Recently, in connection with the bankruptcy case of KB Toys, the Third Circuit Court of Appeals disallowed a claim held by a claim purchaser, citing that the original holder of the claim had received a preference payment prior to the bankruptcy case.1 The ruling affirmed an earlier decision of the Delaware Bankruptcy Court, which we discussed in a previous memorandum2, in which the Bankruptcy Court held that (i) a claim in the hands of a transferee has the same rights and disabilities as the claim had in the hands of the original claimant; and (ii) disabilities attach to and travel with the claim. In reaching its decision, the Third Circuit largely adopted the Bankruptcy Court’s reasoning and analysis. The Third Circuit also held that there was no “good-faith purchaser” defense available to the claim purchaser.3

Although this ruling does not have precedential effect outside of the Third Circuit, claim purchasers should consider the opinion to carry great weight outside of the Third Circuit, including the Southern District of New York. Likewise, while this opinion only dealt with trade claims and not bank loan or bond claims, the reasoning of the Third Circuit and the statutory analysis on which it relied should largely apply to those types of claims as well.

As detailed in our earlier memorandum, the Third Circuit’s decision demonstrates the need for (i) careful diligence of claims and loans as well as carefully drafted indemnifications in the event of a disallowance or other claim impairment; and (ii) careful assessment of the credit worthiness of counter-parties, as representations and warranties and/or indemnifications from troubled counter-parties may be of little value. Where a purchaser perceives an increased risk of disallowance or an inability to collect on representations and warranties and/or indemnifications, purchasers may want to consider negotiating with their sellers to obtain collateral or other forms of credit protection. Purchasers should also consider who should have the right and ability to control disallowance litigation, particularly in situations where concerns exist over the seller’s solvency.