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Third Circuit Finds Clouds Over Debt Trades in Bankruptcy

Posted on: November 18, 2013

In a closely-watched case, the United States Court of Appeals for the Third Circuit recently affirmed the decision of the Delaware District Court, holding that bankruptcy claims are subject to disallowance under section 502(d) of the Bankruptcy Code despite their subsequent sale to a third-party. In In re KB Toys, Inc., No. 13-1197 (3d Cir. Nov. 15, 2013), the Third Circuit found that the “cloud of disallowance” cannot be parted from the claim. This decision (which can be found here) is noteworthy since it runs contrary to the New York federal district court’s previous decision in the Enron chapter 11 case which found claim disallowance as a personal disability that did not adhere to the claim.    

The storm at issue in KB Toys developed between 2004 and 2007 when ASM Capital, L.P. and ASM Capital II, LLP (together, “ASM”), a national claims trader, purchased nine claims from various creditors to whom KB Toys owed money. Although it executed separate assignment agreements with the sellers, ASM found itself stuck under one useless umbrella when all of the sellers were successfully sued by the trustee for the estate for receiving preferences in the 90-day period prior to the bankruptcy. Unable to collect from the original claimants who were all out-of-business by then, the trustee sought disallowance of ASM’s claims under section 502(d) of the Bankruptcy Code. Section 502(d) provides for the disallowance of any claim of any entity that received property that is avoidable or recoverable by the bankruptcy estate.    

In one of the more surprising decisions of 2012, the Delaware Bankruptcy Court completely rejected the NY District Court’s decision in Enron and disallowed the ASM claims. The decision was later affirmed on appeal to the Delaware District Court and then appealed to the Third Circuit Court of Appeals. 

The Third Circuit affirmed the District Court decision. It held that the language of section 502(d) expressly refers to “claims” and not claimants, and therefore disallowance must run with the claim even if the claim is subsequently transferred. To hold otherwise, in the Court’s opinion, would negatively impact bankruptcies, leaving estates with less funds for distribution to creditors, preferences that would never be returned and liability for claims that would otherwise have been disallowed. The Court noted that its decision was “precipitated” by the legislative history of section 502(d) and furthered the statute’s goals of coercing compliance with judicial orders. 

Notably, the Court was unwilling to offer ASM shelter under the good-faith purchaser defense in section 550(b) of the Bankruptcy Code. Instead, the Court found that participants in the secondary market for claims, like ASM, profit from the risks inherent in the bankruptcy process. By “knowingly and voluntarily” entering into the bankruptcy realm, the Court determined that the onus should be on such market participants to assess the potential “atmospheric” risks, including claims disallowance, and to take precautions to protect themselves. It found that the good-faith purchaser defense did not extend to transfers of claims against a debtor. 

The KB Toys decision, and its ramifications, assure continued storm clouds over the distressed debt market. In the meantime, to avoid getting soaked, participants should carefully review a debtor’s statements of financial affairs and schedules of assets and liabilities for possible infirmities and, whenever possible, negotiate indemnities from trade counterparties to reduce exposure from claims disallowance.