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Article: December 2014 Bankruptcy and Restructuring Update

December 01, 2014
Business Litigation Reports

Bankruptcy Code Section 502(d): Getting Back to Basics. Traders in distressed debt face a myriad of questions and issues when acquiring claims against a company in distress. One common issue that traders should always ensure that they have checked off before proceeding with the consummation of a trade is the risk of disallowance of the claim under Bankruptcy Code section 502(d). 11 U.S.C. § 502(d)

Only “allowed” claims may share in distributions from a debtor’s estate. Section 502(d) provides for disallowance of claims where the creditor is in possession of property of the debtor’s estate or received transfers that are avoidable as preferences or fraudulent transfers. The section states that, unless the creditor returns the property of the debtor’s estate or otherwise pays the amount it is liable for, “the court shall disallow any claim of that entity.”

The issue for claims traders is this—if I buy a claim from an entity that has possession of a debtor’s property or is the recipient of an avoidable transfer, is my claim subject to disallowance under section 502(d) even if I have done nothing to trigger section 502(d)? A recent Third Circuit case, In re KB Toys, Inc., 736 F.3d 247 (3d Cir. 2013), suggests yes. In KB Toys, after the debtor filed for bankruptcy, a claims trader purchased several claims. Each claims trading document provided that if the claim was disallowed, the original claimant was obligated to pay restitution to the trader. As it turns out, each original claimant had received a payment within 90 days of the bankruptcy filing, and the debtor’s estate sued each original claimant to recover the preferential payment. Because each original claimant had gone out of business, the debtor’s estate obtained default judgments. The estate then objected to the trader’s claims under section 502(d), even though the trader itself had not received any avoidable transfers. The bankruptcy court sustained the objection, which the Third Circuit affirmed. The court interpreted the phrase “any claim of any entity” in a manner that focused on the claims, not the identity of the holder of the claim. “Because the statute focuses on claims—and not claimants—claims that are disallowable under § 502(d) must be disallowed no matter who holds them.” Id. at 252. The court also noted policy concerns—if the claim was not disallowed, the original claimant would profit by selling the claim and the estate would have less money available to distribute to holders of allowed claims (or a bigger claim pool that would dilute recoveries). And the court noted that the trader had accounted for the risks of disallowance in its trading documents. The final nail in the coffin for the claims trader was a definitive statement that claims transferees have no defense to a section 502(d) claim objection even if they took for value and in good faith. Id. at 255.

KB Toys is not surprising—over the last ten years bankruptcy courts have increasingly disallowed claims under section 502(d) where the claim had been in the hands of a party that had received an avoidable transfer. But KB Toys appears to be the first circuit-level case on the subject, and it leaves no wiggle room for claims traders. Indeed, the Third Circuit rejected the approach adopted by one judge in the Southern District of New York to distinguish between “assignments” of claims and “sales” of claims, Enron Corp. v. Avenue Special Situations Fund II, LP (In re Enron Corp.), 379 B.R. 425, 435-36 (S.D.N.Y. 2007). The Enron court had held that an “assignment” of a claim meant the claim could be disallowed under section 502(d), but that a “sale” of a claim may dictate a different result if the seller acquired the claim in good faith.

In light of KB Toys, claims traders will likely need to conduct more due diligence (thus increasing their costs and lowering purchase prices) to account for the risks of the claim sellers’ possible liability for avoidable transfers and the credit risk of the sellers to either satisfy an avoidable transfer judgment or provide compensation to the claims trader. When acquiring a claim that has not yet been allowed, a claims trader at least should consider:

● Has the seller been listed on the debtor’s schedules and statement of affairs as having received payments from the debtor within 90 days before bankruptcy, or otherwise identified as a potential litigation target?
● Is the trade a recourse/put-back trade or a non-recourse trade?
● What remedies are there for breaches of representations and warranties regarding claim allowance or non-receipt of avoidable transfers?
● Should a portion of the purchase price be escrowed pending claim allowance?
● Who defends (and has settlement authority over) an avoidance action brought by the estate?