Amid the explosion of trading in claims against distressed and bankrupt entities, courts in recent years have issued numerous rulings of interest to both buyers and sellers. Notable decisions have addressed, among other things, "loan to own" acquisition strategies resulting in vote disqualification or claim amount limits; buying claims to block confirmation of a chapter 11 plan; equitable subordination, disallowance, and other lender liability exposure based upon the seller's misconduct; the adequacy of standardized claims trading agreements; claim-filing requirements in the era of computerized records; and buying claims for the purpose of creating appellate standing.
One of the latest developments in the growing body of bankruptcy jurisprudence affecting this area was contributed recently by the U.S. Bankruptcy Court for the District of Delaware in In re Woodbridge Group of Companies, LLC, 2018 WL 3131127 (Bankr. D. Del. June 20, 2018). The court ruled that, because an anti-assignment clause in a promissory note was enforceable under state law, the associated claim asserted in bankruptcy by the purchaser of the note must be disallowed. Among other things, the court noted that "[t]he evidence does not support the claims trader's argument that enforcing the anti-assignment clause would disrupt the market."
Bankruptcy Claims Trading
The proliferation of trading in distressed debt, other claims, and stock and other interests provides a ready market for creditors and shareholders who want to obtain current recoveries without waiting until the end of a bankruptcy case. Although trading in public securities is regulated by disclosure and other requirements contained in federal securities laws, transfers of some types of claims are not subject to such regulation. Astute claims traders with information and expertise that other creditors may not have or may not be willing to develop can profit considerably if claims acquired at a steep discount later reap significant recoveries. For a variety of potential reasons, bankruptcy courts have sometimes played a role in monitoring or regulating such claims trading.
Bankruptcy Rule 3001
Neither the Bankruptcy Code nor the Federal Rules of Bankruptcy Procedure (the "Bankruptcy Rules") expressly give the bankruptcy courts the power to regulate claims trading once a debtor files for bankruptcy. Bankruptcy Rule 3001(e) includes certain notification requirements which vary according to when a claim is transferred and for what purpose (i.e., for security or otherwise) to ensure that the court has an accurate record of the identity of the holder of the claim and, in a chapter 11 case, to ensure that the actual holder of the claim has an opportunity to vote to accept or reject a plan. It does not provide for any court involvement in the trading process.
Bankruptcy Rule 3001 was amended in 1991 to significantly curtail court oversight of claims transfers. See Preston Trucking Co. v. Liquidity Solutions, Inc. (In re Preston Trucking Co.), 333 B.R. 315 (Bankr. D. Md. 2005); see generally COLLIER ON BANKRUPTCY ¶ 3001.08 (16th ed. 2018). Prior to 1991, Bankruptcy Rule 3001(e)(2) required court approval of all claims transfers after notice and a hearing. As a result, prior to 1991, courts frequently used Rule 3001(e) to place significant restrictions on the claims trading process. See, e.g., In re Allegheny International Inc., 100 B.R. 241 (Bankr. W.D. Pa. 1988) (establishing a procedure for claims trading in addition to the requirements of Bankruptcy Rule 3001(e) and requiring the debtor to provide the potential assignor with its best estimate of the value of the claim until a plan and disclosure statement were filed); In re Revere Copper and Brass, Inc., 58 B.R. 1 (Bankr. S.D.N.Y. 1985) (refusing to approve assignments of claims until the creditors had been given a period of approximately 30 days in which to revoke assignments, where the assignee failed to show that the creditors had received sufficient information to make an informed judgment about the purchase offer).
The Advisory Committee Note accompanying the 1991 amendment states that, in the event the transferor makes a timely objection, the "court's role is to determine whether a transfer has been made that is enforceable under nonbankruptcy law."
Under amended Bankruptcy Rule 3001(e), if a claim has been transferred for purposes other than security prior to the filing of a proof of claim, there is no need to submit evidence of the transfer. If a claim has been transferred for purposes other than security after the original claimant files a proof of claim, the transferee is substituted for the transferor in the court's records in the absence of a timely objection by the transferor.
Courts' Continued Role in Regulating Trading
Despite curtailment of the court's role in the claims trading process, courts in certain circumstances have regulated claims trading or disallowed traded claims.
Restricting Trading to Preserve Tax Attributes Chapter 11 debtors intent upon preserving valuable tax attributes commonly seek court orders restricting trading of claims and interests to prevent a corporate ownership change that, if not effectuated as part of a confirmed chapter 11 plan, could limit or eliminate the ability of the debtor or an acquirer to use net operating loss ("NOL") "carrybacks" or "carryovers" to offset past or future taxable income. See 26 U.S.C. §§ 172 and 382. Courts which have restricted trading in this manner generally reason that NOLs are property of the debtor's bankruptcy estate under section 541, that the property is protected from forfeiture by the automatic stay in section 362, and that the court has broad equitable authority under section 105 to restrict trading. See, e.g., Official Comm. of Unsecured Creditors v. PSS S.S. Co., Inc. (In re Prudential Lines, Inc.), 928 F. 2d 565 (2d Cir. 1991), cert. denied, 502 U.S. 821 (1991); In re Triad Guar. Inc., 2016 WL 3523834 (D. Del. June 27, 2016); In re Phar-Mor, Inc., 152 B.R. 924 (Bankr. N.D. Ohio 1993). But see In re UAL Corp., 412 F.3d 775 (7th Cir. 2005) (ruling that the bankruptcy court erroneously enjoined trading and that when two parties decide to trade claims or interests, they are transferring rights which they own and control, rather than seeking to obtain possession or exercise control over the debtor's NOLs).
Disallowance of Traded Claims Under Section 502(d) Section 502(d) of the Bankruptcy Code creates a mechanism for dealing with creditors who have possession of estate property on the bankruptcy petition date or are the recipients of pre- or post-bankruptcy asset transfers that can be avoided because they are fraudulent, preferential, unauthorized, or otherwise subject to forfeiture by operation of a bankruptcy trustee's avoidance powers. This section provides in relevant part as follows:
[T]he court shall disallow any claim of any entity from which property is recoverable under section 542, 543, 550, or 553 of this title or that is a transferee of a transfer avoidable under section 522(f), 522(h), 544, 545, 547, 548, 549, or 724(a) of this title, unless such entity or transferee has paid the amount, or turned over any such property, for which such entity or transferee is liable . . . .
Some courts have held that a transferred claim must be disallowed under section 502(d) even if the transferee is not the entity from which property is recoverable—ruling, in effect, that a claim is not cleansed when it is sold or assigned. See In re KB Toys Inc., 736 F.3d 247, 254 (3d Cir. 2013) ("the cloud on the claim continues until the preference payment is returned, regardless of whether the person or entity holding the claim received the preference payment"); In re Metiom, Inc., 301 B.R. 634 (Bankr. S.D.N.Y. 2003); see also In ASM Capital, LP v. Ames Department Stores, Inc. (In re Ames Department Stores, Inc.), 582 F.3d 422 (2d Cir. 2009) (section 502(d) does not mandate disallowance of administrative claims acquired from recipients of voidable transfers because an administrative expense does not qualify as a "claim" within the meaning of the provision); In re Arctic Glacier Int'l, Inc., 255 F. Supp. 3d 534 (D. Del. 2017) (citing KB Toys and ruling that purchasers of units in a chapter 15 debtor were bound by court-approved releases in a Canadian debtor's plan of arrangement). But see Enron Corp. v. Springfield Associates, L.L.C. (In re Enron Corp.), 379 B.R. 425 (S.D.N.Y. 2007) (infirmities travel with an assigned claim for purposes of section 502(d), but not if the claim is sold), vacating Enron Corp. v. Springfield Associates, L.L.C. (In re Enron Corp.), 333 B.R. 205 (Bankr. S.D.N.Y. 2005) (a transferred claim can be equitably subordinated even if it is transferred to an entity that did not engage in any misconduct), and Enron Corp. v. Avenue Special Situations Fund II, LP (In re Enron Corp.), 340 B.R. 180 (Bankr. S.D.N.Y. 2006) (transferred claims can be disallowed under section 502(d) if the transferor received a voidable transfer).
Unenforceability of Claim Under State Law—Woodbridge Group
Section 502(b)(1) of the Bankruptcy Code provides that a claim shall be disallowed if it is "unenforceable against the debtor . . . under any agreement or applicable law for a reason other than because such claim is contingent or unmatured." In Woodbridge Group, the bankruptcy court held that a claim based upon an assigned promissory note must be disallowed under section 502(b)(1) because the note contained an anti-assignment clause which was enforceable under applicable state law.
Prior to filing for chapter 11 protection in 2017 in the District of Delaware, Woodbridge Mortgage Investment Fund 3 A, LLC ("Woodbridge") issued approximately 9,000 secured promissory notes to various investors, including Elissa and Joseph Berlinger (the "Berlingers"). Both the notes and the underlying loan agreements contained anti-assignment clauses providing that the notes, the loan agreements, and other related documents could not be assigned by the noteholders without Woodbridge's consent and that "any such attempted assignment without such consent shall be null and void."
Woodbridge breached the loan agreements before filing for bankruptcy. In February 2018, the Berlingers entered into an agreement to "sell, convey, transfer and assign" their notes and associated rights to Contrarian Funds, LLC ("Contrarian"). Contrarian then filed a secured claim against Woodbridge on the basis of the transferred promissory notes. Woodbridge objected to the claim, contending that it was unenforceable due to the anti-assignment clause. In addition, in accordance with the terms of the notes, Woodbridge unilaterally imposed a moratorium on any transfers of its $750 million in promissory notes.
The bankruptcy court sustained Woodbridge's objection and disallowed Contrarian's claim.
The court was mindful that the role played by bankruptcy courts in policing claims trading was curtailed in 1991. Even so, the court wrote that it was "aware of no provision in the Bankruptcy Code or of any overarching bankruptcy policy which impairs the Court's authority to determine and enforce applicable non-bankruptcy law concerning contract provisions which may restrict transfers of claims." It also flatly rejected the argument that sustaining Woodbridge's objection to Contrarian's claim would disrupt the claims trading market (citing KB Toys, 470 B.R. at 342 ("The assertion that subjecting transferred claims to § 502(d) disallowance would cause disruption in the claims trading market is a hobgoblin without a house to haunt.")).
The court explained that under applicable state law—here, Delaware law—anti-assignment clauses which restrict the power to transfer are enforceable, albeit narrowly construed due to the importance of free assignability. In addition, in Delaware and elsewhere, there is a distinction between provisions restricting a party's power to assign by express language that any assignment will be void or invalid and those merely restricting the right to assign, in which case the assignment is valid and enforceable but causes a breach of contract. In this case, the court ruled, the notes and the loan agreement expressly limited the noteholders' power to assign.
The court rejected Contrarian's argument that, because it purchased the "claims" or "causes of action" underlying the promissory notes, rather than the notes themselves, the assignment was valid and enforceableunder the Restatement (Second) of Contracts, which limits noteholders' ability to delegate duties in connection with notes but does not bar them from transferring their rights, claims, or causes of action. According to the court, the Restatement provides that an anti-assignment clause, whether it purports to prevent the assignment of claims, causes of action, or notes, is enforceable if expressed in clear and unambiguous language, which was the case here.
The court also rejected Contrarian's argument that Woodbridge's breach of the notes rendered the anti-assignment clauses unenforceable. "It is axiomatic," the court wrote, "that a non-breaching party may not emerge post-breach with more rights than it had pre-breach." According to the court, this conclusion comports with its previous ruling in KB Toys, in which it held that a "disability"—here, the inability to assign the notes without consent—travels with an assigned claim.
Finally, the court rejected the argument that section 9-408 of the Uniform Commercial Code (the "UCC") "overrides and nullifies" any contract provision which restricts the assignment or "requires the consent of the maker of a promissory note before the note may be transferred." UCC § 9-408, the court explained, applies only to grants of security interests in promissory notes, and another provision—UCC § 9-406—"endorses the enforceability of anti-assignment provisions in the sale, or assignability, of promissory notes."
Woodbridge Group is a cautionary tale for claims traders. It highlights the importance of careful due diligence and knowledge of the law. As with many other court rulings addressing claims transfers in the recent past, Woodbridge Group reinforces the view of most courts that a claim travels with its impediments, thereby putting the burden on transferees to thoroughly vet the enforceability of a claim or to demand an appropriate indemnity in a claim transfer agreement. The ruling also suggests that courts may not be receptive to claims traders' contentions that disallowance of transferred claims may disrupt the trading market.
Woodbridge Group is not the only recent court ruling addressing the enforceability of assigned claims under section 502(b). In In re Caesars Entertainment Operating Co., Inc., 588 B.R. 32 (Bankr. N.D. Ill. 2018), the bankruptcy court disallowed assigned tort and contract claims because the tort claims were unassignable under applicable non-bankruptcy law and because, pursuant to a purchase and sale agreement, the contract claims could not be assigned without consent. The court also held that Bankruptcy Rule 3001(e) does not create substantive rights for claims transferees.
In addition, in In re Westinghouse Electric Co. LLC, 2018 WL 3655702 (Bankr. S.D.N.Y. Aug. 1, 2018), the bankruptcy court ruled that, because a series of email exchanges between the holder and the purported purchaser of a claim did not create a binding contract under applicable non-bankruptcy law, the notice of transfer of the claim should be canceled and the original holder recognized as the claimant. The court rejected the argument that customs in the claims trading industry demanded a contrary ruling, noting that industry participants "ought to be clear and direct in setting forth their agreements in the emails they exchange," especially when dealing with less experienced counterparties.