In recent years, the practice of bankruptcy claims trading has grown dramatically and now represents a multibillion-dollar-per-year marketplace. However, a recent decision by the U.S. Court of Appeals for the Third Circuit may give pause to prospective claim purchasers. In In re KB Toys Inc.,[1] the Third Circuit Court of Appeals held that a claim subject to disallowance under § 502(d) of the Bankruptcy Code in the hands of the original holder is also subject to disallowance in the hands of a purchaser. In other words, a sale does not wash the claim of its susceptibility to disallowance under § 502(d).
Section 502(d) provides:
Notwithstanding subsections (a) and (b) of this section, 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 522(f), 522(h), 544, 545, 547, 548, 549, or 724(a) 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.[2]
The question of a claim’s susceptibility to disallowance under § 502(d) in the hands of a transferee was an issue of first impression in the Third Circuit and, indeed, had never before been addressed by a circuit-level court. The question had previously been addressed in three other published opinions, two from the bankruptcy court for the Southern District of New York, and one from the district court for the Southern District of New York. In a 2003 opinion, the Southern District Bankruptcy Court held that a claim in the hands of a transferee should be disallowed pursuant to § 502(d) where the original claimant had failed to repay liabilities that it owed to the estate under chapter 5 of the Bankruptcy Code.[3] The court next reiterated this holding in a 2007 opinion in the Enron case.[4] However, the District Court for the Southern District of New York subsequently overturned the Enron decision, with a widely criticized holding to the effect that a sale of a claim does transfer the claim free from susceptibility to disallowance under § 502(d), but that an assignment does not transfer the claim free from such susceptibility to disallowance.[5]
KB Toys was a chapter 11 case filed in the U.S. Bankruptcy Court for the District of Delaware on Jan. 14, 2004. ASM Capital, L.P. and ASM Capital II, LLP (together, “ASM”) purchased nine claims from certain claimants (the “original claimants”). Following ASM’s purchase of the claims, the bankruptcy court confirmed the debtors’ plan of reorganization, which established a trust for the purpose of collecting and liquidating the debtors’ assets. The trustee brought preference actions, and eventually obtained judgments, against the original claimants. However, the trustee was never able to satisfy the judgments, as the original claimants had themselves gone out of business.
The trustee subsequently objected to the claims, pursuant to § 502(d), on the ground that the original claimants had never returned their preferential transfers. ASM admitted that the preferential transfers had not been returned, but took the position that § 502(d) did not apply to claims in the hands of a transferee who itself did not possess any chapter 5 liability to the estate. In addition, ASM argued that it was entitled to the protections of a “good faith” purchaser under § 550(b) of the Bankruptcy Code.
The bankruptcy court sided with the trustee and disallowed the claims, holding that under § 502(d), “[d]isabilities attach to and travel with the claim.”[6] In addition, the bankruptcy court noted that ASM was a sophisticated entity who, with “very little due diligence, could have determined that the claims might be disallowed.”[7] Accordingly, the bankruptcy court stated that ASM was not entitled to protection as a “good faith” purchaser pursuant to § 550(b).[8] ASM appealed the disallowance, and the district court affirmed the holding of the bankruptcy court.
On appeal from the district court’s affirmance, the Third Circuit Court of Appeals began its analysis by examining the plain language of § 502(d). The court noted that the statute states that “any claim of any entity” shall be disallowed “until the entity who received the avoidable transfer, or the transferee, returns it to the estate.”[9] “Accordingly,” the court explained, “any claim falling into this category of claims is disallowed 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.”[10]
Next, the court examined the policy behind § 502(d), which is to foster equality of distribution by incentivizing the return to the estate of avoidable transfers. The court explained that this purpose would be very easily thwarted if a claimant could completely strip off its § 502(d) disability by simply transferring its claim to a third party. This result would frustrate an important tool used by trustees and debtors in possession to encourage recipients to return avoidable transfers, and the creditor body as a whole would suffer.
The court then turned to the legislative history, noting that § 502(d) was derived from § 57(g) of the Bankruptcy Act of 1898, which provided that “the claims of creditors who have received or acquired preferences … void or voidable under this title, shall not be allowed unless such creditors shall surrender such preferences….”[11] The court cited to a decision from the U.S. Court of Appeals for the Eighth Circuit interpreting § 57(g), which held that “the disqualification of a claim for allowance created by a preference inheres in and follows every part of the claim, whether retained by the original creditor or transferred to another, until the preference is surrendered.”[12] Thus, the court of appeals in KB Toys concluded, “the case law interpreting section 57(g) is consistent with our interpretation of § 502(d).”[13]
Next, the court held that ASM was not entitled to the “good faith purchaser” exception of § 550(b). The court explained that § 550(b) only protects a “good faith” transferee who purchases property of the estate. Since the claims were not property of the estate (but rather claims against the estate), the court concluded that § 550(b) was inapplicable.[14]
Additionally, the court noted that claim purchasers are sophisticated entities, and that they should be aware of the risks inherent in the bankruptcy process. Indeed, the very existence of such risks is the reason why many claimants are willing to sell their claims in the first instance, and why purchasers are able to buy claims at a significant discount to face value. Accordingly, no policy reason exists for affording claim purchasers the benefits of § 550(b).
As a result of the KB Toys decision, it is now clear, at least within the Third Circuit, that claims subject to disallowance under § 502(d) in the hands of the original claimant are similarly disallowable in the hands of a subsequent transferee. In light of this decision, a would-be claim purchaser should be certain to analyze the risk that the original claim-holder may fail to return an avoidable transfer, and thus trigger § 502(d)’s disallowance.
[1] In re KB Toys Inc., 736 F.3d 247 (3d Cir. 2013).
[2] 11 U.S.C. § 502(d).
[3] In re Metiom Inc., 301 B.R. 634 (Bankr. S.D.N.Y. 2003).
[4] In re Enron Corp., 340 B.R. 180 (Bankr. S.D.N.Y. 2006).
[5] In re Enron Corp., 379 B.R. 425 (S.D.N.Y. 2007). The Delaware bankruptcy court in KB Toys explicitly rejected the district court’s reasoning in Enron, especially the drawing of a distinction between “sales” and “assignments” of claims, and noted that the district court’s decision has been widely criticized. See In re KB Toys Inc., 470 B.R. 331, 340-42 (Bankr. D. Del. 2012) (“In this context, use of any distinction between the two terms has been widely criticized.”).
[6] In re KB Toys Inc., 470 B.R. at 335.
[7] Id. at 342. The bankruptcy court noted that all of the original claimants were listed on schedule 3(a) of the debtors’ statement of financial affairs as having received potentially avoidable transfers during the preference period.
[8] Id. at 343.
[9] In re KB Toys Inc., 736 F.3d at 251-52.
[10] Id. at 252.
[11] Id. at 253 (quoting Katchen v. Landy, 382 U.S. 323, 86 S. Ct. 467, 473 n. 5 (1966)).
[12] Id. (quoting Swartz v. Siegel, 117 F. 13 (8th Cir. 1902)).
[13] Id.
[14] Id. at 255.