A recent ruling by a federal court in New York has the potential to severely impact the $500 billion a year distressed debt market.

In Enron Corp. v. Springfield Assocs., L.L.C., No. 05-01025 (S.D.N.Y. Aug. 27, 2007), the U.S. District Court for the Southern District of New York recently addressed whether the principles of equitable subordination and disallowance are applicable to claims held by a transferee to the same extent as claims still held by a transferor guilty of misconduct or wrongdoing.

The district court concluded that both inequitable conduct warranting equitable subordination and receipt of a preference warranting disallowance were personal attributes of the claim holder, which under certain circumstances would not pass to a transferee. Therefore, the district court reversed an order of the bankruptcy court and remanded the case.

Its decision, the court noted, “although fairly simply stated, is complex and of first impression in this Circuit, and will have serious ramifications well beyond the parties involved in this particular appeal.”

Enron Fallout

On Dec. 2, 2001 (the “Petition Date”), Enron filed for protection under chapter 11 of the Bankruptcy Code. Prior to its bankruptcy filing, Enron Corp. was party to a Short-Term Credit Agreement in which it owed a number of syndicated lenders, including Citibank, N.A., approximately $1.75 billion. Subsequent to the bankruptcy filing, Springfield Associates, L.L.C. acquired a claim originally held by Citibank in the secondary market of approximately $5 million of the indebtedness arising under the Short-Term Credit Agreement.

Enron filed suit against a number of financial institutions, including Citibank, alleging, among other things, that each received certain avoidable transfers and each participated in certain pre-petition misconduct with respect to Enron. Enron then filed an adversary proceeding against Springfield, seeking to (i) equitably subordinate Springfield’s claim based solely on Citibank’s alleged inequitable conduct; and (ii) disallow Springfield’s claim pursuant to Section 502(d) of the Bankruptcy Code based on Citibank’s receipt of avoidable transfers.

All parties agreed that Springfield itself never engaged in any improper conduct or received any avoidable transfer.Springfield moved to dismiss the claims brought in the adversary proceeding on the grounds that equitable subordination and disallowance cannot be applied to claims held by transferees solely because of alleged misconduct of their transferors.

The bankruptcy court disagreed and held that a claim that is subject to equitable subordination or disallowance in the hands of the transferor is subject to equitable subordination and disallowance in the hands of a transferee.

Stunned Secondary Market

The bankruptcy court’s decision stunned financial institutions across the spectrum.

It had the potential to create a crippling effect on the secondary debt market for post-bankruptcy debt, because claim purchasers now faced an obligation to conduct additional (and potentially impossible) due diligence to confirm that no prior owner of any portion of a claim engaged in any improper conduct.

The adverse market implications of the bankruptcy court’s decision were evidenced by a joint amicus submission by the Loan Syndications and Trading Association, the Securities Industry and Financial Markets Association, and the International Swaps and Derivatives Association, urging the district court to overturn the bankruptcy court’s holding.

In the Hands of a Transferee

The district court defined the issue on appeal as whether “equitable subordination and disallowance could be applied to a claim in the hands of a transferee based solely on conduct of the transferor.”

The court began its analysis by addressing Enron’s argument that all rights among competing claims to a bankruptcy estate are fixed and determined as of the petition date, including equitable subordination and disallowance. Because Citibank held claims on the Petition Date that were subject to equitable subordination and/or disallowance, such claims were tainted on the Petition Date, Enron claimed.

The district court found that equitable subordination and disallowance each require court action, are discretionary, and can be contingent on the petition date. According to the court, these attributes, together with a close reading of the applicable Bankruptcy Code provisions, reveals that equitable subordination and disallowance do not become fixed to a claim on the petition date.

Claim Attributes

Having established that such attributes were not fixed on the Petition Date, the court moved to the “threshold question of law that the Court must decide: are equitable subordination under section 510(c) and disallowance under section 502(d) attributes of a claim or are they personal disabilities of particular claimants[?]” Attributes of a claim travel with the claim regardless of the method of transfer.

On the other hand, application of personal disabilities of the claimant depends on whether the transfer was by way of a sale or assignment. “A personal disability that has attached to a creditor who transfers its claim will travel to the transferee if the claim is assigned, but will not travel to the transferee if the claim is sold,” the court stated.

With regard to equitable subordination, because the plain language of the Bankruptcy Code invokes “principles of equitable subordination,” the court turned to case law and the legislative history to determine whether the legislative intent was to create a characteristic of a claim or a personal disability of claimant.

First, the court found that the legislative history refers to misconduct on the part of a “holder” of the claim—an indication that Congress intended equitable subordination to be specific to the bad actor. Second, at the time of enactment of Section 510(c) of the Bankruptcy Code, courts did not focus on the claim itself but required misconduct on the part of the creditor asserting the claim before they would apply equitable subordination.

Turning to disallowance, the court focused on the statutory language and structure of Section 502(d), which requires “that the entity that is asserting the claim be the same entity . . . that is liable for receipt of and failure to return property.” Because the purpose of disallowance is to coerce the return of assets obtained by preferential transfer, the court reasoned that this purpose would not be served if disallowance traveled with claims to transferees who never received the preference to begin with.

Personal Disabilities

Accordingly, the district court determined that the principles of equitable subordination and disallowance are both personal disabilities of claimants that do not inhere to the claim.

Next, the court examined whether the claims were transferred by sale or assignment.

“[I]t is undisputed that Springfield is not alleged to have itself acted inequitably or received any preference that would subject its claims to equitable subordination or disallowance,” the court noted. However, Springfield may be subject to equitable subordination and disallowance based solely on the conduct of the transferor if the claims were transferred to Springfield by way of an assignment, concluded the court.

The court remanded the case to the bankruptcy court to decide whether the transfer was an assignment or a sale, and thus whether Citibank’s conduct may be imputed to Springfield.

Such a determination may prove difficult for the bankruptcy court because the district court did not provide characteristics of a sale and an assignment. In a footnote, the court gave an example of a sale (purchase on the open market) and an acquisition (acquisition by operation of law, i.e., subrogation), but did not otherwise expand on the definitions of each type of transaction.

Policy Considerations

Following its legal analysis, the district court addressed the policy concerns relating to its decision.

Enron argued that a decision contrary to the bankruptcy court’s holding would encourage bad faith transferors to engage in “claims washing” by transferring the claim to a good faith purchaser. Springfield’s response was that the claim would not be “washed” because the transferor remains subject to direct actions on both the equitable subordination allegations and the receipt of preference allegations.

The court acknowledged that a bad-faith creditor could “take the money and run, to the detriment of other creditors.” Citing the policy arguments of the amici trade associations, the court recognized that the question became one of “allocating the burden and risk of pursing the bad actor transferor between two groups of innocents: the creditors as a whole or the transferee.”

The court concluded that the balance struck by its decision fairly allocated the risk to the creditors as a whole, rather than to a single good faith, innocent purchaser. Moreover, the bankruptcy court’s decision threatened to “wreak havoc on the markets for distressed debt—a result that has now been avoided.”

Request for Appeal

The district court’s decision has provided a level of comfort to the secondary debt market by assuring that a claim held by an innocent purchaser may not be equitably subordinated or disallowed based on the wrongful acts of a previous holder. The decision, however, leaves open whether additional due diligence will be required by a good faith transferee to confirm it is not participating in potential “claims washing.”

The decision also leaves open the possibility that a particular claim may constitute an assigned claim, and therefore is not protected by the holding. As mentioned above, the court failed to clarify the characteristics of a claim transferred by assignment versus a claim transferred by sale.

Springfield sought an early appeal on this issue, arguing that the distinction introduced a new element of uncertainty that could “sap liquidity and efficiency from the markets,” which was unlikely to be resolved without review by a federal appeals court or the U.S. Supreme Court.

The court denied the request for an early appeal Sept. 25, noting that Springfield’s concern is not a significant issue. Further, Springfield has a chance to prevail in a trial before the bankruptcy court concerning whether it was a “bona fide purchaser” of Enron’s bankruptcy claim, the district court concluded.

“If Springfield is found to be a bona fide purchaser for value of Citibank’s claims, that would require dismissal of Enron’s claims for equitable subordination and disallowance predicated on the conduct of Citibank,” stated the court.

Therefore, the secondary market likely will have to wait until this case has run the full appellate course before market calm prevails.