The Delaware bankruptcy court in the KB Toys, Inc. cases recently held that a claims purchaser takes a claim subject to certain disabilities of the claim as held by the seller, regardless of whether the claim transfer is deemed a “sale” or an “assignment.” See In re KB Toys, Inc., Case No. 04-10120 (KJC) (Bankr. Del. May 4, 2012). In so ruling, the Delaware court’s decision is somewhat at odds with the decision issued by the District Court for the Southern District of New York in the Enron bankruptcy cases. See Enron Corp. v. Springfield Associates, LLC (In re Enron Corp.), 379 B.R. 425, 443 (S.D.N.Y. 2007). In the Enron decision, the district court held that whether a disability travels with a claim to the purchaser depends on whether the transfer is a “sale” (in which case there is no transfer of any disability) or an “assignment” (in which case any disability transfers to the assignee).

When issued, the Enron decision created some uncertainty for claims purchasers. As noted by the KB Toys court, whether the transfer of a claim constitutes a sale or an assignment was not something market participants had focused on and, in fact, many buyers and sellers used the terms interchangeably. While the Enron decision arguably provided claims purchasers with more protection in connection with purchased claims, whether that “protection” applied to any particular transferred claim was not a straight-forward issue. This ambiguity was criticized by many in the market. The KB Toys decision should provide some clarity, at least in Delaware bankruptcy cases, for claims purchasers.

Facts

During the KB Toys bankruptcy case, ASM Capital, L.P. and ASM Capital II , LLP (together, “ASM ”) purchased several trade claims filed against KB Toys. Nine of these claims were subject to an objection filed by the trustee of the KB Toys residual trust. In the objection, the trustee asserted the claims should be disallowed on the basis that the original claimant had not repaid certain “preferential” payments received from KB Toys shortly before it filed for bankruptcy. (The original claimants were defendants in preference actions. The trustee had obtained judgments against each claimant, and none had to date disgorged to the trust those “preferential” payments.)

In its objection, the trustee relied on Bankruptcy Code section 502(d), which provides in relevant part that “the court shall disallow any claim of any entity … that is a transferee of a transfer avoidable under [the Bankruptcy Code] unless such entity or transferee has paid the amount, or turned over any such property, for which such entity or transferee is liable under [the Bankruptcy Code]” Absent payment on the judgment in the preference action, the trustee asserted the trade claims were not entitled to participate in distributions.

ASM filed a response to the objection, arguing that the claims could be not disallowed pursuant to section 502(d) when they were no longer held by the original claimant/ preference defendant.

The Parties’ Arguments

Citing to the Enron decision, ASM asserted that the claims at issue were transferred to ASM by “sales,” not “assignments,” and therefore ASM held the claims free of any of the seller’s disabilities. ASM asserted that the trustee’s basis for the objection — Bankruptcy Code section 502(d) — was intended to focus on the claimant subject to the preference action, not the claim itself. Finally, ASM argued that it had purchased the claims in “good faith,” and therefore the claims could not be disallowed because the Bankruptcy Code protects “good faith” purchasers.

By contrast, the trustee asserted that the claims had been transferred to ASM by “assignment,” so that the taint of the preference judgments traveled with them. The trustee also argued that KB Toys’ statement of financial affairs noted the original claimants had received payments during the 90-day period prior to the bankruptcy case, which gave ASM at least constructive knowledge of the preferential transfers and the risks related to the claimants’ claims. Such knowledge, the trustee argued, precluded a finding of “good faith.” The trustee also questioned the reasoning of the Enron decision.

The Court’s Analysis

Agreeing with the trustee, the KB Toys court found that the plain language of Bankruptcy Code section 502(d), the legislative history, and related case law all support the view “that a claim in the hands of a transferee has the same rights and disabilities as the claim had in the original claimant. Disabilities attach to and travel with the claim.”

Starting with a review of the legislative history supporting section 502(d), the KB Toys court noted that section 502(d) was derived from section 57g of the Bankruptcy Act of 1898, which established the basis for allowance or disallowance of particular claims. Prior cases considering the application of section 57g held that the rights of a transferee of a claim were subject to the equities and burdens of the transferor. The KB Toys court stated that after the enactment of the Bankruptcy Code, courts continued to find that transferees held claims subject to personal disabilities of the transferor, and it highlighted two decisions — In re Metiom, Inc., 301 B.R. 634 (Bankr. S.D.N.Y. 2003) and Enron Corp. v. Avenue Special Situations Fund II, LP (In re Enron Corp.), 340 B.R. 180 (Bankr. S.D.N.Y. 2006). The Metiom court held that “[t]he assignment [of a claim] should not, and does not, affect the debtor’s rights vis-à-vis the claim; it is incumbent, instead, on prospective assignees to take into account possible claim defenses when they negotiate the terms of their assignments.” See In re Metiom, Inc., 301 B.R. at 642-43. This sentiment was also expressed by the bankruptcy court in the Enron decision, stating “participants in the claims-transfer market are aware of, or should be aware of, the risks and uncertainties inherent in the purchase of claims against the debtors, including the possibility of claims being temporarily disallowed under section 502(d) unless and until their predecessors turn over the avoidance transfers. . . .” See In re Enron Corp., 340 B.R. at 202. This Enron bankruptcy court decision, however, was vacated by the district court case discussed above.

Turning to the Enron district court decision, the KB Toys court first noted that the “assignment/sale” distinction stressed by the Enron court is not easily applied when considering the treatment of claims in the hands of a purchaser. As noted above, the markets had used the terms interchangeably and neither word is defined by the Bankruptcy Code. Indeed, the Enron court stressed that the nomenclature used by parties was not dispositive, but rather the legal effect of its provisions was to be considered.

The KB Toys court disagreed with the Enron court’s statement that burdening the transferee of a claim with a disability imposed on a claim by the transferor would “wreak havoc on the markets for distressed debt.” The KB Toys court noted that buyers of debt tend to be “highly sophisticated entities fully capable of performing due diligence” before purchasing claims and, even without any due diligence, claims purchasers are aware of “the ever-present possibility of avoidance actions based on preference liability or fraudulent conveyances.”

Finally, the court dismissed ASM ’s argument that it was a “good faith” purchaser of the claims such that the claims could not be disallowed. The KB Toys court noted that purchasers of claims in bankruptcy are well aware (or should be aware) that they are “entering an arena in which claims are allowed and disallowed in accordance with the Bankruptcy Code and decisional law interpreting those provisions” and in such conditions, claims purchaser are not entitled to the benefits afforded to “good faith” purchasers under the Bankruptcy Code.

Conclusion

The KB Toys court concluded that claims purchasers hold claims subject to the same rights and disabilities under Bankruptcy Code section 502(d) as does the original trade claimant. While the decision is less protective to claims purchasers than the Enron decision, the risks related to Bankruptcy Code section 502(d) are of the type that are arguably easier to identify by claims purchasers. A claim purchaser can review the seller’s records and debtor’s statement of financial affairs and schedules to ascertain what the seller may have received from the debtor within the months immediately preceding a bankruptcy filing. In the Enron decision, the debtor asserted the claims purchasers’ claims should be equitably subordinated based on inequitable conduct of the sellers. Such “inequitable conduct” is not as easily discernible by a review of the books of and records and, accordingly, the Enron court’s “assignment/sale” distinction to protect claims purchasers may be more defensible. Claims purchasers may mitigate equitable subordination risk by negotiating for a right to recourse against the claims seller if the transferred claim is later subject to challenge based on conduct of the original claim holder/transferor.