The Third Circuit recently held that claims purchased from trade creditors by a claims trader will be disallowed under section 502(d) of the Bankruptcy Code when the seller of the claim received, and did not repay, a preference. In doing so, the United States Court of Appeals for the Third Circuit expressed its disagreement with a relatively recent decision in the United States District Court for the Southern District of New York which reached the opposite conclusion.

Section 502(d) provides that the court shall disallow "any claim of any entity" from which property is recoverable under the avoidance provisions of the Bankruptcy Code. The liquidating trustee in the KB Toys chapter 11 case sought to use section 502(d) to disallow claims purchased by a claims trader from various trade creditors of the debtors.

The trade creditors had all received payments from the debtors within 90 days of the bankruptcy filing and were identified as having done so on the statement of financial affairs filed by the debtors shortly after the commencement of their case. The trustee initiated preference actions and obtained a judgment in each case, but could not collect because each trade creditor had gone out of business in the interim period. Subsequently, the trustee sought to disallow the transferred claims held by the claims purchaser, contending that they were disallowable because each original claimant received a preference that was not returned to the estate.

The Third Circuit, in affirming the decisions below, held that the claims could be disallowed because the language of section 502(d) focused on claims not claimants, thus the claim associated with a preference would be disallowable regardless of who held it. The court stated that to hold otherwise would provide an incentive to a creditor who received an avoidable transfer to "cleanse" its claim by selling it, allowing the creditor to receive value on an otherwise valueless claim. Such a result would mean less money for legitimate creditors of the estate because (i) the avoidable transfer would not have been returned to the estate, and (ii) the trustee would be forced to pay out on a claim that should otherwise have been disallowed. The court also expressed its concern that the trustee must be able to use section 502(d) to collect assets and coerce compliance with judicial orders.

The court noted that the purchaser of the claims was a sophisticated claims trader that was clearly aware of the risk of disallowance. This conclusion was based upon the fact that claims were purchased pursuant to assignment agreements, each of which contained provisions shifting the risk of claims disallowance back to the original claimant who was required to pay restitution if the claim was disallowed. The preference information was also publicly available in the statement of financial affairs filed by the debtors.

An alternative argument by the claims purchaser suggesting that it was entitled to the protection of provisions of the Bankruptcy Code that preclude recovery of assets from good faith purchasers of property of the estate was quickly dismissed by the court, which held that the purchaser did not buy property of the estate, but claims against the estate to which such protections do not apply.

While no other circuit courts have considered this question, the KB Toys decision differs from a decision in the Enron chapter 11 case in which the District Court for the Southern District of New York held that disallowance under section 502(d) (and equitable disallowance under section 510(c)) focuses on the claimant as opposed to the claim. Thus, in that case, the court determined that disallowance was a personal disability of the claimant and did not travel with the claim unless there was a "pure assignment," rather than a sale of the claim. The Third Circuit found the distinction between an assignment and a sale to be unpersuasive and chose not to adopt the Enron reasoning.

Though it remains to be seen how other circuit courts will resolve this issue, the KB Toys decision should give pause to both buyers and sellers of bankruptcy claims. Buyers who fail to complete their due diligence regarding obligations of the original claimant to the estate may find themselves with a valueless claim. In addition, sellers who believe they have effectively monetized their claims may be forced to make a restitution payment to their purchaser if the transferred claim is ultimately disallowed.