• In re KB Toys, Inc.: Third Circuit Holds That Purchased Claims Are Taken Subject to Defenses Available Against Original Holders
  • December 2, 2013
  • Law Firm: Stutman Treister Glatt Professional Corporation - Los Angeles Office
  • In a cautionary tale for purchasers of bankruptcy claims, the United States Court of Appeals for the Third Circuit held that a purchaser of a claim against a bankruptcy estate is subject to having that claim disallowed pursuant to section 502(d) of the Bankruptcy Code, where the original holder of the claim (but not the claim purchaser) had received transfers that are avoidable under the Bankruptcy Code. The decision affirms a decision by the Bankruptcy Court for the District of Delaware. In re KB Toys, Inc., --- F.3d ---, 2013 WL 6038248 (3d Cir. Nov. 15, 2013).

    Shortly after commencing their respective chapter 11 cases, the debtors in KB Toys filed their statement of financial affairs ("SOFA") that listed payments made to creditors within 90 days before the date of the chapter 11 petitions. Such payments are potentially avoidable as preferences under section 547 of the Bankruptcy Code, and recoverable under section 550. Claims traders (collectively, "ASM") subsequently purchased a number of claims against the debtors' estates from holders that were listed in the SOFA as having received prepetition payments from the debtors that were potentially avoidable as preferences.

    Both before and after ASM purchased the subject claims, the trustee of the debtors' estates brought suits against the original claim holders and obtained judgments that those holders had received transfers that were avoidable as preferences under section 547. The original holders did not repay these avoided transfers. The trustee then objected to the claims that ASM had purchased from these holders under section 502(d) of the Bankruptcy Code, which provides that "the court shall disallow any claim of any entity from which property is recoverable under section 542, 543, 550, or 553 of this title or that is a 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 is liable under section . . . 550 . . . of this title." 11 U.S.C. § 502(d) (emphasis added). The Bankruptcy Court sustained the trustee's objection to ASM's claims, In re KB Toys, Inc., 2012 WL 1570755 (Bankr. Del. May 4, 2012), and the District Court affirmed.

    The Third Circuit affirmed the lower courts' decisions. The issue before the Third Circuit in KB Toys was "whether a trade claim that is subject to disallowance under § 502(d) in the hands of the original claimant is similarly disallowable in the hands of a subsequent transferee." Looking to the text of the statute and the legislative history, the Third Circuit concluded:

    The language of § 502(d) states that "any claim of any entity" who received an avoidable transfer shall be disallowed. Thus, the statute operates to render a category of claims disallowable-those that belonged to an entity who had received an avoidable transfer. Further, the statute provides that such claims cannot be allowed until the entity who received the avoidable transfer, or the transferee, returns it to the estate. . . . Accordingly, "any claim" falling into this category of claims is disallowable until the avoidable transfer is returned. Because the statute focuses on claims-and not claimants-claims that are disallowable under § 502(d) must be disallowed no matter who holds them.

    The Court stated that holding otherwise would contravene the purpose of section 502(d), which aims to ensure equality of distribution. Protecting transferred claims that are subject to disallowance would create "an incentive [for an original claim holder] to sell its claim and 'wash' the claim of any disability." Moreover, trustees would be deprived of a tool in bankruptcy that would allow them to enhance the estate by pursuing avoidable transfers and leveraging section 502(d) to recover the avoidable transfers. Lastly, the Third Circuit noted that ASM was a sophisticated party in the bankruptcy process that was well-aware of the potential risk that its purchased claims could be subject to disallowance. Indeed, ASM negotiated an indemnity clause in its transfer agreements to protect ASM in the event its claims were disallowed.

    The Third Circuit also rejected ASM's argument that disallowance was inappropriate because the claims were allegedly purchased in "good faith," and ASM was entitled to the protections of the good faith purchaser defense under section 550(b). The Third Circuit held that the good faith transferee defense only applies to parties who purchase property of the debtor, not parties who purchase claims against the estate. Furthermore, the Third Circuit found that there was no policy reason to extend the protections of section 550(b) to ASM, since it was a sophisticated party that voluntarily entered the bankruptcy process and was aware of the risks inherent in purchasing claims.

    Author's Comments

    Notably, in rendering its decision, the Third Circuit relied on the Bankruptcy Court's decisions in Enron ("Enron I"),[1] which were later vacated by the District Court for the Southern District of New York ("Enron II").[2] The Enron II decision focused its analysis "on the claimant as opposed to the claim," and held that a "sale" of a claim relieved the purchaser of any section 502(d) objection, while an "assignment" of the claim did not. The Third Circuit found the Enron II decision problematic, noting that the opinion relied on state law which did not provide for a distinction between sales and assignments. Furthermore, the Third Circuit questioned the Enron II court's use of state law to interpret the application of section 502(d).

    The Third Circuit's citation of the Enron decisions highlights the fact that the KB Toys decision has important implications for claims purchasers that go beyond the risk of disallowance based on the original holder's receipt of a voidable preference or fraudulent transfer. In Enron, the issues were (i) whether a claim purchased post-petition from a holder in whose hands the claim would have been subject to disallowance under section 502(d) due to the claim seller's receipt of avoidable transfers remained subject to disallowance in the hands of a claims purchaser who had not itself received any avoidable transfer, and (ii) whether a claim subject to equitable subordination under section 510(c) of the Bankruptcy Code based on the seller's inequitable conduct remained subject to such equitable subordination in the hands of a purchaser who was not itself guilty of any inequitable conduct that would have warranted equitable subordination. The Bankruptcy Court in Enron I held that the claim purchaser took the claim subject to these this disabilities. The District Court in Enron II reversed on the basis that the outcome depended on whether the claim purchaser took the claim by "sale" or "assignment," and remanded the case to the Bankruptcy Court to determine whether a "sale" or an "assignment" had taken place. (The remand was mooted by a subsequent settlement.)

    The Third Circuit's critique of the Enron II court's "sale"/"assignment" distinction suggests that a claims purchaser may face a greater risk of acquiring a claim that would be vulnerable to disallowance under section 502(d) or equitable subordination under section 510(c) in the hands of the original holder/claim seller in a case filed in Delaware than in a case filed in the Southern District of New York. The Third Circuit's decision also underscores the importance of a claim purchaser's undertaking sufficient due diligence to determine whether the holder of the claim as of the petition date had received a transfer that may be subject to potential avoidance or had engaged in conduct that would subject the claim to equitable subordination. A claim purchaser should also seek indemnities from the seller that give the purchaser recourse against the seller (and any predecessors in interest) in the event that the claim were to be disallowed or equitably subordinated because of the receipt of avoidable transfers or misconduct by the seller of the claim.

    [1] Enron Corp. v. Avenue Special Situations Fund II, LP (In re Enron Corp.), 340 B.R. 180 (Bankr. S.D.N.Y. 2006), and In re Enron Corp., 01-16034 (AJG), 2005 WL 3873893 (Bankr. S.D.N.Y. Nov. 28, 2005), which held that "the transfer of a claim subject to equitable subordination does not free such claim from subordination in the hands of a transferee."
    [2] Enron Corp. v. Springfield Assocs., L.L.C. (In re Enron Corp.), 379 B.R. 425 (S.D.N.Y. 2007).