Southwest Update - In re: Caprock Oil Tools, Inc.

Claim Arising out of Equity Redemption is Subject to Mandatory Subordination in Bankruptcy

In In re: Caprock Oil Tools, Inc., 585 B.R. 832 (Bankr. S.D. Tex. 2018), the United States Bankruptcy Court for the Southern District of Texas determined that a former equityholder’s claim in respect of payments under a stock redemption agreement was subject to mandatory subordination in bankruptcy. The plaintiff, Wayne Hall (“Hall”), served as a vice president of Caprock Oil Tools, Inc. (“Caprock”), a supplier of drill bits used for oil and gas drilling and exploration, and was the owner of 177 shares of Caprock common stock. On January 1, 2010, Hall and Caprock entered into a Shareholder Agreement which, among other things, provided Caprock with the right to repurchase Hall’s shares of common stock upon his termination as an employee of Caprock, and dictated that the amount paid for the common stock would be separated into five equal annual installments. In January 2015, Caprock exercised its option to repurchase Hall’s equity, at which time Hall’s equity was valued at $1,783,228. Caprock sent Hall a check for the initial installment of $356,645.60, but failed to make any of its subsequent payments in respect of the repurchased equity. On April 2, 2017, Caprock filed for chapter 11 bankruptcy, and Hall filed a proof of claim in the amount of $1,479,870.94 in respect of the unpaid installments under the Shareholder Agreement. Caprock sought to subordinate Hall’s claim pursuant to 11 U.S.C. § 510(b), and Hall filed a response, with both parties seeking summary judgment. The Bankruptcy Court granted summary judgment in favor of Caprock.

In reaching its conclusion, the Bankruptcy Court cited § 510(b) of the Bankruptcy Code, which 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, or for reimbursement or contribution allowed under section 502 on account of such a claim, shall be subordinated to all claims or interests that are senior to or equal the claim or interest represented by such security.” After determining that Hall’s shares of common stock in Caprock were indeed a security, the Bankruptcy Court next evaluated whether Hall’s claim constituted a claim “arising from” a purchase or sale of a security. Hall argued that, once his stock was redeemed, he became the holder of a debt obligation rather than an equity interest, and was therefore entitled to the same status as a general unsecured creditor. The Bankruptcy Court disagreed, and noted that, had Caprock never elected to redeem Hall’s common stock, Hall would not have been able to claim status as a general unsecured creditor. The Bankruptcy Court stated “Hall’s ultimate claim against the company is rooted in an equity interest. Characterizing his debt on par with other general unsecured creditors upsets the hierarchy of the bankruptcy priorities and thus allows him a greater recovery than he would normally be entitled to at the expense of other creditors.” Since the facts of the case were not in dispute, the Bankruptcy Court held that Hall’s claim against Caprock was subject to subordination under § 510(b) of the Bankruptcy Code.