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The Delaware Bankruptcy Court (“Bankruptcy Court”) recently issued a ruling that provides additional clarity regarding the treatment of “appraisal rights” in bankruptcy proceedings and the scope of section 510(b) of the Bankruptcy Code.  In In re RTI Holding Company, LLC, et al., (decided August 4, 2021) the Bankruptcy Court subordinated the general unsecured claims filed by holders of “appraisal rights” in respect of the debtors’ equity (the “Claimants”).  In general, “appraisal rights” entitle shareholders of a target company to demand that the purchase price of their shares be determined by a court after an independent valuation.  A successful exercise of such rights would require the purchaser to acquire the shares of perfecting shareholders at an enhanced price (or later fund the difference if the merger had been completed).

The debtors were a number of entities related to the Ruby Tuesday restaurant chain, including Ruby Tuesday, Inc. (“RTI”). In late 2017 the company proposed a “going private” transaction pursuant to which RTI would be merged with a subsidiary. The transaction priced RTI’s stock at $2.40 per share. The Claimants purchased shares of RTI with the expectation that they would be acquired in the merger. Following their purchase of the shares, and in accordance with Georgia law, the Claimants rejected the offer and demanded payment in excess of $5.00 per share, validly perfecting their appraisal rights. In April 2018, RTI commenced an appraisal action, seeking a determination that the fair value of shares was less than or equal to the proposed purchase price (the “Appraisal Action”). The merger was later consummated while the Appraisal Action remained pending. In October 2020, RTI and the other debtors commenced their bankruptcy cases and further activity in the Appraisal Action was stayed.

The Claimants filed general unsecured claims in the bankruptcy cases. The debtors filed a plan of reorganization which subordinated the Claimants’ claims to those of other unsecured creditors (and provided for no distribution on account thereof).  Section 510(b) of the Bankruptcy Code provides that “… 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”  (emphasis added).  The language of section 510(b) is ambiguous, leaving courts to interpret the required nexus between the ownership of the security and the nature of the related claim.  See Baroda Hill Inv. V. Telegroup, Inc., 281 F.3d 133 (3d Cir. 2002).

After reviewing the limited case law, the Bankruptcy Court applied a “but for” test.  Would the claims exist but for the Claimants’ prior ownership of the shares? The court determined that they would not – the claims arose under a Georgia law that is available only to shareholders, and would not exist but for the ownership of the stock. But the court went further. It explained that subordination of a claim must also serve the purpose of Section 510(b) of the Bankruptcy Code. This section is intended to prevent shareholders from achieving recovery as creditors, eliminating the risk inherent in equities. In its consideration, the court focused on the Claimants’ acquisition of the shares following the announcement of the pending merger. The court believed that this timing exhibited their intent to assume the risks of an equity holder, and not those of a creditor.  The court determined that, if it rejected subordination, it would effectively be ruling that the Claimants’ assertions of value were correct, eliminating the risk that the court would have ruled in favor of RTI.  Such a result, the court explained, would be contrary to the intent of section 510(b).

The ruling in RTI Holding Company provides guidance to market participants regarding the scope of section 510(b), particularly in the context of appraisal rights. Subordination of a claim under this section is appropriate (i) if the claim would not have arisen “but for” the ownership of securities and (ii) such subordination furthers the policies of section 510(b). Both prongs leave room for interpretation.  In the instant case, for example, had the Appraisal Action concluded prior to the bankruptcy, resulting in a judgment in favor of the Claimants, the Bankruptcy Court may have come to a different conclusion. In addition, Bankruptcy Court may also have come to a different conclusion had the Claimants held the shares prior to the announcement of the merger. Market participants will have to continue to navigate murky waters awaiting the next challenge to the subordination of claims relating to appraisal rights.