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Shareholder bankruptcy rights may increase

The Ninth Circuit Court of Appeals recently issued a ruling that may improve shareholders' opportunities for receiving a meaningful distribution of funds from corporations undergoing business bankruptcy, if they were possibly defrauded or injured by their ownership of securities. Even though this court has jurisdiction over federal bankruptcy appeals in the western United States, federal courts in the rest of the country and those governing Wisconsin may adopt the court's reasoning in these cases.

Shareholders of businesses undergoing bankruptcy were customarily afforded low priority with distribution rights and remedies. Two obstacles in bankruptcy proceedings often prevented them from obtaining any significant distribution.

Under the Bankruptcy Code's absolute priority rule, equity holders may receive a monetary or stock distribution associated with a Chapter 11 bankruptcy plan or Chapter 7 bankruptcy liquidation when every other senior class of secured and unsecured creditors was fully paid-off. This required the bankrupt business to have sufficient assets to pay all its debts before making shareholder distributions.

Secondly, courts interpreted the Bankruptcy Code as placing claims for the purchase and sale of securities below or subordinated to all unsecured creditors of the business in bankruptcy. This occurred even when there was a breach of contract, fraud, misrepresentation or other violations of securities laws. These rulings eliminated the shareholders' rights in a cause of action related to the sale and purchase of securities.

In other words, it was often impracticable for shareholders to pursue legal claims where a wrongdoer was engaged in a commercial bankruptcy proceeding. Accordingly, management and controllers of businesses under financial distress acted with impunity when they violated securities laws.

In this recent decision, the court ruled that a creditor's claim might not be subordinated under the Bankruptcy Code because the claims did not come from the earlier acquisition of securities. It found that this obligation was associated with a California state court judgment entered against the bankrupt debtors after the stock purchase when the debtors effected the conversion. The stock conversion had no relationship with the purchase or sale of these securities, according to the court.

This case involves only one of the complex business bankruptcy issues facing debtors. Businesses should seek legal representation to help assure their rights are protected.

Source: Observer, "Shareholders attain new rights in bankruptcy proceedings," Charles M. Tatelbaum, Feb. 22, 2017

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