CLIENT ALERT: Distressed Debt Buyers Beware: Delaware Bankruptcy Court Holds That Claim’s Defect Follows Claim Purchaser

An age-old question of commercial law is when does a purchaser of property take the property free and clear of defects?  For distressed debt purchasers, the specific question is whether the purchaser takes the debt free and clear of the debtor’s claims against the seller.  Can a purchaser of a claim enjoy rights superior to the claimant from whom it purchased the claim?  The influential United States Bankruptcy Court for the District of Delaware in In re KB Toys, Inc. et al. (“KB Toys”)has recently said no, holding that the defects follow the claim.

Background

KB Toys, Inc. and certain of its affiliates (collectively, the “Company”) filed Chapter 11 bankruptcy petitions in January 2004.  In August 2005, the Company confirmed a plan of reorganization.  A plan-established trust was formed in part to investigate and pursue avoidance actions and other claims for the benefit of creditors.  Meanwhile, between April 2004 and May 2007, ASM Capital, L.P. and its affiliate ASM Capital II, LLP (collectively, “ASM”) purchased trade claims (the “Sold Claims”) from nine different holders (the “Original Holders”) with an aggregate face amount in excess of $650,000. 

Between February 2006 and June 2009, the plan Trustee filed lawsuits and obtained default judgments against the Original Holders on account of bankruptcy preference claims.  As addressed below, clearly, under the Bankruptcy Code, the Court would have disallowed the claims of the Original Holders.  But these claims were sold.  In July 2009, the Trustee sought disallowance of the Sold Claims on the ground that the “taint” followed the Sold Claims.

The Bankruptcy Court’s Ruling

Bankruptcy Code Section 502(d) provides that “the court shall disallow any claim of any entity . . . that is a transferee of a transfer avoidable under [the avoidance provisions of the Bankruptcy Code], unless such entity or transferee has paid the amount, or turned over any such property, for which such entity or transferee is liable [under the avoidance provisions].”  Under a plain reading of Section 502(d), a claimant who received a voidable preference payment cannot get paid on account of any claim against the debtor’s estate until it returned the preference payment to the debtor’s estate.

But courts have disagreed on whether Section 502(d) applies to a claim transferred to a third party.  Three relatively recent decisions, all arising in bankruptcy cases pending in the Southern District of New York, addressed this point.  In In re Metiom, Inc., 301 B.R. 634 (Bankr. S.D.N.Y. 2003) (“Metiom”) the Bankruptcy Court held that the plain meaning of Section 502(d) provides for disallowance, even where transferred and conformed to the common law principle “that the assignee of a non-negotiable instrument is subject to all of the equities and burdens that attach to the property assigned, because the assignee receives no more than the assignor possessed.”  Three years later, the Bankruptcy Court 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) (“Enron I”) followed Metiom and disallowed transferred bank debt claims, asserting that case law “affirmed the principle that a claim transfer does not change the nature of the claim in bankruptcy; rather it creates a substation of parties.”

On appeal, the Bankruptcy Court was reversed by the District Court in Enron Corp. v. Springfield Associates, LLC (In re Enron Corp.) 379 B.R. 425, 443 (S.D.N.Y. 2007) (“Enron II”).  The District Court held that the plain language of Section 502(d) dealt with claimants, not claims.  The Court further distinguished between an assignment and a sale of claims.  The Court held that while assignees are subject to the well-established doctrine that they can only take what the purchaser had, purchasers in good faith are entitled to better treatment under commercial law, and a “personal disability” will not travel with the claim if sold in good faith.

As noted by the Bankruptcy Court in its May 2012 opinion in KB Toys, the Enron II opinion has been highly criticized--not so much for its interpretation of Section 502(d) as its reliance on a distinction between a “sale” and an “assignment” of a claim.

In the KB Toys opinion, the Bankruptcy Court rejected the holding in Enron II and agreed with the earlier cases regarding the plain meaning of the statute, asserting that “to require the estate to pay claims in these instances would make the estate the claim purchaser’s insurer.”  The Bankruptcy Court ruled against ASM by disallowing its claims because the plan Trustee had asserted claims and won judgments against the Original Holders.

The Bankruptcy Court noted that ASM was sophisticated in that it provided for indemnity clauses in some of its transfer agreements and was on notice of the potential defects because the debtor filed schedules of potentially voidable transfers whereby ASM “could have discovered the potential for disallowance with very little due diligence and factored the potential for disallowance into the price it paid for the trade claims.”  This created difficulty for the Court to apply any sort of good faith purchaser protection as contemplated in Enron II.  But the Court went further, asserting:

A claim purchaser knows that it is obtaining a claim against a debtor whose unfavorable financial condition has caused it to seek the protections afforded by the bankruptcy process.  A purchaser of claims in a bankruptcy is well aware (or should be aware) that it is entering an arena in which claims are allowed and disallowed in accordance with the provisions of the Bankruptcy Code and the decisional law interpreting those provisions.  Under such conditions, a claims purchaser is not entitled to the protections of a good faith purchaser.

Therefore, the Bankruptcy Court suggested that even if in a case where the schedules were not filed prior to the transfer of the claim, it would have ruled against the claimant.  The Court continued:

Buyers of debt, in the Court’s experience, are highly sophisticated entities fully capable of performing due diligence before any acquisition.  However, even without any due diligence, today’s claim purchasers are aware of the ever-present possibility of avoidance actions based on preference liability or fraudulent conveyances.  Under the circumstances now before me, the assertion that subjecting transferred claims to §502(d) disallowance would cause disruption in the claims trading market is a hobgoblin without a house to haunt.

The Bankruptcy Court, however, refused to decide whether its holding would extend to non-trade debt claims, noting that with other types of claims, such as publicly-traded note, bond and debenture claims, “public markets might be affected.”

Conclusion

Purchasers of claims against distressed entities must, at a very minimum, be aware that courts are prepared to apply the same disallowance rules to claims purchasers as to original creditors.  Purchasers should perform some due diligence, which at a minimum should include reviewing the debtor’s schedules when available and also obtaining other available documents and representations from sellers as to payments they may have received.  Purchasers should also seek to protect themselves with contractual remedies against sellers in the event of a future objection or claw-back in bankruptcy.  In short, distressed debt traders should heed the KB Toys Court’s warning: when buying trade claims against a distressed company “a claims purchaser is not entitled to the protections of a good faith purchaser.”

Please feel to contact any of the attorneys listed below if you would like to discuss this matter.

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