Khan v. Barton (In re Khan)

Sympathy for the creditor arguably drove appeals court not to invoke subordination.

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Case Type:
Case Status:
No. 15-60002 - 15-60007 (6 related appeals) (9th Circuit, Jan 23,2017) Published
The Ninth Circuit held that the claim of a former shareholder with a fraud judgment against the principals of corporation was not subject to subordination under 11 U.S.C. § 510(b), and that the principals’ Chapter 13 cases were properly converted to Chapter 7 for bad faith.
Procedural context:
The bankruptcy court held that the former shareholder/creditor’s fraud judgment did not arise from the sale or purchase of equities and thus was not subject to equitable subordination under 11 U.S.C. § 510(b), and further granted creditor’s motions to convert Chapter 13 cases of the two judgment debtors to Chapter 7 due to fraud. The BAP affirmed, but on the grounds that 11 U.S.C. § 510(b) does not apply when the debtors are individuals. The Ninth Circuit affirmed the bankruptcy court ruling, and, rejecting part of the BAP’s ruling, held that § 510(b) applies when debtors are individuals, which followed the Ninth Circuit’s recent decision In re Del Biaggio, 834 F.3d 1003 (9th Cir. 2016).
The two debtors and creditor co-founded and co-owned a corporation. Creditor had a stroke and stopped participating in the management of the corporation. A state court judgment later held that the debtors fraudulently converted creditor’s shares and entered a money judgment in excess of $3 million. Prior to entry of the judgment, the debtors filed Chapter 13 petitions, and sought to subordinate creditor’s claim under § 510(b) as a claim arising from the purchase of securities, and to disallow the claim under § 502(b)(1). The Ninth Circuit held that the state court judgment for fraud and conversion did not arise from the creditor’s purchase of securities, in part because the fraud litigation was based on acts of conversion taken years after the stock was acquired. The Ninth Circuit did not reach the issue of disallowance, since it found subordination did not apply. The Ninth Circuit also held that the bankruptcy court did not clearly err when it found bad faith and did not abuse its discretion when it converted the debtors' Chapter 13 proceedings to Chapter 7 proceedings. Judge Rawlinson dissented from the conclusion of the majority that § 510(b) was inapplicable. Reviewing the authorities, the dissent finds that creditor's claims did “arise from a purchase or sale of securities” within the meaning of § 510(b).
Diarmuid F. O'Scannlain, Ferdinand F. Fernandez, and Johnnie B. Rawlinson

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