KB Toys: Delaware Bankruptcy Court Weighs in on Claims Trading

On May 4, 2012 Judge Kevin J. Carey of the U.S. Bankruptcy Court for the District of Delaware held that a claim against a debtor’s estate, transferred to a third party, is subject to the same infirmities as in the hands of the original holder of the claim.  In re KB Toys, Inc., — B.R. —-, 2012 WL 1570755, at *11 (Bankr. D. Del. 2012).  Judge Carey’s opinion diverged from, and criticized, the decision of the U.S. District Court for the Southern District of New York in Enron Corp. v. Springfield Assocs., L.L.C., 379 B.R. 425 (S.D.N.Y. 2007).  In that case, the court held that whether the disabilities of the original holder are inherited by a subsequent transferee turns on whether the transfer is by way of sale or assignment.

Background

In KB Toys, the liquidating trustee under a confirmed chapter 11 plan sought to disallow various trade claims transferred from certain of KB Toys’ creditors to ASM Capital, L.P. and ASM Capital II, LLP.  Prior to bringing the claims objections, between February 2006 and June 2009, the trustee commenced preference actions against all of the original claimants, and obtained either default judgments or summary judgments against each of them.  All but one of the trade claims transferred to ASM were transferred prior to the commencement of the preference actions; the other claim was transferred after the liquidating trustee had obtained a default judgment against the original claimant.  After the claims were transferred to ASM, the trustee sought to disallow the claims purchased by ASM pursuant to section 502(d) of the Bankruptcy Code.

Section 502(d) of the Bankruptcy Code provides, in relevant part: “the court shall disallow any claim of any entity . . . that is the transferee of a transfer avoidable under section . . . 547 . . . of this title, unless such entity or transferee has paid the amount, or turned over any such property, for which such entity or transferee is liable under section 522(i), 542, 543, 550 or 553 of this title.”  In effect, section 502(d) provides that any claim against the estate asserted by the recipient of an avoidable transfer may be disallowed unless and until the recipient relinquishes the debtor’s property back to the estate.

When a claim held by a defendant in an avoidance action is transferred to a third party (in this case, ASM), courts have reached different conclusions as to whether the 502(d) “disability” is a “personal disability” of the defendant, or if the “disability” travels with the claim itself.  In KB Toys, the trustee argued that ASM inherited the 502(d) disability, while ASM argued that the disability remained with the original claimants.  The court agreed with the trustee.

Does the Section 502(d) Disability Stay with the Original Holder or Travel with the Claim?

In light of the divergence of views as to the proper reading of section 502(d) in this context, Judge Carey looked to the legislative history and case law interpreting the statutory predecessor to section 502(d), section 57g of the Bankruptcy Act.  Judge Carey held that both the legislative history and the case law suggested that under section 502(d) disabilities should travel with claims, and are not personal to claimants.

Judge Carey then examined two decisions from the Bankruptcy Court for the Southern District of New York interpreting section 502(d) – Enron Corp. v. Ave. Special Situations Fund II, LP (In re Enron Corp.), 340 B.R. 180 (Bankr. S.D.N.Y. 2006) and In re Metiom, Inc., 301 B.R. 634 (Bankr. S.D.N.Y. 2003).  In Enron, under facts similar to those in KB Toys, Judge Arthur J. Gonzales, relying on Metiom, found that “bank-loan claims, which were transferred by the original holder of the claims, who is alleged to have received avoidable transfers, [are subject] to disallowance under §502(d) of the Bankruptcy Code in the hands of the transferee.”

In reaching that decision, Judge Gonzales reasoned that when a claim has been transferred from a defendant subject to an avoidance action, allowing the transferee to participate in the distribution process would undermine the purpose of section 502(d) – namely, by allowing the recipient of a potentially voidable transfer to share in the proceeds of the estate before the voidable transfer is returned.  The District Court for the Southern District of New York subsequently reversed, holding that, based on the plain language of the statute, “section 502(d) focuses on the claimant as opposed to the claim and leads to the inexorable conclusion that disallowance is a personal disability of a claimant, not an attribute of the claim.”  Enron Corp. v. Springfield Assocs., L.L.C., 379 B.R. at 443.

In reaching its decision, the District Court drew a distinction between claims that are transferred by assignment versus sale.  Specifically, as set forth in the Enron decision, upon the sale of a claim, the section 502(d) disability remains with the original holder and does not pass with the claim to the transferee; conversely, upon assignment of a claim, the disability is inherent in the claim and passes to the transferee.

The District Court’s opinion in Enron has been the subject of criticism as it leaves unanswered the questions of how to draw the distinction between sale and assignment, and why the distinction is so critical to this question.  In KB Toys, Judge Carey criticized the Enron decision.  Specifically, in response to the trustee’s assertion that the transfers constituted assignments, and ASM’s assertion that the transfers were, in fact, sales, Judge Carey stated that “even if, for this purpose, there exists a clear and principled way to distinguish between an assignment and a sale, the exercise, in this context, is unhelpful and unrevealing of the appropriate outcome.”

Further, Judge Carey found unpersuasive the District Court’s concern that an inability to transfer claims free of 502(d) disabilities could wreak havoc on the distressed debt markets.  Judge Carey stated that “the assertion that subjecting transferred claims to section 502(d) allowance would cause disruption in the claims trading market is a hobgoblin without a house to haunt.”

Notably, Judge Carey pointed out that the original holders of the claims were identified in the Debtors’ Statements of Financial Affairs as parties potentially subject to avoidance actions – and the Statements of Financial Affairs were filed with the Bankruptcy Court before ASM acquired the claims.  Accordingly, Judge Carey reasoned that ASM was, or should have been, on notice of the potential for a challenge to the claims under section 502(d) of the Bankruptcy Code.

Judge Carey also observed that many of the claims transfer agreements at issue included indemnification provisions in favor of ASM in the event of disallowance – which suggested that ASM may have had a sufficient understanding of the risks of potential disallowance, and that ASM presumably accepted this risk in negotiating to acquire the claims. Ultimately, Judge Carey adopted the analysis of the Bankruptcy Court, in Enron, holding that section 502(d) pertains to claims and not claimants.  Accordingly, under the reasoning of KB Toys, when a party subject to an avoidance action transfers a claim, the claim remains subject to potential disallowance under section 502(d) in the hands of the transferee.

Was ASM Protected as a Good Faith Purchaser?

In furtherance of its effort to establish that the transferred claims were free of disabilities, ASM asserted that it was, in effect, a good faith purchaser and therefore should not be subject to any infirmities inherent in the claims.  Specifically, ASM argued that “because 502(d) refers to 550(b) of the Bankruptcy Code, the rights of a good faith purchaser, including a claim purchaser, are protected in section 502(d).”  Section 550 provides for the return to the estate of property transferred by a debtor by way of a voidable transfer, but also provides an exception for “a transferee [and subsequent transferees] that takes for value. . .in good faith, and without knowledge of the voidability of the transfer avoided.”

In Enron, the transferee also advanced this argument, but Judge Gonzales rejected the argument.  Specifically, Judge Gonzales found that “a purchaser of a claim, by definition, knows that it is purchasing a claim against a debtor and is on notice that any defense or right of the debtor may be asserted against that claim.”  In KB Toys, Judge Carey expanded on this principle:

“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.”

Accordingly, ASM could not claim good faith purchaser status with respect to the transferred claims; the claims were subject to potential disallowance in the hands of ASM under section 502(d).

Conclusion

The KB Toys decision serves as an important reminder to investors in bankruptcy claims and distressed assets generally, that a bankruptcy claim acquired by transferee may be subject to challenge due to matters which have no relationship to, and entirely predate, the acquisition itself and the transferee’s involvement with the credit.  Under the reasoning of KB Toys, purchased claims may be disallowed if the original holder was subject to an avoidance action and has yet to return the voidable transfer to the debtor.

Further, it bears noting that Judge Carey’s admonition directed towards parties who invest in bankruptcy claims is consistent with recent rulings from other courts with respect to otherwise unrelated issues; indeed, decisions in the TOUSA case and the Madoff cases also emphasize the same theme – that a recipient of assets from an insolvent estate must scrutinize closely the assets and the transferor.  Bankruptcy investors are well-advised to take notice of these statements concerning applicable law, and to exercise necessary due diligence in evaluating potential risks associated with transfers of bankruptcy claims.

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