If you hold a claim in bankruptcy by way of a transfer, you may need to be sure the transaction was accomplished by a sale and not merely by an assignment. Yet another decision highlights the growing complexity in bankruptcy claims as we discuss below.

The United States District Court for the Southern District of New York recently held that when a claim is sold postpetition it is not subject to equitable subordination under section 510(c) or disallowance under section 502(d) based solely on the acts of the original claimant. Under this decision, claims not merely "assigned" but "sold" that would have otherwise been either equitably subordinated or disallowed under section 502(d) if they remained in the hands of the original claimant can now be asserted against a bankruptcy estate as if they were never held by a claimant guilty of inequitable conduct or a creditor that refused to return an avoidable transfer.

Factual Background

Prior to its bankruptcy, Enron was a borrower under a long-term and short-term revolving credit agreement with a syndicate of banks, including Citibank as paying agent and co-administrative agent. After Enron filed for bankruptcy, Citibank and certain other syndicate banks transferred some portion of their claims to certain third-party transferees. One such transferee was Springfield Associates, L.L.C., which acquired $5,000,000 of the indebtedness arising under the short-term credit agreement from BT/Deutsche Bank, which had acquired the indebtedness from Citibank. The transfer agreements between Citibank and BT/Deutsche Bank and between BT/Deutsche Bank and Springfield contained seller warranties and indemnities against any acts of Citibank resulting in the claim receiving less favorable treatment in bankruptcy.

After the Citibank claim was transferred to Springfield, Enron began an adversary proceeding against Citibank and other banks. In its complaint, Enron sought, among other things, the equitable subordination of the banks' claims under section 510(c), disallowance of the banks' claims under section 502(d), and compensatory damages and punitive damages based on alleged misconduct that injured Enron's creditors.

Shortly thereafter, Enron filed a series of adversary proceedings against the transferees of the banks' claims, including Springfield. In these complaints, Enron sought the equitable subordination of the transferees' claims under section 510(c) and the disallowance of the transferees' claims under section 502(d) based on the alleged misconduct of the banks that held such claims on the petition date. Enron's complaint against Springfield did not allege that Springfield had engaged in any misconduct or had received any avoidable transfers. Following Enron's commencement of the action against Springfield, Springfield sued its assignors to enforce the warranties and indemnities contained in the respective transfer agreements.

Springfield moved to dismiss, arguing that its claim could not be equitably subordinated or disallowed based solely on the alleged acts or omissions of Citibank, the original holder of the claim. The Bankruptcy Court denied Springfield's motion to dismiss, finding in two separate opinions that a transferee of a claim in bankruptcy stands in the shoes of the transferor and is subject to all defenses that could be asserted against the original claimant, including equitable subordination and disallowance under section 502(d) of the Bankruptcy Code. Springfield sought leave from the District Court to file an interlocutory appeal, which the District Court granted.

The District Court's Opinion

In reversing the Bankruptcy Court, the District Court held that equitable subordination under section 510(c) and disallowance under section 502(d) are personal disabilities that are not fixed as of the petition date and do not inhere in the claim. The District Court, however, further held that a transferee may be subject to equitable subordination or disallowance under section 502(d) based on the conduct of the transferor if the claim was transferred by way of an assignment as opposed to a sale.

The District Court found that there is a legal distinction between the “assignment” of a claim asserted against a bankruptcy estate and the “sale” of a claim asserted against a bankruptcy estate. According to the District Court, if a bankruptcy claim is assigned, then the transferee of the claim steps into the shoes of the transferor and is subject to all legal and equitable defenses that could be asserted against the transferor, unless an exception to the assignment law rule that an assignor cannot give more than he has applies. If a bankruptcy claim is sold, then the transferee of the claim is not subject to the personal disabilities of the seller, unless the transferee purchased the claim with actual notice of the defenses asserted against the transferor.

The District Court further found that the defenses of equitable subordination and disallowance under section 502(d) are “personal disabilities” of the claimant and not attributes of the claim held by such claimant on the petition date. Accordingly, applying the aforementioned distinction between the assignment of a bankruptcy claim and the sale of a bankruptcy claim, if a bankruptcy claim is sold, then the claim in the hands of the transferee cannot be subject to equitable subordination or disallowance under section 502(d) based on the misconduct of the transferor, unless the transferee was aware of such misconduct at the time of the transfer. If a bankruptcy claim is assigned, however, then the claim in the hands of the transferee is subject to equitable subordination or disallowance under section 502(d) based on the misconduct of the transferor, unless the transferee can show that an exception to the assignment law rule that an assignor cannot give more than he has applies.

Because the District Court found that the Bankruptcy Court did not consider the issues addressed by the District Court, the matter was remanded to the Bankruptcy Court to determine whether Springfield's claim was transferred by way of assignment or sale. In making this determination, the District Court directed the Bankruptcy Court to consider the respective transfer agreements between the parties, and stated that “sales of claims on the open markets are indisputably sales and subrogation of a surety to the rights under a claim is indisputably an assignment.” The Bankruptcy Court has yet to issue an opinion applying the legal standard adopted by the District Court.