Trading Places on Traded Claims: Debtor’s Avoidance Defense Follows the Claim

November 21, 2013

The United States Court of Appeals for the Third Circuit recently held that bankruptcy claims subject to disallowance under section 502(d) of the Bankruptcy Code will also be disallowed in the hands of an assignee or purchaser of the claim. In In re KB Toys, Inc., No. 13-1197 (3d Cir. Nov. 15, 2013), the Court of Appeals affirmed the District and Bankruptcy Courts’ decisions that issues of disallowance are not personal to a claimholder but actually run with the claim, and transferring the claim to someone else will not “wash” the claim. This holding directly conflicts with the Southern District of New York Court’s Enron holding, in which the New York court found that claim disallowance was particular to the holder of the claim and did not travel with the claim once it was sold. The KB Toys holding places the onus on claim purchasers to perform sufficient due diligence on the claims being purchased and the original claimholder before settling the trade.

The KB Toys case involved nine trade claims that were purchased by ASM Capital L.P. and its affiliate from nine different trade creditors pursuant to individual assignment agreements. Some of the assignment agreements contained restitution provisions standard in claim trading documents to protect purchasers from avoidable transfers, setoffs and other claim infirmities, though not all of them contained such language. Prior to the claim transfers, the trade creditors were listed on the debtors’ statement of financial affairs as having received payments from the debtors within 90 days of the commencement of the bankruptcy case. The bankruptcy Trustee filed preference actions against each of the original claimholders and obtained judgments in all the actions, but the judgments were uncollectable, because all of the original claimants had gone out of business by then. Accordingly, the Trustee filed objections against the transferred claims seeking to disallow them under section 502(d), because each original trade creditor had received a preference prior to transferring its claim.

The Bankruptcy Court agreed with the Trustee and disallowed the claims, holding that a claim purchaser holding a trade claim is subject to the same 502(d) challenge as the original claimant. The court stated that “[d]isabilities attach to and travel with the claim.” The District Court affirmed the Bankruptcy Court’s holding. On appeal, the Third Circuit analyzed the language of the section, the policy behind the section and the facts of the case and affirmed the lower courts’ decisions.

First, the Court of Appeals held that the language of 502(d) focused on claims that are disallowable, not claimants, and, as such, claims that fall into the 502(d) category must be disallowed no matter who holds them. Second, it found that, to hold otherwise, would incentivize claimants who had received an avoidable transfer to sell their claims and “wash the claim of any disability.” The original claimant would receive value for a claim that would be disallowed but for the transfer, and the purchaser would be able to share in the distribution of the estate’s assets. Such a result would be contrary to the goal of equitable distribution of estate assets which is the backbone of the Bankruptcy Code. Finally, the Court of Appeals noted that ASM was a sophisticated party who, by including the restitution language in some of the assignment agreements, clearly knew that the claims it was purchasing could be disallowed.1 As such, ASM’s conduct was consistent with the Court’s interpretation of 502(d).

The Third Circuit Court of Appeals also addressed the Enron ruling in which the District Court for the Southern District of New York held that 502(d) disallowance is personal to the claimholder and only travels with the claim if the claim is assigned, not sold. Enron Corp. v. Springfield Assocs., L.L.C. (In re Enron Corp.), 379 B.R. 425 (S.D.N.Y. 2007). According to the New York court, under state law, assignees stand in the shoes of assignors, and, thus, if the assignor has a disability asserting a claim, so will the assignee. The Third Circuit found the New York court’s reasoning unconvincing, first, because it disagreed that section 502(d) focused more on the claimant than the claim, and second, because the state law on which the New York court relied did not, in fact, make any distinction between assignments and sales

The secondary trading market has had trouble with the Enron holding since it was published, primarily because it is difficult to distinguish between claim sales and claim assignments. Neither state law nor the federal bankruptcy law distinguishes between the two methods of transfer. Moreover, standard distressed debt trading documents and typical claim trading agreements contain indemnification language to protect against claims that are disallowed because of setoffs or preferences. Unfortunately, in the KB Toys case, these protections were not sufficient, as the claimants who sold their claims and were obligated under the indemnification (or restitution) provisions were out of business. Still, had ASM reviewed the debtors’ schedules, it would easily have discovered that the claims it was purchasing were vulnerable to preference attack and could have price protected itself in negotiating the trade. The lesson to be learned from this case is that potential claim purchasers must perform due diligence on the claims they seek to acquire and the counterparties with whom they trade, as the case law, at least between New York and Delaware, may be changing on whether claim disallowance risks will travel with the claim and take up residence in the claim purchaser’s pockets. 

1 In fact, ASM had purchased one of the claims after the Trustee had already obtained a judgment on the claim, so it was put on notice that there was a disability attaching to the claim and should not be surprised when the claim was disallowed.

This article was originally published by Bingham McCutchen LLP.