Contributed by Brian Wells
The recent decision by the United States Bankruptcy Court for the District of Delaware in KB Toys serves as a reminder for the unwary that claims trading is not a game and sends a message to the claims trading community: Buy at your own risk.
The decision addresses section 502(d) of the Bankruptcy Code, which prevents distributions on account of “any claim of any entity” that has received but has not returned a preferential transfer. Specifically, the court considered whether a claim would be subject to disallowance once the original holder has sold it to a third party. Courts in the Southern District of New York have split on the issue. Two bankruptcy judges found that claims can be disallowed whether or not they remain in the possession of the original holder, but a later district court judge held that 502(d) cannot disallow claims once they have been sold (as opposed to assigned) to a third party. In KB Toys, Judge Carey weighed in on the issue, holding that the disability imposed by section 502(d) follows claims to any future owner. As a result, in Delaware parties cannot collect on account of a claim where the original holder has an unreturned preferential transfer.
Although KB Toys, the “toy store in the mall,” filed for chapter 11 in 2004, it was not until after confirmation that the newly minted KBTI trust began investigating and pursuing avoidance actions for the benefit of its creditors. Many of its targets were named in the debtor’s Statement of Financial Affairs (“SOFA”), a document issued during the bankruptcy that included a “preference section” identifying parties that likely received payments during the 90 day preference window. As the trustee filed actions against the identified parties, it began collecting default judgments. The trade creditors, it turned out, had sold their claims to ASM, and having thus been paid were not concerned with defending the trustee’s preference actions. Time after time, the trustee sued an identified trade creditor, only to find that the creditor’s claim had already been sold to ASM. (On one occasion, ASM purchased an identified claim after the trustee had brought its preference action.) Nine judgments later, the trustee—without a single returned preference to show for these actions—set its sights on ASM. The trustee sought to disallow each of ASM’s claims for which it had a corresponding judgment against the original claimant. If the trustee prevailed, ASM stood to lose its entire investment in the purchased claims. This time, the trustee wound up with a fight.
Their dispute revolved around the statutory language of 502(d), with both parties claiming that the provision came down in their favor by disallowing “any claim of any entity” that kept preferences. To ASM, this language tied disallowance to the claimant, so that only claims in the hands “of any entity” that received, but did not return, an avoidable transfer would not receive a distribution. Conversely, the trustee read this to mean that disallowance applied to “any claim” originally held by the preference recipient, even if it had later been purchased by a third party.
The bankruptcy court framed the issue as whether the purchaser of a trade claim holds that claim subject to the same rights and disabilities, including challenge under section 502(d), as is the original holder of the claim. Judge Carey quickly moved beyond plain meaning, noting that the Metiom, Enron I, and Enron II courts had marshaled plain meaning arguments and yet come out with opposite conclusions. He then turned to the origin of section 502(d), identified in the legislative history as section 57(g) of the Bankruptcy Act of 1898.
To Judge Carey, section 57(g) clearly stated that disallowance follows claims by identifying “the claims of creditors” who had made a preferential transfer, and mandating that they, i.e. the claims, “shall not be allowed” unless the creditor returned the preferential payment. The bankruptcy court bolstered this reading of section 57(g) with pre-Code case law, which found, generally, that assignees and sureties stood in the shoes of the party from whom they had purchased their claim, meaning that the purchaser could collect only if the original claimant could as well. The court noted that though these cases addressed section 502(d)’s statutory predecessor, they remained good law because there was no indication that Congress intended to change the provision, either in the form of legislative history or explicit changes in the provision’s language.
Turning to more recent cases, the court noted that the judges in Metiom and Enron I had also interpreted section 502(d) consistent with pre-Code case law so that disallowance follows the claim. Both Judge Gonzales and Judge Drain reasoned that section 502(d) gives the estate an affirmative defense to a claim, and that this defense cannot be destroyed by transferring the claim. In addition, they found that transferring a claim merely substitutes one party for another and thus would not give the transferee greater rights. The Enron I court also noted that the basic policy of 502(d), which is to prevent the recipient of an avoidable transfer from collecting unless the recipient returns the avoidable transfer, would be severely undercut if such creditors could merely sell their claims and essentially receive a distribution.
Judge Carey also criticized Enron II, in which the United States District Court for the Southern District of New York overturned Enron I and held that, where a claim is sold, section 502(d) disallows only the claims in the hands of the party who received the avoidable transfer. Judge Carey took issue with the Enron II court’s holding that 502(d) applied to the transferee of assignments but not sales, and that whether something is an assignment or sale turns on the substance of the transaction. He noted that these terms are not easily distinguishable, are not defined anywhere in the Code, and that this aspect of the decision has been widely criticized. Judge Carey also rejected the Enron II argument that a contrary ruling would upset the distressed debt markets, describing it as a “hobgoblin without a house to haunt.” He noted that claims trading has continued to grow in size, scope, and sophistication and that today’s traders are highly sophisticated entities capable of due diligence and fully aware of the risks of avoidance actions.
Turning to the case at hand, the court noted that ASM could have discovered the potential disallowance with very little diligence as it had been put on notice by the SOFA. Furthermore, the court found that the presence of indemnity provisions in four of the nine contracts showed that ASM had sufficient understanding and leverage to negotiate such provisions, and thus concluded that in the other contracts ASM chose to bear the risk of disallowance. To rule otherwise, the court found, would force the estate to be ASM’s insurer. Finally, the court rejected ASM’s argument that their purchase was made in “good faith,” finding that the protections of a good faith purchaser do not extend to a claims purchaser who knows that the debtor is in bankruptcy, where claims can be allowed or disallowed under the Bankruptcy Code and case law.
As a result of this decision, purchasers of claims from Delaware bankruptcy cases now bear the risk that purchased claims may be rendered worthless under section 502(d) for reasons beyond their control, i.e. because the transferor of the claim received an avoidable transfer and has refused to return it. Among other things, purchasers can mitigate this risk through heightened due diligence and the use of indemnification clauses in their purchase agreements.