According to a recent decision by the United States District Court for the Southern District of New York,1 a claim sold post-petition is not subject to equitable subordination based solely on the original claimholder's conduct. Likewise, a claim sold post-petition cannot be disallowed based on the original claimholder's receipt of (and failure to repay) an avoidable transfer.
Before its bankruptcy, Enron was a borrower under a short-term credit agreement between Enron and Citibank. The aggregate liability under the short-term credit agreement was over $1.7 billion. After Enron filed for protection under Chapter 11 of the Bankruptcy Code, Citibank and certain other syndicate banks transferred, directly or indirectly, some portion of their claims to other entities. One of the transferees was Springfield Associates, L.L.C., which acquired Citibank's claim under the short-term credit agreement in the sum of approximately $5 million. After Citibank transferred the claim to Springfield, Enron filed adversary proceedings in its bankruptcy case against both Citibank (the original claimholder) and Springfield (the current claimholder), as well as other claimants, seeking equitable subordination of the claims under Section 510(c) of the Bankruptcy Code and disallowance of the claims under Section 502(d) of the Bankruptcy Code. In the adversary proceedings, Enron alleged that the original claimholders had engaged in inequitable conduct which injured creditors of Enron. Enron also asserted that the original claimholders had received, and had refused to repay, prepetition transfers that were avoidable under the Bankruptcy Code. Enron, however, did not allege any wrongdoing on the part of Springfield or that Springfield had received and refused to repay any avoidable transfer.
Springfield moved to dismiss the adversary proceeding against it, arguing that its claim could not be equitably subordinated or disallowed based solely on the original claimholder's conduct. Upon review, the bankruptcy court denied Springfield's motion to dismiss. Dissatisfied with the court's ruling, Springfield sought leave from the district court to file an interlocutory appeal, which the district court granted.
The Opinion and Decision
In a case of first impression, United States District Judge Shira A. Scheindlin reversed the bankruptcy court's ruling, disallowing and subordinating the claims held by Springfield (the post-petition purchaser) based on the conduct of Citibank (the original creditor) and held that equitable subordination under Section 502(c) of the Bankruptcy Code and disallowance under Section 502(d) are "personal disabilities that do not inhere in the claim."2 Furthermore, the court held that whether equitable subordination and disallowance can be applied to an innocent transferee of a claim depends on the nature of the transfer and, more particularly, on whether the transfer is a sale or an assignment.
Of particular interest in the court's decision is Judge Scheindlin's "assignment v. sale" distinction. In reversing the bankruptcy court, the district court stated that, if the transfer of the claim can be characterized as an assignment, then the transferee stands in the shoes of the transferor and is subject to all legal and equitable defenses that could have been asserted against the original claimholder. On the other hand, the court stated that, if the transfer of the claim is more properly characterized as a sale, then the transferee takes the claim free of "personal disabilities that do not inhere in the claim," provided the transferee had no actual notice of the facts that give rise to the personal disability.3 In light thereof, the court ultimately opined that "unless there was a pure assignment (or other basis for the transferee to step in the shoes of the transferor), as opposed to a sale of the claim, the claim in the hands of the transferee is not subject to equitable subordination or disallowance based solely on the conduct of the transferor."4
Noting the importance of the "assignment v. sale" distinction, the court stated:
The distinction [between assignments and sales] is particularly imperative in the distressed debt market context, where sellers are often anonymous and purchasers have no way of ascertaining whether the seller (or a transferee up the line) has acted inequitably or received a preference. No amount of due diligence on their part will reveal that information, and it is unclear how the market would price such unknowable risk. Parties to true assignments, by contrast, can easily contract around the risk of equitable subordination or disallowance by entering into indemnity agreements to protect the assignee.5
In crafting the distinction, the court relied on the well-established doctrine that a party can assign no greater rights than it holds. While the court noted that this doctrine is subject to two exceptions (the holder-in-due-course doctrine in the case of a negotiable instrument and the third-party-latent-equities doctrine), the court concluded that neither exception applied in this case. In particular, the court stated that the holder-in-due-course doctrine is inapplicable because the transfer occurred post-petition. Moreover, the court concluded that the third-party-latent-equities doctrine did not apply because New York law does not recognize the doctrine in the case of the transfer of a chose in action.
While Enron argued that allowing claim transferees to take free of the risk of equitable subordination would let culpable transferors effectively "launder" their claims to the detriment of creditors, the court dismissed this argument. The court reasoned that the risk of such harm was exaggerated and that the court's analysis was consistent with the protections traditionally afforded to innocent transferees. In any event, because the court found that the Bankruptcy Court "ignored the distinction between assignments and sales and never addressed whether equitable subordination travels with the claim or is a personal disability," the court remanded the matter to the Bankruptcy Court to determine whether Citibank's transfer of its claim to Springfield was an assignment or a sale.6
No doubt, the "assignment v. sale" distinction made by District Judge Scheindlin will be the subject of further litigation in the Enron case and stir debate between practitioners and academics alike. While the distinction represents a creative approach to addressing the issues of whether a claim sold post-petition is subject to equitable subordination and disallowance based solely on the original claimholder's conduct, the distinction is likely to draw dissent from other courts as unnecessarily elevating form over substance.