On Aug. 27, 2007, the District Court for the Southern District of New York reversed and remanded two decisions that had been appealed from the bankruptcy court in the ongoing Enron case that had denied a motion to dismiss an action for equitable subordination and disallowance of certain claims. In so doing, the district court has, at least temporarily, quelled a firestorm of debate over an issue that goes to the heart of the claims and debt-trading world: whether a claim can be transferred free and clear of a seller’s bad conduct.
But the recent district court decision concerning claim transfers and the liability of claims transferees has not fully resolved many of the issues that were of concern to the financial markets. In the case below, Enron had sued various transferees of claims and sought to subordinate and disallow the transferred claims based on the alleged misconduct of the transferors and the receipt by the transferees of allegedly avoidable transfers. When the bankruptcy court held that equitable subordination under §510(c) of the Bankruptcy Code and claim disallowance under §502(d) could be applied to transferees of claims, the distressed-debt market was rattled—indeed, as noted in the district court’s opinion, there was an “outcry from commentators” expressing “great concern that the effect of [the opinions below would] wreak havoc in the markets for distressed debt.” The bankruptcy court opinions held that the potential for equitable subordination and claim disallowance—what one might construe as “personal disabilities of claimants” rather than “characteristics that inhere in a claim”—moved with a claim, regardless of whether and how (or, for that matter, how many times) a claim had been sold, assigned or otherwise transferred.
The reversal of the bankruptcy court opinions has thus been heralded by many as the salvation of the claims-trading industry. However, given the rather murky sale/assignment distinction on which the district court opinion hinges, and a remand to the bankruptcy court for further fact-finding about that distinction, the opinion represents at best a Pyrrhic victory for traders—a sentiment apparently shared by the appellants (i.e., the supposed victors) who filed a motion for certification of interlocutory appeal which was recently denied by the district court on Sep. 24.
Springfield Associates LLC and Citibank, with certain other defendants and interveners, had filed an interlocutory appeal last May from the aforementioned orders, which denied motions to dismiss complaints that sought equitable subordination of claims under §510(c) and disallowance of claims under §502(d). The question presented on appeal was “whether equitable subordination under §510(c) and disallowance under §502(d) can be applied, as a matter of law, to claims held by a transferee to the same extent they would be applied to the claims if they were still held by the transferor based on alleged acts or omissions on the part of the transferor.”
The district court opinion addresses two separate arguments advanced by Enron. The first is that the general principle of bankruptcy law that all rights among competing claims to a bankruptcy estate are fixed and determined as of the date of the petition applies to equitable subordination and disallowance. Therefore, Enron argued, if a given claimant held claims on the petition date and its claims are subject to equitable subordination and/or disallowance, the claims are forever tainted on the petition date. The opinion disagreed, relying on the plain language of §510(c) and §502(d) to hold that neither equitable subordination nor disallowance are fixed as of the petition date. With respect to equitable subordination, the opinion notes that the remedy must be court-ordered, is permissive, can be based on post-petition inequitable conduct and is not available to creditors who did not suffer an injury; therefore, other creditors’ circumstances can become relevant post-petition. Similarly, with respect to §502(d) disallowance, given that court action is necessary and that disallowance is contingent on the refusal or failure to return an avoidable transfer by the recipient of that transfer, claims can be disallowed based solely on post-petition events, and it is thus not possible as Enron had sought to argue, for the claims’ status to be fixed as of the petition date.
The second Enron argument that the opinion addresses is that principles of assignment law dictate that the transferee of a claim can have no greater rights than the transferor would have if it still held the claim, and therefore a claim that is “tainted” in a transferor’s hands is also tainted in a transferee’s hands. In disagreeing with Enron’s argument, the district court splits, without extensive analysis, transfers of claims into two categories: assignments and sales. The district court holds that equitable subordination under §510(c) and disallowance under §502(d) are “personal disabilities” of the claimant, given the language of the relevant statutes, legislative history and case law. The court then explains that assignments result in a transferee “stepping into the shoes” of the transferor. While in a sale situation, “sellers are often anonymous and purchasers have no way of ascertaining whether the seller (or a transferee up the line) has acted inequitably or received a preference,” and therefore buyers do not step into sellers’ shoes in a sale context. Finally, the court states “unless there was a pure assignment . . . as opposed to a sale of the claim, the claim in the hands of the transferee is not subject to equitable subordination or disallowance based solely on the conduct of the transferor.”
The district court held that §510(c) equitable subordination and §502(d) disallowance (where applicable) do not travel with a claim when it moves from a seller to a buyer; however, these disabilities may remain with a claim when it moves from an assignor to an assignee. The opinion ultimately remands the case to the bankruptcy court for a finding as to whether the transfers at issue were an assignment or a sale.
As noted above, the opinion raises as many questions as it seeks to resolve: a great deal of debt is traded using documents somewhat indiscriminately labeled “purchase and sale” and “assignment and acceptance” or “assignment and assumption,” or is simply not documented by more than a trade confirmation. This potential problem is compounded by the fact that most loan and credit agreements contain appendices, often labeled as “assignment,” which lenders are required to use in order to transfer their debt to a downstream purchaser/assignee. The present holding may protect a few transferees, but its reach is uncertain and thus not likely to be particularly extensive.
The appellants sought further review of this issue, making clear that they were not satisfied with the sale versus assignment distinction, but as noted earlier, their motion was denied in a Sep. 24 order. We will have more extensive analysis of this issue in our forthcoming newsletter and will continue to update clients on either the ongoing appeal process or the decisions of the bankruptcy court on remand.