Opinion
CIVIL ACTION NO. 18-0724
10-31-2019
IN RE: SPECTRUM ALLIANCE, LP, Debtor The Northeast Carpenters Annuity Fund, Appellant v. Spectrum Alliance, LP, Appellee.
MEMORANDUM
I. Introduction
Presently before this Court is an appeal by Northeast Carpenters Annuity Fund ("Fund") from an Order of the United States Bankruptcy Court for the Eastern District of Pennsylvania recategorizing the Fund's proof of claim against debtor Spectrum Alliance, LP ("Spectrum") as a proof of interest and, accordingly, subordinating the Fund's interest pursuant to 11 U.S.C. § 510(b). Upon referral from this Court, the Honorable Lynne A. Sitarski, United States Magistrate Judge, prepared a Report and Recommendation, recommending affirmance of the Bankruptcy Court's Order and denial of the Fund's appeal. (ECF No. 12.) The Fund objected to Judge Sitarksi's Report and Recommendation. (ECF No. 13.) Spectrum responded. (ECF No. 15.) For the reasons set forth herein, Judge Sitarksi's Report and Recommendation is adopted by this Court over the Fund's objections and the Order of the Bankruptcy Court is affirmed.
Citations omitted for brevity but the facts are well known to the parties at this point. All document quotations are derived from the respective referenced document located in the case Appendix (ECF No. 4-1). For additional background, see the parties' briefs, and the Report and Recommendation (ECF No. 12) of the Honorable Lynne A. Sitarski, United States Magistrate Judge.
The Northeast Carpenter's Annuity Fund ("Fund") is a benefit fund providing retirement benefits to union members. Spectrum Alliance, LP ("Spectrum") is a limited partnership incorporated under the laws of Pennsylvania. Spectrum Alliance Services, GP, LLC is a general partner of Spectrum. Trefoil Properties, L.P., a Delaware limited partnership, is the sole member of general partner Spectrum Alliance Services, GP, LLC. In October 2012, the Fund purchased five million dollars' worth of Class A shares in Spectrum, thereby becoming a limited partner. As a partner, the Fund was bound by Spectrum's Partnership Agreement, which states that partners are not entitled to redeem their partnership interests but that they may request redemption of their interest and "the General Partner shall endeavor in good faith to effect such redemption." However, prior to investing, and to induce the Fund to invest, Trefoil—Spectrum's General Partner's sole member—entered into a Guaranty and Suretyship Agreement with the Fund. Said Agreement worked around the Partnership Agreement's redemption terms by making Trefoil "surety for the payment to [the Fund] of the [redemption amount]," and making the redemption amount "due and payable in full" by six months from the date of a written redemption request by the Fund. On October 18, 2012, the Fund and Spectrum also entered into a letter agreement (dubbed "Side Letter") pursuant to which the Fund had "the right to demand and obtain the immediate redemption of the Fund's entire interest in Spectrum" if, at certain evaluation times, the Fund's investments in Spectrum appraised "greater than 5% below the original value." Due to a low September 2013 valuation, the Fund submitted a redemption request on October 1, 2013. Spectrum did not honor the Fund's request for redemption before, in June 2017, Spectrum filed a voluntary petition for reorganization pursuant to Chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the Eastern District of Pennsylvania.
The Fund indicates the Bankruptcy Court did not permit factual evidence of the Fund's efforts to enforce the redemption request between the time of the Fund's request for redemption and the time of the bankruptcy petition. Such evidence may be relevant to an abandonment analysis or other similar issue, but the law applicable to this appeal does not consider such issues.
After Spectrum filed for bankruptcy, the Fund filed a proof of claim, seeking redemption of its $5,000,000 investment in Spectrum plus interest. The Bankruptcy Court found the Fund was an equity security holder and, accordingly, recategorized the Fund's proof of claim as a proof of interest and subordinated its interest pursuant to 11 U.S.C. § 510(b). The Fund appealed the Bankruptcy Court's recategorization and subordination to the United States District Court for the Eastern District of Pennsylvania pursuant to 28 U.S.C. § 158(a). Upon referral from this Court, the Honorable Lynne A. Sitarski, United States Magistrate Judge, prepared a Report and Recommendation, recommending affirmance of the Bankruptcy Court's Order and denial of the Fund's appeal. (ECF No. 12.) The Fund filed objections to Judge Sitarksi's Report and Recommendation. (ECF No. 13.) Spectrum responded to the Fund's objections. (ECF No. 15.)
"The district courts of the United States shall have jurisdiction to hear appeals [ ] from final judgments, orders, and decrees ... of bankruptcy judges entered in cases and proceedings [in] the judicial district in which the bankruptcy judge is serving." 28 U.S.C. § 158(a).
III. Standard of Review
When objections are filed to the Report and Recommendation ("R & R) of a Magistrate Judge, the district court must conduct a de novo review of those portions of the R & R to which objections are made. 28 U.S.C. § 636(b)(1). If there are no objections to the R & R, or when reviewing those portions of the R & R to which no objections are directed, the court, as a matter of good practice, should "satisfy itself that there is no clear error on the face of the record in order to accept the recommendation." Fed. R. Civ. P. 72(b), advisory committee notes; see also Oldrati v. Apfel , 33 F. Supp. 2d 397, 399 (E.D. Pa. 1998) ("In the absence of a timely objection ... this Court will review [the Magistrate's] Report and Recommendation for ‘clear error.’ ") (citations omitted).
"Objections which merely rehash an argument presented to and considered by a magistrate judge are not entitled to de novo review." Gray v. Delbiaso , CIVIL ACTION NO. 14-4902, 2017 WL 2834361, at *4, 2017 U.S. Dist. LEXIS 101835, at *11 (E.D. Pa. Jun. 30, 2017). "Where objections do not respond to the Magistrate's recommendation, but rather restate conclusory statements from the original petition, the objections should be overruled." Prout v. Giroux , CIVIL ACTION NO. 14-3816, 2016 WL 1720414, at *11, 2016 U.S. Dist. LEXIS 57085, at *30 (E.D. Pa. Apr. 29, 2016). "[F]ederal district courts are not required to engage in de novo review of objections to a Magistrate's R & R that lack specificity." Guzman v. Rozum , CIVIL ACTION NO. 13-7083, 2017 WL 1344391, at *9, 2017 U.S. Dist. LEXIS 55661, at *22 (E.D. Pa. Apr. 12, 2017).
IV. Discussion
Generally speaking, the Fund's objections essentially repackage arguments presented in its appeal, which was referred to and considered by Judge Sitarksi. Therefore, the Fund's objections are not entitled to comprehensive de novo review. However, because the Fund's objections endeavor to respond particularly to the content of Judge Sitarksi's R & R and for thoroughness' sake, this Court shall conduct de novo review limited to the Fund's specific objections.
The Fund enumerates five objections in the introduction of its brief. However, all five speak to one of two closely interrelated issues: 1.) whether the Fund's interest is correctly characterized as a security interest or as a credit interest, and 2.) whether the Fund's interest was correctly subordinated pursuant to § 510(b) of the Bankruptcy Code. Thus, this Court shall limit its review to those two issues.
The Fund objects to the Magistrate's conclusion that the Fund's proof should be characterized as a proof of interest, not a proof of claim. (Objs. 1.) It argues the Magistrate arrived at the wrong characterization because she disregarded the applicable legal standard for characterization of claims. (Objs. 1.) The Fund also objects to the finding that its interests are subject to subordination pursuant to 11 U.S.C. § 510(b). (Objs. 1.) This Court shall address the Fund's objections ad seriatim.
"An ownership interest is not a debt of the partnership. Partners own the partnership subject to profits or losses. Creditors, however, hold claims regardless of the performance of the partnership business. Thus, an ownership interest is not a claim against the partnership." In re Ben Franklin Hotel Assocs ., 186 F.3d 301, 305 (3d Cir. 1999).
B. Security Interest vs. Creditor Interest
In arguing that the R & R erred by characterizing the Fund's proof of interest as a proof of claim, the Fund quotes In re Ben Franklin Hotel Assocs . to emphasize the proposition that interest holders may also be creditors. (Objs. 1-2 (quoting Civil Action No. 97-7449, Bankruptcy No. 93-17088 SR, 1998 WL 94808 at *2, 1998 U.S. Dist. LEXIS 2304 at *7 (E.D. Pa. Mar. 4, 1998) ).) The Fund submits that by and through the Side Letter, it negotiated for and obtained the independent contractual right to redeem its equity interest in Spectrum and since the Fund's proof of claim was based on breach of said contractual right—not on its equity interest—the R & R erroneously concluded that the Fund's proof of claim is really a proof of interest. (Objs. 2-3.) The Fund also argues the R & R overlooked the specific factors of an applicable interest-character test, summarily and erroneously determining satisfaction thereof. (Objs. 2-4.)
The Fund quotes one multi-factor test but concedes that the test it quotes is one of several. (Objs. 3 (quoting NTP Marble, Inc. v. Papadopoulos (In re NTP Marble, Inc. ), 491 B.R. 208, 210 (Bankr. E.D. Pa. 2013) ("On the question of re-characterization, the Third Circuit has observed that courts have adopted a variety of multi-factor tests borrowed from non-bankruptcy case law.")).)
The Fund's insistence that a security holder may also be a creditor shows too little. It shows that the Fund, as a security holder, is not categorically foreclosed from being a creditor, but it does not establish what is required to carry the day—that the Fund is necessarily a creditor with respect to the interest at issue. The Fund's argument is therefore rejected.
The Fund's attempt to establish itself as a creditor pursuant to the multi-factor interest-character test in NTP Marble, Inc. v. Papadopoulos (In re NTP Marble, Inc. ), 491 B.R. 208, 212 (Bankr. E.D. Pa. 2013) is also not persuasive. The factors contained therein include:
(a) names given to the instruments, if any, evidencing the indebtedness; (b) presence or absence of a fixed maturity date and a schedule of payments; (c) no fixed rate of interest and interest payments; (d) whether repayment depended on success of the business; (e) inadequacy of capitalization; (f) identity of interests between creditor and stockholder; (g) security, if any, for the advances; (h) ability to obtain financing from outside lending institutions; (i) extent to which the advances were subordinated to the claim of outside creditors; (j) the extent to which the advances were used to acquire capital assets; (k) presence or absence of a sinking fund; (l) presence or absence of voting rights; and (m) other considerations.
NTP Marble, Inc. v. Papadopoulos (In re NTP Marble, Inc. ), 491 B.R. at 212. As a preliminary matter, the test contains thirteen factors and the Fund only argues that five of them support its position. (Objs. 3-4.) Thus, at first blush, the Fund does not employ the test persuasively. Furthermore, some of the arguments advanced by the Fund with respect to the five factors it does employ do not withstand scrutiny.
Regarding the first factor—names given to instruments evidencing the indebtedness, the Fund argues the Side Letter is the instrument evidencing the indebtedness and its contents provide a separate right of payment. However, by its terms, the first factor considers the names of the instruments evidencing the indebtedness, not their contents. The name "Side Letter" conjures thoughts of side deals or workarounds, which comports with the intent of the Side Letter—working around the non-committal redemption terms of the Partnership Agreement. While parties may be free to contract around other contracts, parties are not free to contract around key bankruptcy laws. In re Intervention Energy Holdings, LLC , 553 B.R. 258, 263 (Bankr. D. Del. 2016) ("The Bankruptcy Code pre-empts the private right to contract around its essential provisions."); see In re Nortel Networks, Inc. , 522 B.R. 491, 507 (Bankr. D. Del. 2014) (implying an agreement to contract around the Bankruptcy Code's priority scheme would be impermissible). Thus, as with all interests in a bankrupt entity, the Fund's contractual right may take on a new character post-petition.
With respect to the second factor—presence or absence of a fixed maturity date and schedule of payments, the Fund argues "[t]he Side Letter set forth a fixed maturity date with respect to the right of payment (30 days following the June 30, 2013 valuation)." (Objs. 4.) However, the Fund appears to oversimplify the matter. The Side Letter provided that, in the event of a "materially low[ ]" appraisal of the Fund's investments as of June 30, 2013, the Fund would "have the right to demand and obtain the immediate redemption of [its] entire interest in [Spectrum] in accordance with the Guaranty and Suretyship Agreement but unrestricted by any limitations ... set forth therein." Valuation of the Fund's investments as of June 30, 2013 was not expected to be completed until August 2013, and "materially low[ ]" valuation was a predicate for demand, which was not automatic and was a predicate for maturity. Thus the Side Letter set forth an ambiguous predicate maturity date, not a fixed maturity date. And while, once the Fund demanded redemption, "immediate" was specific with respect to the timing of payment, it can hardly be considered a "schedule of payments."
See R & R 3 n.2. Because it had to evaluate performance data for dates up to and including June 30, 2013, the valuation could not be provided promptly on June 30, 2013.
With respect to the fourth factor—whether repayment depended on success of the business, the Fund argues its right to repayment did not depend on Spectrum's success because it depended on the contractual obligation generated by the Side Letter. However, according to the terms of the Side Letter, the Fund's right to make a redemption request was triggered only if its investment in Spectrum fell below 95% of its initial value. Thus, repayment depended on Spectrum's success, or lack thereof. In fact, the Fund's objections state that it "demanded and procured the Side Letter specifically because of [its] concerns regarding the valuation of its equity interest," which, in turn, depends on Spectrum's performance. (Objs. 4.) With only two of thirteen factors remaining—1.) fixed payment and interest rates and 2.) voting rights—the Fund makes a weak showing with respect to its chosen interest-character test. As such, the Fund's interest-character test argument does not persuade this Court that the Bankruptcy Court and the Magistrate clearly erred by characterizing the Fund's interest as a security interest and not a creditor interest. Therefore, the Fund's associated objection is overruled.
C. Subordination Pursuant to 11 U.S.C. § 510(b)
The Fund further contends its interest should not be subordinated pursuant to § 510(b) of the Bankruptcy Code. Section 510(b) provides, in relevant part:
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 ... 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 text of the statute indicates that the question of whether the Fund's interest should be subordinated is determined by the nature of the Fund's interest. If the Fund's interest is a creditor interest, § 510(b) does not compel its subordination. If the Fund's interest is a security interest, § 510(b) compels its subordination. Therefore, because the Fund's objections do not show its interest is a creditor interest, its objection to subordination must likewise be overruled. A brief survey of applicable, controlling case law confirms this result.
The Third Circuit recently evaluated the scope of 11 U.S.C. § 510(b) in two cases that are factually analogous to the instant case. In Baroda Hill Invs., Inc. v. Telegroup, Inc. (In re Telegroup, Inc. ), appellant-claimant LeHeron Corporation, Ltd. ("LeHeron") was a shareholder of appellee Telegroup, Inc. ("Telegroup"). 281 F.3d 133, 135 (3d Cir. 2002). Telegroup filed a Chapter 11 bankruptcy petition and LeHeron subsequently filed a proof of claim seeking damages for Telegroup's breach of a stock purchase agreement provision that required Telegroup to ensure the stock was "registered and freely tradeable." Id. at 135-36. The bankruptcy court and the district court both found LeHeron's claims should be subordinated pursuant to § 510(b) and LeHeron appealed to the Third Circuit. Id. On appeal, LeHeron argued § 510(b) should be construed narrowly to mean only claims predicated on illegality at the time of issuance of stock should be subordinated pursuant to § 510(b), not claims predicated on post-purchase illegality. Id. Telegroup argued for a broader construction (ultimately adopted by the Third Circuit) under which "claims for breach of a stock purchase agreement, which would not have arisen but for the purchase of ... stock, may arise from that purchase, even though the actionable conduct occurred after the transaction was completed." Id. The Third Circuit found the scope of § 510(b) presented a matter of first impression and carefully considered the text of the statute, the legislative history with underlying policy considerations, and decisions from other jurisdictions. The Third Circuit considered the "arising from" language ambiguous and susceptible to both the narrower interpretation advanced by LeHeron and the broader interpretation advanced by Telegroup. Id. at 138. However, utilizing a "but for" causation analysis to answer the question of whether a claim arises from the purchase or sale of a security, the Court of Appeals found the broader reading of § 510(b) "more comfortable." Id. Finally, after reviewing the legislative history, policy considerations, and decisions from other jurisdictions, the Third Circuit settled into the broader interpretation and held that "a claim for breach of a provision in a stock purchase agreement requiring the issuer to use its best efforts to register its stock arises from the purchase or sale of the stock, and therefore must be subordinated pursuant to § 510(b)." Id. at 137-44.
The same could be said of the parties' arguments here but the remainder of the Third Circuit's analysis in In re Telegroup, Inc. along with the factual similarities between that case and this one compel this Court to conclude In re Telegroup, Inc. is controlling of this case.
Although the Third Circuit limited its holding to stock purchase agreement provisions that "requir[e] the issuer to use its best efforts to register its stock," this Court finds the provision at issue in In re Telegroup, Inc . analogous to the stock purchase agreement provision at issue here inasmuch as both were intended to facilitate liquidation of equity investments. Id. at 144. In re Telegroup, Inc. is further analogous because the Fund's claim and LeHeron's claim were each based on a post-purchase-agreement breach, and LeHeron intended to liquidate its equity investment in Telegroup just as the Fund here intended to redeem its equity investment in Spectrum. Id. at 142. Thus, this Court finds In re Telegroup, Inc. analogous and therefore finds its holding applicable and controlling here.
Strictly speaking, the provision at issue here is part of the Side Letter—an agreement between the Fund and Spectrum, not part of the Partnership Agreement. However, the Side Letter modified the terms of the Guaranty and Suretyship Agreement, which modified the terms of the Partnership Agreement and was generated to induce the Fund to invest in Spectrum. See supra Part II. As such, the Side Letter is one part of a multi-document stock purchase agreement between the Fund and Spectrum.
Put another way, neither LeHeron nor the Fund intended to bear the risk of business insolvency. However, the Third Circuit did not find such an argument persuasive. In re Telegroup, Inc. , 281 F.3d at 142.
The Third Circuit extended its In re Telegroup, Inc. holding in Frankum v. Int'l Wireless Communs. Holdings, Inc. (In re Int'l Wireless Communs. Holdings, Inc. ). 68 F. App'x 275, 277-78 (3d Cir. 2003). Therein, claimant-appellants Frankum and Wasaff ("F & W") received stock from appellee International Wireless Communications Holdings, Inc. ("IWCH") as consideration for the sale of their shareholdings in another mobile communications company. The stock purchase agreement contained provisions requiring IWCH to either provide F & W a near-term opportunity to liquidate its holdings by conducting an initial public offering within a specified period of time or, if it did not timely provide such an opportunity, to essentially limit F & W's risk by issuing F & W additional stock to account for loss in the value of F & W's stock while F & W awaited the opportunity to liquidate. Id. at 276-77. IWCH filed for Chapter 11 bankruptcy before providing F & W an opportunity to liquidate and before issuing F & W additional shares. Id. at 277. In bankruptcy proceedings, F & W filed a proof of claim for the initial value of their stock and both the bankruptcy court and the district court found their claim should be subordinated pursuant to § 510(b). Id. at 277. F & W appealed. After revisiting the legislative history and policy behind the statute, the Third Circuit found F & W should bear the risk that IWCH might not honor the stock purchase agreement. Id. at 278. The Third Circuit also applied the "but for" causation analysis from In re Telegroup, Inc. and found that F & W would not have had a claim but for their purchase of IWCH stock. The Court of Appeals considered In re Telegroup, Inc. controlling of In re Int'l Wireless Communs. Holdings, Inc. and concluded that § 510(b) required subordination of F & W's claim. Id. at 278.
There is no apparent explanation for or resolution of the discrepancy between the spelling of the name in the caption and the spelling of the name in the body of the opinion.
Stock received as consideration is purchased for purposes of § 510(b). In re Int'l Wireless Communs. Holdings, Inc. , 68 F. App'x at 277.
A fundamental policy consideration underlying § 510(b) is that shareholders should bear the risk that their securities may have been fraudulently issued. In re Telegroup, Inc. , 281 F.3d at 139-40. In In re Int'l Wireless Communs. Holdings, Inc. , the Third Circuit logically extended this risk to include the risk that a shareholders "shares will not be delivered according to the terms of their contract with [the issuer]." In re Int'l Wireless Communs. Holdings, Inc. , 68 F. App'x at 278.
Likewise, here, the Fund bore the risk that Spectrum would not deliver the Fund's shares according to the terms of their agreement and the but-for causal connection between the Fund's claim and its purchase of Spectrum shares weighs in favor of subordination. Thus, In re Int'l Wireless Communs. Holdings, Inc. is also instructive and controlling of the instant case.
The but-for causation inquiry is not necessarily intended to be dispositive or to encompass every claim brought by a shareholder. See In re Telegroup, Inc. , 281 F.3d at 144 n.2. However, but-for causation between claim and stock purchase weighs in favor of subordination.
The foregoing compels subordination of the Fund's claim pursuant to 11 U.S.C. § 510(b). The Fund's associated objection is therefore overruled.
V. Conclusion
Having reviewed the Report and Recommendation for clear error and finding none, and having conducted de novo review of the specific issues raised by Appellant's objections, for the reasons set forth above, Appellant's Objections are overruled, and Judge Sitarski's Report and Recommendation is adopted.
An appropriate Order follows.
REPORT AND RECOMMENDATION
LYNNE A. SITARSKI, UNITED STATES MAGISTRATE JUDGE
Presently before the Court is the appeal of the Northeast Carpenters Annuity Fund from an Order of the United States Bankruptcy Court for the Eastern District of Pennsylvania. The Bankruptcy Court categorized the Fund's claim as a proof of interest, finding that the Fund was an equity security holder, and thus its interest was subject to subordination pursuant to 11 U.S.C. § 510(b). The Honorable C. Darnell Jones II referred this matter to me for a Report and Recommendation. For the reasons set forth below, I respectfully recommend the District Court deny the Fund's appeal and affirm the Order of the Bankruptcy Court.
I. BACKGROUND
The Northeast Carpenters Annuity Fund ("Appellant" or "the Fund") is a multi-employer benefit fund providing retirement benefits to union members. Spectrum Alliance, L.P., ("Appellee" "Debtor" or "Spectrum") is a limited partnership incorporated under the laws of Pennsylvania. Spectrum Alliance Services GP, LLC, is a Pennsylvania limited liability company and the general partner of Spectrum. Trefoil Properties, L.P., ("Trefoil" or "Guarantor") is a Delaware limited partnership and the sole member of Spectrum Alliance Services GP, LLC. This bankruptcy appeal involves the Fund's request to redeem its investment in Spectrum.
On October 23, 2012, the Fund purchased five million dollars of Class A shares in Spectrum pursuant to a Subscription Agreement. (Appellant's Br., ECF No. 4, at 3; App'x, ECF No. 4-1 at A1; A231-239). As a Class A limited partner, the Fund was bound by Spectrum's Partnership Agreement. (Id. at A231, ¶ 3(a)). The Partnership Agreement provides, in relevant part:
The Fund submitted relevant documents and portions of the Bankruptcy Court record as Appendices to its Brief. (ECF Nos. 4-1 through 4-10). The Appendix is sequentially numbered A1 through A528. The Court will use the pagination A1-A528 for ease of reference.
No Partner shall have the right to require redemption of such Partner's Partnership Interest, and neither the Partnership nor its General Partner(s) shall have any obligation to cause any requested redemption to occur. Notwithstanding the foregoing, any Partner may at any time request redemption of its Partnership Interest by sending written notice of such request to the General Partner. Upon receipt of any such redemption request (and in the order received by the General Partner, if more
than one such request is pending at any time), the General Partner shall endeavor in good faith to effect such redemption, including offering such Partnership Interest to the other Partners pursuant to Section 11.2 of this Agreement.
(A63-64, at § 11.1, ¶ (e)).
Before the Fund invested in Spectrum, the Fund entered into a Guaranty and Suretyship Agreement with Trefoil "to induce [the Fund] to make the Investment." (Id. at A1; ¶ D ("As security for the redemption of the Investment by Spectrum in accordance with the Partnership Agreement, [the Fund] has required the execution and delivery of this Guaranty by [Trefoil].")). Because there was no automatic right of redemption from Spectrum, the Fund and Trefoil entered the Guaranty and Suretyship Agreement which provided that Trefoil "becomes surety for the payment to [the Fund] of the amount (the ‘Redemption Amount’), due [the Fund] pursuant to the Redemption Notice, which Redemption Amount shall be due and payable in full by ... six (6) months after the date of the Redemption Notice." (Id. at A1 ¶ 1(a)).
The parties also exchanged a "Side Letter" agreement on October 18, 2012. (Id. at A9-16). The Side Letter states "[t]his letter agreement is entered into concurrently with the execution and delivery of a Subscription Agreement by [the Fund], ... pursuant to which [the Fund] has made a Capital Commitment of U.S. $5,000,000 to, and subscribed for a limited partnership interest in, [Spectrum]." (Id. at A9). Most pertinent to the instant appeal, the Side Letter provides the "Valuation Policy" for Spectrum's portfolio:
The General Partner further agrees that it shall cause all [Spectrum] investments to be appraised by June 30, 2013. In the event that the valuations reported are, in the aggregate, materially lower than the valuations used by the General Partner to establish the value of [the Fund's] interest in [Spectrum] (materiality shall be defined as greater than 5% below the original value), then [the Fund] shall have the right to demand and obtain the immediate redemption of [the Fund's] entire interest in [Spectrum] in accordance with the Guaranty and Suretyship Agreement but unrestricted by any time limitations or blackout provisions or periods set forth therein.
(Id. at A13).
On or about September 3, 2013, the Fund received the valuations of Spectrum's portfolio. (A21). On October 1, 2013, the Fund notified Spectrum that "the Board of Trustees [of the Fund] has decided to redeem its interest in Spectrum Alliance, LP in accordance with the terms of our October 18, 2012 Side Letter, as amended and supplemented.[ ] Please accept this email as the Fund's formal request for such redemption." (Id. ). The Fund's investment was not redeemed.
The October 18, 2012 Side Letter was supplemented by a July 8, 2013 Side Letter. (A19-20). The October Side Letter provided that Spectrum's portfolio would be "appraised by June 30, 2013." (A13). However, there was confusion regarding the appraisal and valuation timing; specifically, the portfolio was to be appraised "as-of" June 30, 2013, therefore the valuations could not be provided on that date. (A17-18). Thus, the parties exchanged the July 8, 2013 Side Letter which amended and clarified the October Side Letter because the parties "expect the appraisal for the balance of the portfolio to be completed and issued during August 2013." (A19).
On June 20, 2017, Spectrum filed a voluntary petition for reorganization pursuant to Chapter 11 of the Bankruptcy Code, 11 U.S.C. §§ 101 et seq. (Pet., ECF No. 2-3, at 3-6). On August 18, 2017, the Fund filed its Proof of Claim, Numbered Claim 39, for $7,996,932.11 (the Fund's $5,000,000 capital contribution with 11% annual interest). (Proof of Claim No. 39, ECF No. 2-4, at 80-83). Spectrum filed its First Omnibus Objection on October 26, 2017. (Debtor's First Omnibus Obj., ECF No. 2-4, at 2-5). Spectrum objected to the Fund's Proof of Claim because "the Fund's claim against [Spectrum] is based on its position as a limited partner. Therefore, [Spectrum] submits a redemption, such as the one described in the exhibits to Proof of Claim 39, does not automatically convert equity to debt and therefore [Spectrum] requests Proof of Claim Number [39] be disallowed in its entirety by the Court." (Id. at Ex. A, p. 8).
On December 6, 2017, the Honorable Jean K. FitzSimon of the United States Bankruptcy Court for the Eastern District of Pennsylvania held a hearing on the Fund's Proof of Claim and Spectrum's Objection. (A191-200). The Fund noted that Spectrum objected to its claim "on the basis that we are an equity security holder." (A195, at 5:18-19). The Fund contended that because it submitted a redemption request "we're really a creditor and not a shareholder." (A196, 6:11-12). The Fund and Spectrum submitted briefing to Judge FitzSimon regarding Proof of Claim 39 and the Objection thereto. (A202-222).
At a subsequent hearing held on January 29, 2018, Judge FitzSimon concluded Spectrum's objection should be granted because the Fund was an equity security holder. (See A381). She explained: "This is an objection by [Spectrum] to the claim of the Northeast Carpenters. And I think, sadly, counsel, the Third Circuit has simply said that all of the lovely cases that you cited from the Bankruptcy Courts around the country do not apply in the Third Circuit. And that the Third Circuit says a security, is a security, is a security and it is always entitled to subordination by the debtor." (Id. at 5:4-10). A "security" is defined in the Bankruptcy Code as, inter alia , an "interest of a limited partner in a limited partnership," and the Fund was a limited partner in Spectrum, a limited partnership. 11 U.S.C. § 101(49)(xiii). By Order dated February 1, 2018, Judge FitzSimon granted the objection, and ordered that "Proof of Claim 39 filed by the Fund is hereby re-characterized as a proof of interest and shall be considered equity." (A514-515, ¶¶ 1-2).
On February 16, 2018, the Fund filed the instant appeal from Judge FitzSimon's February 1, 2018 Order. (Appeal, ECF No. 1). The Fund and Spectrum filed their briefs in support of their respective positions on appeal. (Appellant's Br., ECF No. 4; Appellee's Br., ECF No. 5). On May 29, 2018, the Fund filed its Reply. (Appellant's Reply, ECF No. 10). By Order dated June 3, 2019, the Honorable C. Darnell Jones II referred this matter to me for a Report and Recommendation. (Order, ECF No. 11).
II. LEGAL STANDARD
The Court has jurisdiction over this appeal from the Bankruptcy Court's February 1, 2018 Order pursuant to 28 U.S.C. § 158(a), which provides that "[t]he district courts of the United States shall have jurisdiction to hear appeals [ ] from final judgments, orders, and decrees ... of bankruptcy judges entered in cases and proceedings referred to bankruptcy judges under section 157 of this title. An appeal under this subsection shall be taken only to the district court for the judicial district in which the bankruptcy judge is serving."
"In reviewing a bankruptcy court's decision, we review its legal determinations de novo , its factual findings for clear error, and its exercise of discretion for abuse thereof." In re RBGSC Inv. Corp. , 253 B.R. 352, 362 (E.D. Pa. 2000) ; see also In re United Healthcare Sys., Inc. , 396 F.3d 247, 249 (3d Cir. 2005) ("Exercising the same standard of review as the district court, ‘[w]e review the bankruptcy court's legal determinations de novo , its factual findings for clear error and its exercise of discretion for abuse thereof.’ " (quoting In re Trans World Airlines, Inc. , 145 F.3d 124, 130-31 (3d Cir. 1998) )).
III. DISCUSSION
In its appeal, the Fund raises two related claims of error by the Bankruptcy Court. First, the Fund contends the Bankruptcy Court erred by characterizing its Proof of Claim as a Proof of Interest. (Appellant's Br., ECF No. 4, at 10-13). Second, the Fund argues the Bankruptcy Court erred by concluding its claim was subject to subordination pursuant to 11 U.S.C. § 510(b). (Id. at 14-20). I will address each in turn. For the following reasons, I respectfully recommend that the Fund's appeal be denied, and that the District Court affirm the Order of the Bankruptcy Court.
A. Characterization of Claim
In its first argument, the Fund argues the Bankruptcy Court erred in finding that its "proof of claim" was in fact a "proof of interest." I conclude the Bankruptcy Court did not err, and I respectfully recommend the Fund's appeal on this basis be denied.
"The Bankruptcy Code distinguishes between a ‘proof of claim,’ which may be filed by a ‘creditor,’ and a ‘proof of interest,’ which may be filed by an ‘equity security holder.’ " In re Winstar Commc'ns, Inc. , 554 F.3d 382, 414 (3d Cir. 2009) (quoting 11 U.S.C. § 501(a) ). "In the Bankruptcy Code, the distinction between creditors (who hold ‘claims’ against the estate) and equity investors (who hold ‘interests’ in the estate) is important, for holders of claims receive much more favorable treatment than holders of interests." In re Insilco Techs. Inc. , 480 F.3d 212, 217 (3d Cir. 2007). "Thus, if a filed claim is rejected on the ground that it is not a claim at all, but an interest, then the holder of that interest is relegated to the end of the line, where any recovery is unlikely." Id. at 218. "Even in the flexible world of Chapter 11 reorganizations, the absolute priority rule, 11 U.S.C. § 1129(b)(2)(B), requires that equity holders receive nothing unless all creditors are paid in full." Id. at 218, n.10.
The Bankruptcy Code defines a "creditor" as an "entity that has a claim against the debtor that arose at the time of or before the order for relief concerning the debtor." 11 U.S.C. § 101(10)(A). An "equity security holder" is a "holder of an equity security of the debtor." Id. § 101(17). An "equity security" includes, inter alia , "interest of a limited partner in a limited partnership." Id. § 101(16)(B).
I find no error in the Bankruptcy Court's conclusion that the Fund's "proof of claim" was rightly characterized as a "proof of interest" because the Fund is an equity security holder, not a creditor. Here, the Fund purchased $5,000,000 of Class A shares in Spectrum. (A231-239 (Subscription Agreement)). The Fund thus became a Class A limited partner in Spectrum. (Id. ). Spectrum is a limited partnership. Accordingly, the Bankruptcy Court properly characterized the Fund's "proof of claim" as a "proof of interest" because the Fund is an equity security holder; i.e., the Fund made a capital contribution to Spectrum and purchased an "interest of a limited partner in a limited partnership." 11 U.S.C. § 101(16)(B) ; (A231 ("[The Fund] subscribes for and agrees to acquire an uncertificated Class A Limited Partner Interest in the Partnership ... upon the terms and conditions set forth herein and in the Amended and Restated Agreement of Limited Partnership.")). I conclude the Bankruptcy Court did not err and respectfully recommend the Fund's appeal on this basis be denied.
B. Subordination of Claim from Purchase of Security
The Fund next asserts the Bankruptcy Court erred in concluding its claim was subject to subordination pursuant to 11 U.S.C. § 510(b). (Appellant's Br., ECF No. 4, at 14-20). Specifically, the Fund argues "Appellant's claim should not be subject to subordination under Section [510(b) ] of the Bankruptcy Code because Appellant's claim does not arise from the purchase or sale of securities of Appellant, rather the claim arises from the separate contractual provision in the Side Letter and the redemption request made thereunder." (Id. at 14; see also Appellant's Reply, ECF No. 10, at 2 ("Appellant is not claiming a right of redemption created by the Partnership Agreement, but is claiming a right of redemption created by the Side Letter.")). Spectrum contends that "the Bankruptcy Court correctly found that Appellant's claim is subject to mandatory subordination pursuant to 11 U.S.C. § 510(b)." (Appellee's Br., ECF No. 5, at 12-15). I conclude the Bankruptcy Court did not err, and I respectfully recommend the Fund's appeal on this basis be denied.
Spectrum also claims that the Fund waived its argument premised on the Side Letter because, according to Spectrum, the Fund did not raise this argument before the Bankruptcy Court. (Appellee's Br., ECF No. 5, at 16-19). I disagree, and conclude the Fund did not waive its argument. The Fund extensively argued to the Bankruptcy Court, at the hearing and in its briefs, that the Side Letter imposed a debt obligation onto Spectrum. (See, e.g. , A195-196, at 5:22-6:12 ("[W]e have a separate contract with them, a side letter ... And it was on that basis that we submitted the redemption request a year later.... So that's the basis for our claim that we're really a creditor and not a shareholder."); A208, at ¶¶ 27-29 ("The Side Letter, by its terms, is a valid and binding contract providing a right of redemption .... The Side Letter provides an obligation on behalf of Debtor to pay a sum certain in the event of a redemption request, which condition has occurred.")). Accordingly, the Fund did not waive this argument.
Section 510(b) of the Bankruptcy Code provides "a claim arising from rescission of a purchase or sale of a security of the debtor ..., [or] for damages arising from the purchase or sale of such a security ... shall be subordinated to all claims or interests that are senior to or equal the claim of interest represented by such security, except that if such security is common stock, such claim has the same priority as common stock." 11 U.S.C. § 510(b) ; In re Int'l Wireless Commc'ns Holdings, Inc. , 68 F. App'x 275, 278 (3d Cir. 2003) ("[A]ll damage claims arising from the purchase of shares should be subordinated ...." (citing In re Telegroup, Inc. , 281 F.3d 133, 141 (3d Cir. 2002) )). "[A] mandatory subordination claim requires three elements: first, the claim involves a security; second, that there was a purchase or sale of such security; and third that the damages which make up his claim arose out of that purchase or sale." In re NTP Marble, Inc. , 491 B.R. 208, 212 (Bankr. E.D. Pa. 2013).
The Bankruptcy Court properly concluded the Fund's interest was subject to subordination under § 510(b). First, "the claim involves a security." The Bankruptcy Code defines a "security" as including, inter alia , an "interest of a limited partner in a limited partnership." 11 U.S.C. § 101(49)(xiii). As noted above, the Fund purchased five million dollars of Class A shares in Spectrum, thus becoming a Class A limited partner in Spectrum, which is a limited partnership. (A231-239). Second, there was a purchase and sale of the interest in Spectrum. The Fund purchased the interest for five million dollars, Spectrum sold the interest. (Id. ). Lastly, the damages which the Fund claims arose from that purchase: the Fund claims Spectrum failed to properly redeem its investment in Spectrum as a Class A limited partner. "Because the [ ] plaintiffs' damages claim would not exist ‘but for’ plaintiffs' [security] ownership, it is subordinated." In re Int'l Wireless Commc'ns Holdings, Inc. , 68 F. App'x at 278 (citing In re Telegroup, Inc. , 281 F.3d at 143 ).
The Fund argues that its interest was not subject to subordination because of the Guaranty and Surety Agreement and Side Letter modifying and clarifying the Guaranty Agreement. The Fund contends because of the Agreement and Side Letter, once it requested its interest be redeemed, the Fund became a creditor as opposed to an equity security holder. (Appellant's Br., ECF No. 4, at 14-20; Appellant's Reply, ECF No. 10, at 2). I find this argument unpersuasive. The Guaranty Agreement is a contract between Trefoil and the Fund. The Fund "required the execution and delivery of this Guaranty by [Trefoil] ... to induce [the Fund] to make the Investment." (A1). The Agreement provided that if the Fund mails to Trefoil the Redemption Notice "simultaneously with its mailing to Spectrum, [Trefoil] hereby absolutely, irrevocably and unconditionally guarantees to [the Fund] ... and becomes surety for the payment to [the Fund] of the [Redemption Amount.]" (Id. ). Spectrum is not a party to that contract. The Guaranty Agreement provides the Fund recourse against Trefoil as surety if Spectrum failed to provide the Redemption Amount; it did not create an automatic right of redemption or convert its equity into debt as the Fund contends.
Additionally, to the extent the Fund contends Spectrum and Trefoil breached contracts and thus converted their equity investment into debt, I find this argument unpersuasive. In In re Telegroup, Inc. , 281 F.3d 133, 141-42 (3d Cir. 2002), the Third Circuit noted that "Congress enacted § 510(b) to prevent disappointed shareholders from recovering their investment loss by using fraud and other securities claims to bootstrap their way to parity with general unsecured creditors in a bankruptcy proceeding." The Telegroup Court further explained "because claimants retained the right to participate in corporate profits if Telegroup succeeded, we believe that § 510(b) prevents them from using their breach of contract claim to recover the value of their equity investment in parity with general unsecured creditors. Were we to rule in claimants' favor in this case, we would allow stockholders in claimants' position to retain their stock and share in the corporation's profits if the corporation succeeds, and to recover a portion of their investment in parity with creditors if the corporation fails." Id. at 142. Similarly, were the Court to hold in the Fund's favor, it would permit every investor to bootstrap an equity investment with a redemption right, and claim entitlement to recoup its full investment in line with general unsecured creditors if such redemption was not paid due to poor performance.
The Fund argues its "claim arises from the separate contractual provision in the Side Letter and the redemption request made thereunder." (Appellant's Br., ECF No. 4, at 14). The Fund's reliance on the Side Letter is misplaced. The Side Letter clarified the Guaranty and Suretyship Agreement, which, as noted supra , was a contract between the Fund and Trefoil, not Spectrum. Indeed, the Side Letter provided the "Valuation Policy" and stated that if the valuation was materially lower "then the [Fund] shall have the right to demand and obtain the immediate redemption of [the Fund's] entire interest in [Spectrum] in accordance with the Guaranty and Suretyship Agreement but unrestricted by any time limitations or blackout provisions or period set forth therein." (A13) (emphasis added). The Side Letter did not grant an automatic right of redemption against Spectrum; rather, it modified the Guaranty Agreement between the Fund and Trefoil. The Bankruptcy Court properly concluded that the Fund's interest should be subordinated because the Fund was an equity security holder, and its claim solely arose out of that purchase.
Moreover, the Partnership Agreement provides the procedure for requesting a redemption, and explicitly provides there was no automatic right of redemption: "No Partner shall have the right to require redemption of such Partner's Partnership Interest, and neither the Partnership nor its General Partner(s) shall have any obligation to cause any requested redemption to occur." (A63-64, at § 11.1, ¶ (e)).
IV. CONCLUSION
In sum, I conclude the Bankruptcy Court did not err in subordinating the Fund's claim. The Fund purchased an interest Spectrum and became a limited partner in that limited partnership, thus the Fund was an equity security holder. Because it was an equity security holder and its claim related to the purchase of securities, its claim was properly subordinated under Section 510(b). "[The Fund] would not have filed the proof of claim but for their purchase of the [Spectrum] shares." See In re Int'l Wireless Commc'ns Holdings, Inc. , 68 F. App'x at 278 ; see also In re Motels of America, Inc. , 146 B.R. 542, 544 (Bankr. D. Del. 1992) ("[I]t should be subordinated pursuant to 11 U.S.C. § 510(b), which in summary, subordinates claims of security holders .").
Therefore, I respectfully make the following:
RECOMMENDATION
AND NOW, this 30TH day of July, 2019, it is respectfully RECOMMENDED that the Fund's appeal be DENIED and the District Court AFFIRM the Order of the Bankruptcy Court.
The parties may file objections to this Report and Recommendation. See Local Civ. Rule 72.1. Failure to file timely objections may constitute waiver of any appellate rights.