When the Federal Deposit Insurance Corporation (FDIC) determines that a bank is insolvent, the FDIC will sometimes take it over to ensure that the bank’s deposits are secure. One way the FDIC protects these deposits is by selling off the loans that the bank owns, often at a discount. This leads to the following question: If a debtor defaults on one of these loans, can the purchaser of the loan recover its full value, or is the purchaser’s recovery limited to the amount it paid?
The Question
Consider the following hypothetical: A bank lends $1.5 million to a debtor. Subsequently, the bank becomes insolvent and is taken over by the FDIC. Suppose that even though the debtor still owes $1 million on the loan, the FDIC assigns it to a purchaser at the discount price of $600,000. If the debtor then defaults on the loan and declares bankruptcy, what amount can the purchaser try to claim?
The Answer
The answer to this question is clear: Under most circumstances, the purchaser can claim the full value of the loan (i.e., the entire $1 million, rather than being limited to $600,000). Although this issue has arisen in the current troubled economic climate, the courts actually settled it back in the late 1980s when there were a significant number of FDIC takeovers.
The Law
Where an assignee purchases a loan, the assignee steps into the shoes of the original lender and is entitled to enforce all of the lender’s rights and borrower’s obligations under the loan.[2] The amount paid by the purchaser is irrelevant to the assignee’s rights.[3]
For example, in In re Hill, a creditor purchased an unsecured claim against the debtor at a discount.[4] The debtor objected to the claim and argued it should be disallowed because the creditor paid only nominal consideration for it even though the debtor’s plan of reorganization would pay 100 percent to the unsecured creditors.[5] The debtor argued that allowing the creditor to recover 100 percent on a debt purchased for nominal consideration would unjustly enrich the creditor and provide a windfall.[6] The court felt that the debtor’s argument defied “common sense and the law” and that the debtor was confusing “the transfer of accounts with equitable subrogation.”[7] The court further stated that “the consideration paid for these accounts has absolutely no bearing on the allowance or disallowance of [the] claim, and [we] will not dignify the argument with further discussion.”[8]
The Exception
There is one exception to this rule: A bankruptcy court may disallow or limit an assigned claim only if the assignment of the claim: (1) involved a breach of fiduciary duty, fraud or other misconduct; and (2) such breach, fraud or other misconduct enabled the assignee to acquire the claim for inadequate consideration.[9]
The only authority holding a that creditor-assignee may not assert the full amount of a claim purchased at a discount involves cases where the court found that the purchaser either occupied a fiduciary position with respect to the debtor or engaged in fraud or other wrongdoing in connection with purchase of the claim. This line of authority stems from the U.S. Supreme Court case of Pepper v. Litton, where the dominant and controlling stockholder of a debtor purchased claims against the debtor and attempted to assert them in the bankruptcy case.[10] In upholding the disallowance of the stockbroker’s claims, the Court stated:
A director is a fiduciary. So is a dominant controlling stockholder or group of stockholders. Their powers are powers in trust. Their dealings with the corporation are subject to rigorous scrutiny and where any of their contracts or engagements with the corporation is challenged the burden is on the director or stockholder not only to prove the good faith of the transaction but also to show its inherent fairness from the viewpoint of the corporation and those interested therein. The essence of the test is whether or not under all the circumstances the transaction carries the earmarks of an arm’s length bargain.[11]
Bankruptcy courts have applied the doctrine of Pepper v. Litton and limited claims purchased at a discount in situations where the purchaser of the claim occupies a fiduciary position with respect to the debtor.[12] The logic behind such decisions is that, under Pepper v. Litton, the dealings of a fiduciary with its corporation are subject to heightened scrutiny and “[t]he essence of the test is whether or not under all the circumstances the transaction carries the earmarks of an arm’s length bargain.”[13] To the extent a fiduciary pays less for a claim or note than the full amount of the claim or note, the earmarks of an arm’s-length transaction are not present and the claim may be reduced.
The bankruptcy court explained this exception in the 1988 case of In re Executive Office Ctrs. Inc., even though it held that the exception did not apply in that case.[14] In Executive Office, an assignee purchased 15 notes and mortgages from an assignor at a 50 percent discount of its face amount.[15] One of the notes and mortgages pertained to a loan in which the obligor was a debtor who had defaulted on the note and filed for bankruptcy.[16] When the purchaser sought to enforce its claim against the debtor in full under the note and mortgage, the debtor objected to the purchaser’s claim. The debtor sought to either have the assignee’s claim disallowed in full or have the claim reduced to the amount paid for it, citing to the court’s equitable powers under 11 U.S.C. §105.[17]
While the court concluded that it had the power under §105 of the Bankruptcy Code to disallow or reduce the claim, the court held, in accordance with a long line of cases, that it could only properly invoke this power when the assignment: (1) involved a breach of fiduciary duty, fraud or other misconduct; and (2) such breach, fraud or other misconduct enabled the assignee to acquire the assigned claim for inadequate consideration.[18] Since no special fiduciary or other relationship existed among the assignee, assignor and obligor, and because no fraud or other wrongdoing was present in the assignment, the court declined to disallow or reduce the claim and allowed the assignee to enforce it in full.[19]
Conclusion
If the purchaser in the hypothetical above is neither a fiduciary nor otherwise engaged in fraud or wrongdoing that would justify reduction or disallowance of the claim on equitable grounds, the normal rule applies where the assignee steps into the shoes of the obligee and the purchaser is entitled to enforce all of the bank’s rights and the debtor’s obligations.[20] Therefore, if the debtor defaulted on its obligations, the purchaser is able to pursue a claim from the debtor for more than it paid for the loan—the full $1 million. The amount that the purchaser paid to receive the assignment of the loan is irrelevant.
About the Author: Gary Marsh is a senior partner in the Bankruptcy Department at McKenna Long & Aldridge LLP in Atlanta. He is Board Certified in Business Bankruptcy and Creditor's Rights and is a Fellow in the American College of Bankruptcy Attorneys.
1. Marsh acknowledges the assistance in preparing this article from David Gordon and Adam Linkner, an associate and summer associate, respectively, at McKenna Long & Aldridge LLP.
2. Citibank NA v. Tele-Resources Inc., 366 F.2d 95, 98 (2d Cir. 1983); In re Quakertown Shopping Ctr. Inc., 366 F.2d 95, 98 (3d Cir. 1966).
3. In re Moulded Products, 474 F.2d 220, 224 (8th Cir. 1973), cert. denied, 412 U.S. 940; In re Lorraine Castle Apts. Bldg. Corp., 149 F.2d 55 (7th Cir. 1945), cert. denied, 326 U.S. 728.
4. In re Hill, 399 B.R. 472, 473–74 (Bankr. W.D. Ky. 2008).
5. Id. at 474.
6. Id.
7. Id. See also In re Fairfield Executive Assocs., 161 B.R. 595 (D. N.J. 1993).
8. Id.
9. In re Executive Office Ctrs. Inc., 96 B.R. 642, 649–50 (Bankr. E.D. La. 1988).
10. Pepper v. Litton, 308 U.S. 295, 299 (1939).
11. Id. at 306.
12. See, e.g., In re Gallic-Vulcan Mining Corp., 135 F.2d 725, 728 (10th Cir. 1943) (limiting amount of purchased claim against debtor to amount paid for claim rather than amount of claim itself where claim was purchased by director of debtor).
13. Pepper, 308 U.S. at 306.
14. In re Executive Office Ctrs. Inc., 96 B.R. 642 (Bankr. E.D. La. 1988).
15. Id. at 645.
16. Id.
17. Id. at 645–46.
18. Id. at 649.
19. Id. at 651.
20. See, e.g., Moulded Products, 474 F.2d at 224 (“The cases in which claims are limited to the amount of consideration paid generally deal with transactions where the assignee is in a fiduciary relationship with the corporation or is a close relative of someone in such a fiduciary relationship.”); Lorraine Castle, 149 F.2d at 57 (“[T]he court may limit to cost claims acquired in the course of proceedings by attorneys, trustees under indentures, security-holders committees and others. These provisions are not applicable to third parties, to strangers or to any one who is under no fiduciary obligation toward any beneficiary of the trust.”).