In In re KB Toys,1 a recent decision by the Third Circuit Court of Appeals, the Court held that a claim that is disallowable under § 502(d)2 if held by the original claimant is also disallowable in the hands of a purchaser or subsequent transferee. In other words, if a creditor sells or assigns its claim to a claims trader and the creditor later becomes liable on a preference or fraudulent transfer,3 the claim may be disallowed in the hands of the claims trader if the creditor fails to pay the amount it owes to the estate. Prior to In re KB Toys, other courts reached conflicting conclusions on the interpretation of § 502(d). Some courts, consistent with In re KB Toys, have held that the focus of § 502(d) is on claims rather than claimants and an assignment of claims to a third party does not alter the trustee’s right to seek a disallowance of those claims under § 502(d).4 Other courts have held that the focus of § 502(d) is on the claimant rather than the claim and have provided that under certain circumstances a trustee may not disallow a claim in the hands of a purchaser of the claim even if the original claimant is liable to the estate for an avoidable transfer.5
In re KB Toys dealt with ASM Capital II, LLP (“ASM”), who purchased several claims (the “Claims”) from various trade creditors (the “Original Claimants”) that held claims against the estate of KB Toys and its affiliates (the “Debtors”). Certain of the claim assignment agreements provided that the Original Claimants would be required to pay restitution to ASM if the Claims were disallowed. The Debtor’s statement of financial affairs (“SOFA”) revealed that each of the Original Claimants were potentially subject to preference actions. The liquidating trustee of the Debtor’s estate (the “Trustee”) brought preference actions against all of the Original Claimants and ultimately obtained judgments against each. Because each of the Original Claimants themselves went out of business, they were unable to pay the judgments and the Trustee subsequently filed objections to the Claims seeking to disallow them pursuant to § 502(d). The bankruptcy court disallowed the claims. On appeal to the District Court, the District Court affirmed.
The Third Circuit also affirmed. Looking to the language of § 502(d), the Court concluded that the plain language of § 502(d) focuses on claims rather than claim holders. The Court further noted that a contrary reading of the statute would undermine the policy objectives of § 502(d) by incentivizing claimants to sell their claims in order to “wash” the claims of liability under § 502(d). Specifically, “the original claimant would have an incentive to sell its claim - so it could receive some value for an otherwise valueless claim - and the transferee would have an incentive to buy the claim - because once the claim is in its hands, the claim is eligible to receive a distribution.” The Court reasoned that this would result in two-fold harm to the rest of a debtor’s creditors. First, the original claimant would be less likely to return the avoidable transfer thus decreasing funds available for distribution to all creditors. Second, the estate would be required to pay on a claim, which, if held by the original claimant, would have been disallowed.6
The Court also rejected ASM’s argument that it was a good faith purchaser under § 550(b).7 The Court held that § 550(b) only protects a purchaser who purchases property of the estate, and a claim against a debtor is not property of the estate. The Court also focused upon the ability of claims purchasers, such as ASM, to understand, voluntarily accept and mitigate the risks and uncertainties inherent in the bankruptcy process, including the risk of disallowability under § 502(d). In particular, the Court noted that ASM had constructive notice of the potential preference liability because the Debtors’ SOFA revealed that each of the Original Claimants were potentially subject to preference actions.
In light of the Court’s ruling in In re KB Toys, both buyers and sellers of claims should carefully consider the risks associated with potential avoidance liability and § 502(d) when entering into agreements for the transfer of claims. Specifically, claims traders should investigate a creditor’s preference exposure by seeking information from the creditor and by reviewing a debtor’s SOFA. In addition to considering the risks from the bankruptcy process itself, claims buyers must also consider the creditworthiness of creditors and their ability to meet their restitution and indemnity obligations. As illustrated by In re KB Toys, even if an assignment agreement contains indemnity and restitution provisions, those provisions will provide little protection in the event a claims transferor later becomes insolvent or is otherwise unable to meet its obligations under an assignment or sale agreement.