Restructuring

Contributed by Brian Wells
Bankruptcy claim traders have no choice but to rely on their transaction documents to determine which of a claim’s risks are assumed and which are left with a seller.  Their trust in those documents should be considerably stronger in the wake of Longacre Master Fund, Ltd. v. ATS Automation Tooling Systems Inc., a recent decision from the United States Court of Appeals for the Second Circuit.  In Longacre, the Second Circuit vacated a decision from the United States District Court for the Southern District of New York that had found, through loose contractual interpretation, an unexpected exception to the recourse provided upon impairment of the purchased claim.  Longacre illustrates some common pitfalls to be avoided when drafting an agreement to transfer a bankruptcy claim and gives some assurance that precautionary drafting can be trusted to protect both claim purchasers’ and sellers’ chosen allocation of risks.  But Longacre also serves as a reminder: any bankruptcy can give rise to surprises.
The transaction in issue arose from the bankruptcy of Delphi Automotive Services, at one time the largest auto-parts manufacturer in the U.S.  The parties to the transaction at issue in Longacre were ATS Automation Tooling Systems Inc., an unsecured trade creditor who had supplied Delphi with parts for its parts, and Longacre Master Fund, Ltd., a hedge fund founded by former Bear Sterns traders that used fundamental analysis to identify bankruptcy-claim bargains.  ATS traded the claim, which had a nominal value of about $2.2 million, to Longacre for 89 cents on the dollar.  The trade agreement included provisions designed to protect Longacre from risks related the claim’s treatment in bankruptcy, including disallowance under section 502(d) of the Bankruptcy Code.
Section 502(d) provides for the disallowance of a claim (meaning it will not receive a distribution) where the original holder has received, but not returned, a preferential transfer.  To successfully disallow a claim, the debtor must prevail in the related preference action and the recipient of the avoidable transfer must fail to return the property.  However, distributions can be temporarily withheld while the claim is subject to a pending objection, i.e. prior to a determination on the merits in the pending avoidance action.  Because preference actions can extend beyond the deadline for objecting to claims, a debtor sometimes files a motion to preserve its 502(d) objection prior to the conclusion of the preference action.
The risk of 502(d) disallowance is one of many bankruptcy-specific risks that are difficult for claim purchasers to calculate.  The original claimant is in a far better position to assess the likelihood that it will be sued in a preference action because it is aware of all of its prepetition transactions with the debtor.  Because claim traders generally prefer to focus on the likely distributions under a plan rather than speculate on a counter-party’s preference risk, trade agreements often include contractual mechanisms that allocate the risk of claim disallowance and impairment of the traded claim to the seller.
Longacre’s agreement with ATS had two principal protections from this risk.  First, ATS warranted that, to the best of its knowledge, the claim was not subject to a preference action or impairment.  Second, if the claim were “impaired,” broadly defined to mean offset, objected to, disallowed, or subordinated, Longacre could require ATS to refund the purchase price plus 10% interest accruing from the purchase date.  Furthermore, if a “possible impairment” were filed against the claim and was not successfully defended within 180 days, ATS would automatically have to refund the purchase price with interest.  As a result of these protections, upon any impairment, Longacre would be guaranteed a 10% return—meaning Longacre’s bet rested only on the timing and amount of distributions under a plan.
The bet appeared a winner.  Within months, Delphi had confirmed a plan paying unsecured creditors in full.  As a result, Longacre had secured an 11% return on its investment over a short period of time (recall that the claim was purchased for 89 cents on the dollar).  But the deal soured with the onset of the financial crisis, as Delphi could not get the requisite number of investors to participate in its plan.  As distributions were delayed for months, then years, creditor recoveries dwindled along with the estate.  An amended plan was eventually consummated, but because recoveries were less than 100% and had been significantly delayed, Longacre’s position became a loser.  Or so it seemed.
Unbeknownst to Delphi’s creditors, the debtor had filed hundreds of preference complaints in secret.  (The bankruptcy court allowed the complaints to be filed under seal because it seemed unlikely the complaints would be necessary.)  By doing so the debtor avoided the costs of pursuing such claims when a full recovery seemed likely, yet preserved them for use if the plan fell through.  Because ATS had received a $17.3 million payment during the preference window, it was named in one such complaint.  Years after the amended plan’s consummation, the debtor filed an omnibus objection to claims that were related to the until-then secret preference actions—including the action against ATS.  Specifically, the debtor sought an order to “preserve” its objections to the claims because, depending on the outcome of the preference actions, the claims “could potentially be subject to disallowance” pursuant to section 502(d).  The court issued an order preserving the objections.
Soon after, Delphi served ATS with the preference complaint.  ATS promptly acted to defend itself, but because of procedural disputes the preference action was not heard on its merits for months (i.e., after the 180 days provided for in the contract had run).  The debtor eventually conceded to ATS and voluntarily withdrew its objection (or reservation of objection) to the claim, leaving Longacre’s recovery intact, though still less than hoped for.
Where ATS found annoyance, Longacre found opportunity.  Pointing to the terms of their agreement, Longacre informed ATS that the omnibus objection was a “possible impairment” and that, because it had not been timely resolved, Longacre was entitled to a refund of the purchase price plus the interest that had accrued.  This interest amounted to $820,000, a sizeable figure for a claim purchased for $1.9 million and potentially enough to push Longacre’s trade out of the red and into the black.  When ATS balked at this demand, Longacre took ATS to court.
ATS promptly filed a motion seeking summary judgment from the United States District Court for the Southern District of New York.  The court concluded that the omnibus objection was not an impairment because it was not actually an “objection to” the claim—instead, it merely preserved the debtor’s right to object if it prevailed in the avoidance action.  Furthermore, the court found that because an actual 502(d) objection had never been filed, there was no “possible impairment” and the 180-day deadline had never been triggered.  Finally, in reliance on Enron Corp. v. Springfield Assocs., LLC, the court found that even if there had been an objection to the claim, the claim would not have been impaired because the claim had been sold.  (As we discussed previously, Enron held that 502(d) disallowance only affects a claim that has been assigned, as opposed to sold.)  Based on the foregoing, the court found that Longacre had no right to recover anything from ATS.
Longacre appealed from this decision to the United States Court of Appeals for the Second Circuit.  In a summary (i.e., nonprecedential) order, the Second Circuit vacated the district court’s decision.  Focusing on the precise wording of the contract, it concluded that Delphi’s objection easily qualified as a possible impairment.  The court pointed to the fact that Delphi’s motion stated it was “objecting to” the claim and that the bankruptcy court’s order stated the “objection” was preserved.  The Second Circuit found the district court’s distinction between an “objection” and an “objection that is effectively a reservation of rights” irrelevant, as the contract referenced “objections” generally without exclusions.
The Second Circuit also found that there was a material issue of fact as to whether ATS had breached its warranty that the claim was not subject to an impairment or preference action.  It questioned the district court’s conclusion that, because the transaction was a sale and not an assignment, ATS could not have expected impairment.  It pointed out that at the time of the agreement ATS could not have been so confident as to the agreement’s characterization—the agreement was called an “assignment of claim” and in multiple places referenced the sale and the assignment of the claim.  In light of that uncertainty, as well as ATS’s knowledge of the $17.3 million payment in the preference window, the Second Circuit found the district court’s conclusion untenable.  In vacating the finding, the Second Circuit was very careful to avoid endorsing the Enron sale/assignment distinction, which has yet to be tested at the circuit level.
Although this decision came as an unexpected blow to ATS, claim traders should take comfort that the Second Circuit chose to strictly adhere to the terms in the trade agreement.  The decision reassures traders that they can rely on contractual terms allocating impairment risk, enabling them to pick and choose which risks they want to assume.  The decision also emphasizes the need for drafters to carefully identify whether a claim transfer is made by assignment or sale.  As long as Enron remains the governing law, lack of clarity in this regard can turn a hedged bet into a gamble.