Third Circuit Holds that Transferred Trade Claims Remain Subject to Disallowance under Section 502(d)

Contributed by Edward Wu
The Third Circuit recently affirmed a decision by the United States District Court for the District of Delaware in the case of In re KB Toys Inc. which is of significance to the field of distressed debt investing.
The involvement of distressed debt investors in bankruptcy cases has increased over time.  The objectives of such investors in purchasing claims in bankruptcy cases range from simply seeking an eventual distribution in excess of the purchase price of the debt to more sophisticated endeavors, such as seeking to influence the plan confirmation process or to control the reorganized debtor.  Whatever the motivations, such endeavors are not without risk as the debtor or other parties-in-interest may seek to disallow the purchased claims.
The issue in KB Toys was whether a trade claim that is subject to disallowance under section 502(d) of the Bankruptcy Code in the hands of the original claimant is similarly disallowable in the hands of a subsequent transferee.  In essence, section 502(d) provides that a bankruptcy court shall disallow “any claim of any entity” that has received an avoidable transfer (such as a preference or a fraudulent conveyance), unless the avoidable transfer is returned to the estate.
After the chapter 11 cases of KB Toys commenced, certain of the debtors’ trade creditors sold their claims to distressed debt investors ASM Capital, L.P. and ASM Capital II, LLP.  The liquidating trust established pursuant to the debtors’ confirmed chapter 11 plan brought preference actions against each of the original trade creditors and obtained a judgment in each case.  The judgments, however, were uncollectable because the trade creditors against whom the judgments were obtained had gone out of business.  The liquidating trust then sought to disallow the trade claims purchased by ASM pursuant to section 502(d).  The bankruptcy court granted the liquidating trust’s claims objection, which was upheld on appeal to the district court.  An appeal to the United States Court of Appeals for Third Circuit ensued.
The Third Circuit began its analysis by examining the plain language of section 502(d), and in particular, the portion of the statute providing for the disallowance of “any claim of any entity” that received an avoidable transfer.  Based on its interpretation that the statute “focuses on claims—and not claimants,” the Court held that “claims that are disallowable under §502(d) must be disallowed no matter who holds them.”
The Court’s holding was further supported by an in-depth analysis of several policy considerations.  The Court explained that a contrary result would negatively impact the administration of bankruptcy cases by creating a loophole that would permit and incentivize creditors to avoid disallowance under section 502(d) through transferring their claims for value to another party who may then receive distributions on account of the claim.  The loophole would not only decrease the distributions to other holders of allowed claims but it would also deprive the debtor of the leverage that section 502(d) exerts on creditors to return avoidable transfers.  While ASM argued that a claim purchaser should not bear the risk that an avoidable transfer is not returned by the original claimant, the Court disagreed.  Claim purchasers, according to the Court, voluntarily chose to take part in the bankruptcy process and are typically sophisticated entities that are in a position to perform due diligence to analyze and protect against the risk of disallowance.  In addition to negotiating a purchase price that accounts for the risk of disallowance, the Court stated that claim purchasers may shift risk back to the original claimant through an indemnity clause.
The Third Circuit noted that its ruling was consistent with the conclusion reached by the United States Bankruptcy Court for the Southern District of New York in the cases of In re Metiom, Inc. and In re Enron, the latter of which was reversed.  In Enron, the district court held on appeal that disallowance under section 502(d) is a personal disability of a particular claimant and not an attribute that runs with the claim unless, pursuant to state law, the transferee took the claim by assignment as opposed to sale.  The Third Circuit disagreed with the district court’s statutory interpretation in Enron that section 502(d) ties disallowance to particular claimants as opposed to their claims that may be transferred.  The Third Circuit also criticized the district court’s holding in Enron for the reasons that the state law relied upon in Enron did not provide a clear basis to distinguish between assignments and sales and, furthermore, the use of state law may lead to outcomes that are neither uniform nor consistent with bankruptcy law.
Finally, the Third Circuit rejected the contention that ASM was entitled to the protections available for a good faith purchaser under section 550(b) of the Bankruptcy Code.  The Court indicated that section 550(b) protects good faith transferees that purchase property of the estate that may otherwise be recovered by the bankruptcy trustee.  In contrast to property of the estate, ASM purchased claims against the estate.  As such, section 550(b) was inapplicable to ASM.
One question that may not be resolved by the Third Circuit’s decision is whether other categories of claims beyond trade claims are subject to disallowance under section 502(d) after such claims have been transferred.  The Delaware bankruptcy court had qualified its decision in KB Toys by stating that it made no determination as to whether other types of transferred claims beyond trade claims can be disallowed under section 502(d), specifically noting that publicly traded note, bond and debenture claims are excluded from the disclosure requirements of Bankruptcy Rule 3001(e) to facilitate the trading of public securities.  While the Third Circuit’s decision specifically provides that the issue on appeal “only concerns trade claims,” the Third Circuit did not qualify its holding to trade claims as the Delaware bankruptcy court did, and certain language in the Third Circuit’s opinion is broad enough to encompass almost any type of transferred claim.