreement. The plain language of the agreement provided that, with respect to the securities in his account, the lender was to receive regular dividends and interest on the securities and interest at the rate of 4% annually in consideration of his subordinated status. Since creditors never had an interest in the dividends during subordination, it would follow that they had no such interest thereafter.