A recent federal district court appellate decision issued in the Enron chapter 11 case1 has ruled that the postpetition transfer of a prepetition bankruptcy claim from one party to another may insulate the transferred claim against certain types of attack based solely on conduct by a prior holder of the same claim. Whether a particular claim is protected depends upon how the claim was transferred.

The Bankruptcy Court in Enron had held that a bankruptcy claim could be subject to subordination or disallowance in the hands of a postpetition transferee solely because of the conduct of a prior holder of the same claim. According to the District Court on appeal, however, whether a bankruptcy claim held by a postpetition transferee is subject to either form of attack depends upon how the claim was transferred. The District Court sought to distinguish between claims that are sold postpetition to good faith purchasers (which claims, in the court’s view, are not subject to these types of challenge), and claims that are assigned postpetition (which remain vulnerable).

Under the District Court’s ruling in Enron, and in stark contrast to the result reached by the Bankruptcy Court, the value of a bankruptcy claim acquired postpetition and in good faith is not necessarily jeopardized by conduct of a prior holder of the same claim. The District Court’s ruling is important for all parties engaged in the acquisition of distressed debt and underscores certain practical considerations a potential transferee should consider in connection with any such acquisition.

Disallowance and Equitable Subordination of Claims Under the Bankruptcy Code

The District Court and Bankruptcy Court decisions involve issues surrounding the mechanisms for claim disallowance and equitable subordination under the Bankruptcy Code. Generally, the Bankruptcy Code enables a party in a bankruptcy case to seek a judicial determination that, due to certain conduct by a creditor, a particular claim asserted against the debtor’s estate should receive less favorable treatment than that to which it otherwise would be entitled under the Bankruptcy Code.

Specifically, pursuant to section 502(d) of the Bankruptcy Code, the bankruptcy court is required to disallow the claim of any entity that has received certain types of avoidable transfers, or that has received property that is otherwise recoverable by the debtor’s estate under certain specified sections of the Bankruptcy Code, unless the entity has returned the transferred property to the estate. 11 U.S.C. § 502(d). The practical effect of section 502(d) is to preclude a creditor from sharing in recoveries from the debtor’s estate if the creditor is improperly holding property of the debtor’s estate.

In contrast, pursuant to section 510(c) of the Bankruptcy Code, the bankruptcy court may “under principles of equitable subordination” subordinate all or part of a particular claim to all or part of another claim. 11 U.S.C. § 510(c). Section 510(c) allows the court to redress creditor misconduct that causes harm to a debtor’s estate (and by extension to other creditors) by subordinating all or part of the offending creditor’s claim.

Enron Facts and Procedural History

In May 2000 and May 2001, Enron entered into two separate credit agreements with various groups of lenders, including Citibank N.A. (“Citibank”). Subsequently, on December 2, 2001, Enron and certain of its affiliates filed voluntary chapter 11 cases in the United States Bankruptcy Court for the Southern District of New York. Accordingly, as of the commencement of Enron’s chapter 11 cases, the lenders (including Citibank) held claims against Enron’s estate for amounts owed to the lenders under the credit agreements.

At different times after Enron’s chapter 11 filing, certain of the lenders under the credit agreements transferred portions of their claims against Enron’s estate to various third parties. Some of the claims that were held by Citibank when Enron filed bankruptcy were transferred to BT/Deutsche Bank, and then were further transferred from BT/Deutsche Bank to Springfield Associates, L.L.C. (“Springfield”).

In January 2005, Enron initiated an adversary proceeding against Springfield, seeking to equitably subordinate Springfield’s claim under section 510(c) of the Bankruptcy Code, or alternatively to disallow Springfield’s claim under section 502(d) of the Bankruptcy Code. Enron alleged that misconduct by Citibank, the prior holder of Springfield’s claim, justified subordination of the claim now held by Springfield under section 510(c). Alternatively, Enron asserted that Springfield’s claim should be disallowed because Citibank had received a voidable transfer that it had failed to return to Enron’s bankruptcy estate. Enron’s claims against Springfield presupposed that disallowance under section 502(d) and equitable subordination under section 510(c) apply with equal force to the claim in the hands of Citibank or Springfield.

Springfield moved to dismiss the adversary proceeding, asserting that, as a matter of law, alleged prior acts or omissions by Citibank could not serve as a basis either to disallow or to equitably subordinate the claim now held by Springfield. The Bankruptcy Court disagreed, and denied the motion to dismiss Enron’s actions for disallowance and equitable subordination. In essence, the Bankruptcy Court determined that a claim in the hands of a transferee remains subject to disallowance or equitable subordination based exclusively upon acts or omissions of the prior holder of the claim. Springfield appealed the Bankruptcy Court’s decisions to the District Court.

The District Court’s Ruling and Analysis

Drawing a Bright Line Between Assignments and Sales

As a threshold matter, the District Court found that the Bankruptcy Court, in considering the impact of sections 502(d) and 510(c) of the Bankruptcy Code upon postpetition transfers of claims, failed to distinguish between two different types of transfers – assignments and sales. According to the District Court, the determination of whether the transfer to Springfield occurred by way of assignment or by way of sale is a critical, threshold inquiry to be considered in addressing whether Springfield’s claim is potentially subject to section 502(d) disallowance or section 510(c) equitable subordination.

Specifically, the court reasoned that on the one hand, if a transfer is in the nature of an assignment, the law of assignments dictates that the transferee (or assignee) is deemed to “step into the shoes” of the transferor (or assignor). In that instance, the assignee of a claim “takes with it whatever limitations it had in the hands of the assignor.”2 On the other hand, if a transfer is not an assignment but rather is in the nature of a sale, the law of assignment does not apply to the transaction or the relationship between the parties. In that case, a purchaser (as opposed to an assignee) is not deemed to “step into the shoes” of the transferor (or seller), but rather “can obtain more than the transferor had in certain circumstances.”3

The Bankruptcy Court did not consider the implications raised by the distinction between assignments and sales. Rather, it adopted the blanket position that a claim in the transferee’s hands remains subject to disallowance and equitable subordination to the same extent as if the claim were still held by the transferor who received the avoidable transfer or committed the misconduct.

The District Court explained that distinguishing between the two forms of transfer is central to the determination of whether a claim in the hands of a postpetition transferee is potentially subject to 502(d) disallowance or 510(c) subordination. The court reasoned that certain attributes of a bankruptcy claim are actually inherent characteristics of the claim that travel with it irrespective of whether the claim is transferred by way of assignment or sale. For example, claims for penalties or damages arising from the purchase or sale of a debtor’s securities are generally subject to subordination because of the nature of the claim itself, not any conduct on the part of the claimholder. In contrast, other attributes are not necessarily inherently intertwined with the claim itself, but rather are more aptly characterized as personal “disabilities” attributable to the holder of the claim. Inherent characteristics travel with a claim regardless of whether it is transferred by way of assignment or sale. Whether personal “disabilities” travel to the transferee of a bankruptcy claim, however, depend upon whether the claim is transferred by an assignment or by a sale.

Although the District Court cites to the New York Commercial Code in support of the distinction between assignments and sales, the court does not explain how it would actually apply New York law in distinguishing between a transfer in the form of an assignment and a transfer in the form of a sale. Rather, the District Court, having set out a bright line rule that the method of transfer (sale versus assignment) determines the outcome, leaves for the Bankruptcy Court on remand the question of whether the transfer to Springfield was an assignment or a sale.

Disallowance and Equitable Subordination Are Personal Disabilities

Having identified the importance of determining whether a transfer is an assignment or a sale (though without explaining how to make that determination), the District Court next considered whether being subject to section 502(d) disallowance or section 510(c) equitable subordination are inherent attributes of a claim and thus travel with the claim regardless of the form of transfer (i.e., sale or assignment), or whether they are personal disabilities that may be imputed to a transferee in the case of an assignment, but not in the case of a sale. Looking at the plain statutory language and, in certain instances, the legislative history to sections 502(d) and 510(c), the District Court concluded that Congress intended for disallowance under section 502(d) and equitable subordination under section 510(c) to constitute personal disabilities of the claimholder whose action or inaction justifies disallowance or equitable subordination of the claim. Accordingly, the District Court vacated the Bankruptcy Court’s decisions denying Springfield’s motion to dismiss Enron’s disallowance and subordination actions under sections 502(d) and 510(c), because Springfield’s claim would not be subject to disallowance or equitable subordination on the basis of Citibank’s conduct if the claim had been transferred to Springfield by sale as opposed to by assignment. The District Court remanded the case to the Bankruptcy Court to determine whether the transfer to Springfield was in the nature of an assignment or a sale.

Considerations for Potential Postpetition Transferees of Distressed Claims

The District Court’s ruling clearly protects good faith purchasers of distressed debt from disallowance or equitable subordination attacks on the basis of the prior conduct of the party selling the claim. The decision, however, does not entirely eliminate risk to postpetition transferees of distressed debt, because a court could still determine a particular postpetition transfer to be an assignment, as opposed to a sale, and therefore subject to disallowance and/or equitable subordination based upon the transferor’s prepetition conduct. In addition, the decision may raise confusion in the distressed debt marketplace, as it is questionable whether the distinction between assignments and sales may be practically applied to claim transfers in that arena. Notably, in light of the potential for confusion, various Wall Street trade associations, including the Loan Syndications and Trading Association, recently supported an (albeit unsuccessful) attempt by Springfield to appeal the decision to the Court of Appeals for the Second Circuit.

In light of this decision, distressed debt purchasers seeking to shield acquired claims from equitable subordination or 502(d) disallowance attacks might want to consider (to the extent feasible and appropriate) taking steps to ensure that a given transaction is structured as a sale, as opposed to an assignment. Further, given the risk that a particular transfer may ultimately be deemed to have been an assignment and not a sale, potential transferees should consider the inclusion of broad indemnification obligations in any documentation associated with a particular transfer, requiring the transferor to compensate the transferee for any losses if the claim is disallowed or subordinated as a result of a prior holder’s conduct. In addition, distressed debt purchasers would be wise to review existing indemnity agreements associated with prior transfers of the claim, in order to ensure that the chain of indemnity obligations is continuous and unbroken.

Of course, it will not always be possible to rely upon indemnity obligations of a transferor to protect a transferee in the event a claim is ultimately disallowed under section 502(d) or subordinated under section 510(c). For example, postpetition transfers of distressed bonds are typically accomplished anonymously and without the negotiation of any sort of accompanying legal documentation. However, the District Court asserts in its opinion (though without explanation) that transfers of distressed debt on the “open market” would constitute sales and therefore not be subject to disallowance or equitable subordination; as a result, in instances where indemnities and other provisions are not customarily negotiated, the claim in the hands of the transferee should not be subject to disallowance or subordination.

Conclusion

Under the District Court’s decision, a claim transferred by sale is not subject to disallowance or equitable subordination under sections 502(d) or 510(c) of the Bankruptcy Code on the basis of a prior holder’s conduct, while a claim transferred by assignment remains potentially subject to either form of challenge. The comfort provided by the opinion may be somewhat limited, however, in that the court does not explain how it would propose to distinguish between an assignment and a sale in general, and also does not provide any guidance as to whether the distinction has any relevance in the distressed debt markets. Subsequent decisions on this topic should be followed closely, as it is likely that future decisions will further develop the relationship between postpetition transfers of distressed debt and the mechanisms for claim disallowance and equitable subordination under the Bankruptcy Code.