Recent Bankruptcy Court Decision Finds Control Liability Claim Ranks Pari Passu With Claims Of Other Unsecured Creditors

A recent Delaware bankruptcy court decision clarifies when a control liability claim against a debtor for alleged violations of federal and state securities laws will be statutorily subordinated under section 510(b) of the Bankruptcy Code. The court in In re Washington Mutual, Inc., No. 08-12229 (MFW), 2011 WL 6739076 (Bankr. D. Del. Dec. 20, 2011), held that Tranquility Master Fund, Ltd. had properly asserted a general unsecured claim against Washington Mutual, Inc. for control person liability when one of WMI’s subsidiaries allegedly sold residential mortgage backed securities through offering materials containing material misrepresentations and omissions. Significantly, the court analyzed and rejected WMI’s argument that Tranquility’s control liability claim should be statutorily subordinated under section 510(b) of the Bankruptcy Code, which prevents a shareholder’s interest in the debtor from rising to the level of a creditor, because section 510(b) only applies to securities issued by the debtor. The decision paves the way for control person liability claims against debtors to rank pari passu with claims of other unsecured creditors. Because subordinated creditors often receive no meaningful recoveries, and given the potential magnitude of claims at issue, the decision has important implications for creditors of debtors with exposure to control liability claims.