On May 4, 2012, in the KB Toys case, Bankruptcy Judge
Kevin J. Carey of the United States Bankruptcy Court for the
District of Delaware disallowed certain trade claims purchased on
the secondary market because the sellers of those claims had not
repaid their preference liability.1 In so ruling, the
court concluded that Section 502(d) of the Bankruptcy
Code—which provides for the disallowance of any claim of
any entity that is a transferee of a preferential or fraudulent
transfer unless it has repaid the transferred amount to the
bankruptcy estate—imprints a "taint" on the
trade claim that travels with the claim into the hands of
subsequent purchasers.2 The court rejected the analysis
from 2007 of the United States District Court for the Southern
District of New York in Enron that concluded on appeal (in
reversing the bankruptcy court) that disallowance pursuant to
Section 502(d) created a "personal disability" that did
not transfer with claims when they are sold to good faith
purchasers on the open market.3
The Bankruptcy Court's Analysis
ASM Capital, L.P. and ASM Capital II, L.P. (collectively,
"ASM") purchased certain trade claims from trade
creditors (the "Original Trade Creditors") whose
provision of goods or services gave rise to the claims. The
liquidating trustee brought preference actions against the Original
Trade Creditors—in most cases after but in one case
before ASM purchased the claims—and obtained default or
summary judgments that established the Original Trade
Creditors' preference liability. The trustee then sought to
disallow the trade claims held by ASM pursuant to Section 502(d) on
the grounds that the previous holders of those claims, the Original
Trade Creditors, had not repaid their preference
liability.4
The bankruptcy court framed the issue as "whether the
purchaser of a trade claim holds the purchased claim subject to the
same rights and disabilities, and is subject to Bankruptcy Code
§ 502(d) challenge, as is the original holder of the
claim."5 The court initially focused on the
language of Section 502(d), which provides in relevant part:
"[T]he court shall disallow any claim of any entity . . . that
is a transferee of a transfer avoidable under section . . . 547 . .
. of this title, unless such entity or transferee has paid the
amount . . . ." Because courts had disagreed about the plain
meaning of this section,6 the bankruptcy court also
looked to the legislative history and rationale of the previous
cases to guide its analysis.
With respect to the legislative history, the bankruptcy court
determined that Section 502(d) of the Bankruptcy Code is derived
from Section 57g of the Bankruptcy Act of 1898 (repealed 1978). The
court interpreted Section 57g as establishing the basis for
allowance or disallowance of particular
claims—focusing on the claims
themselves as opposed to the holders of the claims. This supported
its thesis that Section 57g of the old Bankruptcy Act (and thus its
successor, Section 502(d) of the current Bankruptcy Code) provided
a disability that traveled with the claim from seller to
buyer.7
The bankruptcy court also found persuasive two New York bankruptcy
court opinions—In re Metiom and the bankruptcy
court's opinion (subsequently reversed) in Enron. The
bankruptcy court adopted the Metiom court's view that
Section 502(d) provided a defense to the claim that "cannot be
altered by the claimant's subsequent assignment of the claim to
another entity . . . ."8 Rather, the prospective
assignees must consider these possible defenses when they negotiate
the terms of assignment of the claims.9 The bankruptcy
court also extensively quoted the Enron bankruptcy
court's opinion and highlighted its view that a transfer of a
claim does not change the character of the claim itself, but rather
merely substitutes parties.10
Rejection of the District Court's Enron opinion from the Southern District of New York
The Bankruptcy Court in the KB Toys case then turned
its analysis to the district court opinion in Enron. It
first recognized that, based on its plain reading, the district
court ruled that Section 502(d) imposes a personal disability on
the claimant—not the claim—and thus the
personal disability does not travel with the claim to a new holder.
In addition, the Enron district court opined that the
purpose of Section 502(d) "would not be served if a claim in
the hands of a claimant could be disallowed even where the claimant
never received the preference to begin with, and as a result, could
not be coerced to return it."11
The KB Toys court then discussed how the Enron
district court buttressed its opinion with an analysis that
distinguished between an "assignment" of a claim and a
"sale" of a claim. When a claim is assigned, the assignee
stands in the shoes of the assignor, and is subject to all the
defenses that could have been asserted to defeat the claim in the
assignor's hands. By contrast, when a claim is sold, the buyer
takes free of any personal disabilities of the seller.12
Thus, whether the disability of Section 502(d) travels with the
claim to the next holder turns on whether the claim is assigned
(disability travels) as opposed to sold (disability does not
travel). The Enron district court thus stressed that
"sales of claims on the open markets are indisputably
sales."13
The KB Toys bankruptcy court fundamentally disagreed with
the Enron district court's "assignment"
versus "sale" analysis. It first noted that these
concepts are not easily distinguishable and that neither is defined
in the Bankruptcy Code. Next, to emphasize its rejection of that
opinion, it cited multiple articles from commentators that
essentially contended that the assignment-versus-sale analysis not
only introduced a novel distinction that ignores the
interchangeability of those terms, but also did not provide any
clear guidance for market participants going forward. And even if
one could "distinguish between an assignment and a sale, the
exercise, in this context, is unhelpful and unrevealing of the
appropriate outcome."14
Having rejected the assignment-versus-sale analysis, the bankruptcy
court turned to concerns of potential disruption of the distressed
debt markets. In this regard, the court took the view that claims
traders are sophisticated players that are capable of performing
due diligence, but in any event should understand and account for
the risk that avoidance actions could give rise to a defense to a
claim. Indeed, the court stated that the notion that disallowance
of claims in the hands of a purchaser under Section 502(d) would
upset the distressed debt market is "a hobgoblin without a
house to haunt."15
The court then concluded that ASM's claims must be disallowed
because of the existing preference liability of the Original Trade
Creditors. It noted that the debtors' statement of financial
affairs had listed the prepetition payments during the preference
period, thereby putting ASM on constructive, if not actual, notice
of the Original Trade Creditors potential preference liability and
corresponding risk of disallowance of the trade claims under
Section 502(d). ASM could have uncovered this risk with a modicum
of due diligence and priced the trades accordingly or obtain, as it
did in some of the trades, an indemnity from the Original Trade
Creditor.16
The Bottom Line
The Delaware bankruptcy court has found that a buyer of trade
claims takes subject to the disability of Section 502(d). If a
trade claim is subject to disallowance in the seller's hands
based on its failure to return an avoidable transfer, then the
buyer will take the trade claim subject to that same risk arising
from the seller's preference liability. Claims buyers will have
to rely on their own due diligence efforts and indemnities in the
purchase agreement, or simply take the risk that a trade claim
might be disallowed under Section 502(d) (and discount the price
accordingly).
Of critical importance, the Enron district court ruled
that the assignment-versus-sale analysis also applied when a claim
that was subject to equitable subordination in the hands of a bad
actor was transferred to another party that had not engaged in
misconduct. In other words, the Enron district court held
that a good faith purchaser of claims takes free of any equitable
subordination risk that may have existed while the seller held the
claims.17 Given the Delaware bankruptcy court's
fundamental disagreement with the Enron district
court's assignment-versus-sale analysis and given its overall
embrace of the reasoning of the Enron bankruptcy court
(with little deference paid to the Enron district
court's criticism of that decision), one could reasonably
expect that the Delaware bankruptcy court would likewise follow the
Enron bankruptcy court and hold that claims in the hands
of a buyer may be equitably subordinated to the same extent as they
would be in the hands of the seller.
That said, the bankruptcy court did allow that its analysis applied
only to trade claims purchased from the
original holders and it made "no determination about whether
the same result should ensue in circumstances involving other types
of transferred claims." It specifically noted that drafters of
the Bankruptcy Code often give special protection to transfers in
"public markets."18 Moreover, part of its
analysis concerned the constructive (if not actual) notice imputed
to the buyer of the trade claims given the information that was
available in the schedules. Thus, the door remains open for the
Delaware bankruptcy court to reach a different result with respect
to (i) transfers of notes, bonds, bank debt and other such
instruments, and (ii) transfers that occurred prepetition or in
other circumstances where information concerning the disability was
not available.
Footnotes
1. In re KB Toys, Inc., 2012 WL 1570755 (Bankr. D. Del. May 4, 2012).
2. Id., at *11.
3 Id. at *9-11 (analyzing Enron Corp. v. Springfield Assocs., LLC (In re Enron Corp.), 379 B.R. 425 (S.D.N.Y. 2007)). WilmerHale represented the Loan Syndications and Trading Association, the Securities Industry and Financial Markets Association and the International Swaps and Derivatives Association as amici curiae in the Enron proceedings before the district court.
4 KB Toys, at *1-2.
5 Id., at *2.
6. Id., at *3 (comparing In re Metiom, Inc., 301 B.R. 634, 642-43 (Bankr. S.D.N.Y. 2003) and the bankruptcy court's decision in Enron Corp. v. Avenue Special Situations Fund II, LP (In re Enron Corp.), 340 B.R. 180, 194 (Bankr. S.D.N.Y. 2006) with the district court's reversal of the bankruptcy court in Enron, 379 B.R. at 443.
7 Id., at *5.
8. Id., at *7 (quoting In re Metiom, 301 B.R. at 642-43).
9 Id.
10 Id., at *7-8 (analyzing In re Enron, 340 B.R. at 198-99).
11. Id., at *9 (quoting In re Enron, 379 B.R. at 443).
12. Enron, 379 B.R. at 435-36.
13 Id., at 446 n. 104.
14. KB Toys, at *9.
15 Id., at *10.
16 Id.
17 Enron, 379 B.R. at 442.
18 KB Toys, at *10 n.14.
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