United States: Ending The 10b-5 Hold-up: Aéropostale Rejects Debtor's Attack On Traders

In an August 2016 decision in the Aéropostale bankruptcy case,¹ the Bankruptcy Court for the Southern District of New York held that allegations of insider trading did not justify equitable subordination and were not "cause" to deny a credit bid. The decision helps bridge the gap between the treatment of insider trading allegations in bankruptcy court and their treatment everywhere else. If followed, the decision would also eliminate the sometimes extortionate practices employed by issuers, under the guise of enforcing the anti-fraud provisions of the securities laws, to frustrate the exercise of creditor rights in the bankruptcy process.

For more than six decades, it has been black letter law outside of bankruptcy court that an issuer cannot sue those trading in its own securities under Securities Exchange Act § 10(b).² Only a purchaser or seller in the class of traded securities has standing to pursue a private right of action under Rule 10b-5.³ The classic Supreme Court case of Blue Chip Stamps v. Manor Drug Stores remains the law of the land in this regard, despite suggestions that its holding be modified to allow issuers and others who have not traded in the securities to pursue non-monetary relief under the Rule.⁴

In bankruptcy cases, however, debtors and other parties seeking to extort concessions from bondholders often use accusations of insider trading to threaten sanctions against the traders.⁵ These allegations are used for pure tactical advantage. The debtor has not been harmed. The shareholders have not been harmed. Neither would have standing outside of bankruptcy court to sue under 10b-5. Invariably, no bondholder who might have been harmed – no buyer or seller of the (allegedly) improperly traded security – appears to complain.⁶

Yet the mere allegation of insider trading – whether founded or not – threatens potential civil and even criminal sanction, which in the contemporary legal environment can have disastrous consequences for funds and other traders.

This happened most notoriously in Washington Mutual,⁷ where the court initially held that a committee of equityholders had standing to complain of alleged insider trading by bondholders. This initial holding led to five months of litigation and a settlement providing material value to the shareholders on the condition that the court vacate its original holding so as to eliminate the precedent.⁸

Aéropostale is a useful corrective against this behavior. In Aéropostale, funds together with their affiliates, including one entity that was a supplier to the debtors (collectively the funds and related entities, the "Lender Related Entities"):

• agreed to supply a substantial percentage of the debtor's inventory, conditioned on minimum liquidity,
• extended secured credit to the debtors, subject to the same liquidity condition,
• held material amounts of the debtor's stock, and
• had representatives on the board.

Aéropostale's liquidity cratered, and certain of the Lender Related Entities froze their credit line, disposing of their stock at the same time. Aéropostale and certain subsidiaries (the "debtors") filed for Chapter 11 and moved to sell substantially all of their assets. The debtors sought to equitably subordinate the claims of the Lender Related Entities on the grounds that certain of the related funds had sold their stock in violation of Rule 10b-5, and argued that such alleged violation constituted "cause" to deny the funds the right to credit bid their credit-line claims.

Bankruptcy Judge Lane ruled against the debtors on both points. On equitable subordination, he held that insider trading was not sufficient to justify equitable subordination without "evidence in the record to establish tangible harm to the debtors or the creditors sufficient of equitable subordination." The court reasoned:  

The Debtors argue that by selling their stock in Aéropostale, [the Lender Related Entities] undermined the integrity and public's regard of the Debtors ... But this is not the type of harm that courts are concerned about when determining whether to equitably subordinate a claim. The cases cited by the Debtors ... focus on the integrity of the marketplace and whether there has been harm from a public policy point of view and are thus not relevant to the inquiry before this Court. Once again, there has been no evidence of a harm here that could serve as a basis for relief in this bankruptcy case.¹⁰

Judge Lane also questioned whether the Lender Related Entities did in fact "misappropriate" the debtors' non-public information when, in fact, the debtors had permitted their own officers to trade during the same period with the same information.¹¹

Finally, Judge Lane rejected the debtors' argument that insider trading constituted "cause" sufficient to deny the Lender Related Entities the right to credit bid their secured claims under Section 363(k). There was no allegation that the funds had obtained any unfair advantage over the sale process, and the evidence showed that the funds had not interfered in the sale process. Insider trading was therefore irrelevant.¹²

It is to be hoped that other courts pay attention to Aéropostale. If insider trading provides no cause of action to issuers outside Chapter 11, then, absent evidence of damage to the debtor, insider trading should not provide any cause of action inside Chapter 11.¹³ The Supreme Court limited suits under Rule 10b-5 to purchasers and sellers to avoid other plaintiffs, including issuers, from generating "largely groundless claim[s] ... representing an in terrorem increment of the settlement value."¹⁴ Those concerns apply equally to the use of insider trading allegations by uninjured debtors and other non-parties to the relevant trades or trading markets.¹⁵/p>

Footnotes

1 In re Aéropostale, Inc., 555 B.R. 369 (Bankr. S.D.N.Y. 2016).
2 Birnbaum v. Newport Steel Corp., 193 F.2d 461 (2nd Cir. 1952), endorsed in Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 731-48 (1975) ("Blue Chip Stamps").
3 An issuer may sue only if it itself was a purchaser or seller of the relevant security. Blue Chip Stamps, 421 U.S. at 738.
4 See Chaffee, Beyond Blue Chip: Issuer Standing to Seek Injunctive Relief Under Section 10(b) and Rule 10b-5 Without the Purchase or Sale of a Security, 36 Seton Hall L. Rev. 1135 (2006) (arguing that issuers should be allowed to seek an injunction notwithstanding Blue Chip Stamps).
5 In the Chapter 11 case of Service Merchandise, Inc., the debtor accused a committee member of trading on inside information in retaliation for the creditor's objection to the debtor's motion to extend exclusivity.  The debtor never alleged any damage or, indeed, how the inside information could have been material, since prices declined dramatically after the trades. In the Chapter 11 reorganization of Todd Shipyards, the debtor tried to lever its largest creditor into concessions by accusing the creditor of using "material" non-public information to buy debentures, even though the so-called material information was negative.
6 Our searches have disclosed no reported opinion dealing with a securities claim brought by one bondholder against a bondholder in the same class for insider trading in that class.  There are a few – very few – SEC enforcement actions.
7 In re Washington Mutual, Inc. 461 B.R. 200, 254-67 (Bankr. D. Del. 2011).
8 In re Washington Mutual, Inc., 2012 Bankr. LEXIS 895 at *52-59 (Feb. 2013); see especially *59: "The portions of the September Order and September Opinion that the Motion seeks to vacate are fact-specific, unique to this bankruptcy, and are non-binding on other courts."
9The quotation is from Benjamin v. Diamond (In re Mobile Steel Corp.), 563 F.2d 692, 700 (5th Cir. 1977).
10 In re Aéropostale, Inc., 555 B.R. 369 at *109-110, text between notes 26 & 27 (Bankr. S.D.N.Y. 2016).
11 Id. at *113, text at note 27.
12 Id. at *117-23, text between notes 29 and 31.
13 The Third Circuit, in Citicorp Venture Capital, Ltd. v. Committee of Creditors (In re Papercraft), 160 F.3rd 982 (3rd Cir. 1998) and 323 F.3rd 228 (3d Cir.), cert. denied, 540 U.S. 825 (2003), subordinated claims acquired by a major shareholder using non-public information obtained by its representative on the debtor's board of directors. Judge Lane properly distinguished Papercraft on the ground that the bankruptcy court found that the shareholder's claim buying had damaged the debtor and provided the shareholder/creditor with unfair advantage over other creditors.
14 Blue Chip Stamps, 421 U.S. 723, 741 (1975).
15 See Viking Associates v. Drewes, 120 F.3rd 98, 102 n.4 (8th Cir. 1998).  In Viking, insiders – the debtor's children – withheld information from a Chapter 7 trustee while they bought up all claims against the debtor's estate.  The Eighth Circuit reversed the bankruptcy court's order rescinding the claims purchases. "The wronged parties could have objected [to the transfers] to the Bankruptcy Court, or could have pursued their remedies under nonbankruptcy law, by suing to rescind the transfer of the claims in any court ... with jurisdiction.  The claims transferors have taken neither of these steps. We think people should be allowed to decide for themselves whether to seek redress for an alleged injury."

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