Three bankruptcy judges in New York have now warned claims traders that buying claims will not insulate them from having the claim denied under Section 502(d) if the seller of the claim received a preference or a fraudulent transfer from the debtor.
The newest opinion comes from the pen of Bankruptcy Judge Sean H. Lane of Manhattan. Although seemingly complex, the essential facts were few and simple.
The debtor made several fraudulent or preferential transfers to nondebtor affiliates. The affiliates held claims against the debtor. The affiliates allegedly “sold” their claims to creditors who filed proofs of claim in the debtor’s chapter 11 case.
The debtor was under the wing of a chapter 11 trustee who objected to the claims, relying on Section 502(d). The section requires the bankruptcy court to disallow “the claim any entity from which property is recoverable [as a preference or fraudulent transfer] or that is a transferee of a transfer avoidable [as a preference or fraudulent transfer] . . . , unless such entity or transferee has paid the amount . . . for which such entity or transferee is liable . . . .”
The creditors opposed the claim objection, contending in substance that the claims of the debtor were personal to the affiliates and did not travel with the claims they purchased. The creditors wrapped themselves in the flag woven by District Judge Shira Scheindlin of Manhattan, who reversed bankruptcy Judge Arthur Gonzalez in In re Enron Corp., 379 B.R. 425 (S.D.N.Y. 2007).
Enron was a signal victory for the claims trading industry, because Judge Scheindlin held that an outright purchaser of a claim is immune from an objection under Section 502(d). On the other hand, she said, Section 502(d) applies to someone who merely takes an “assignment” of a claim.
Judge Scheindlin had taken the case on an interlocutory appeal and reversed Bankruptcy Judge Gonzalez, who had denied the creditors’ motion to dismiss.
Unfortunately for claims traders, Enron was their last victory. The Third Circuit rejected Enron in In re KB Toys Inc., 736 F.3d 247 (3d Cir. 2013). According to Judge Lane, the Third Circuit “concluded that disallowance under Section 502(d) follows the claim.” [N.B. The Third Circuit upheld Bankruptcy Judge Kevin Carey of Delaware, who stepped down from the bench last year.]
The Third Circuit said that Section 502(d) “focuses” on claims, not the claimants who hold them. KB Toys, supra, at 252. The Philadelphia-based appeals court was also concerned with policy, because disallowing the Section 502(d) defense to a claim would allow the recipient of a voidable transfer to “wash” the claim. Id.
Other bankruptcy judges in the Southern District of New York have criticized or declined to follow Enron, although its author was a district judge in the same district. See In re Metiom, Inc., 301 B.R. 634 (Bankr. S.D.N.Y. 2003), by Bankruptcy Judge Robert Drain, and In re Motors Liquidation Co., 529 B.R. 510, 572 n.208 (Bankr. S.D.N.Y. 2015), by Bankruptcy Judge Robert E. Gerber.
In his April 22 opinion, Judge Lane also cited “[n]umerous bankruptcy scholars” who disagree with Enron.
Judge Lane said he was more persuaded by the Third Circuit and other courts that disagreed with Enron.
With the law not on their side, the creditors appealed to equity, claiming they too were victims of the debtor, which was part of the largest bank fraud in India’s history.
Judge Lane paraphrased the creditors as contending that a rule disallowing their claims would “wreak havoc in the claims trading market or unfairly punish good faith purchasers.” However, Judge Lane found “no equitable basis to bypass Section 502(d).”
Like the Third Circuit, Judge Lane concluded that “the claim purchasers should be the ones to bear the risk.” Aware of the risks, he said that purchasers could protect themselves with due diligence and indemnities.
Observation
The creditors may appeal and attempt to create a split of circuits. Even if they prevail, the victory may be fleeting.
From an examination of the record, it appears that the creditors may have taken claims as security for debt. If an appellate court were to reverse, Judge Lane might well disallow the claims on remand under the rubric of Enron if it turns out that the creditors took the claims in a pledge or assignment, not a sale.
Three bankruptcy judges in New York have now warned claims traders that buying claims will not insulate them from having the claim denied under Section 502(d) if the seller of the claim received a preference or a fraudulent transfer from the debtor.
The newest opinion comes from the pen of Bankruptcy Judge Sean H. Lane of Manhattan. Although seemingly complex, the essential facts were few and simple.
The debtor made several fraudulent or preferential transfers to nondebtor affiliates. The affiliates held claims against the debtor. The affiliates allegedly “sold” their claims to creditors who filed proofs of claim in the debtor’s chapter 11 case.
The debtor was under the wing of a chapter 11 trustee who objected to the claims, relying on Section 502(d). The section requires the bankruptcy court to disallow “the claim any entity from which property is recoverable [as a preference or fraudulent transfer] or that is a transferee of a transfer avoidable [as a preference or fraudulent transfer] . . . , unless such entity or transferee has paid the amount . . . for which such entity or transferee is liable . . . .”
The creditors opposed the claim objection, contending in substance that the claims of the debtor were personal to the affiliates and did not travel with the claims they purchased. The creditors wrapped themselves in the flag woven by District Judge Shira Scheindlin of Manhattan, who reversed bankruptcy Judge Arthur Gonzalez in In re Enron Corp., 379 B.R. 425 (S.D.N.Y. 2007).