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Third Circuit Holds that Claims May Be Disallowed under 11 U.S.C. § 502(d) Despite Transfer to a Third-Party Purchaser

November 18, 2013

Last week, the Third Circuit Court of Appeals held that a bankruptcy claim transferred to a third-party purchaser can be disallowed under 11 U.S.C. § 502(d) if the original claimant received property that is avoidable or recoverable by the bankruptcy estate. In re KB Toys Inc., Case No. 13-1197 (3d Cir. Nov. 15, 2013). Section 502(d) disallows any claim of any entity that received property that is avoidable or recoverable by the bankruptcy estate. Disagreeing with a recent decision from the United States District Court for the Southern District of New York, the Third Circuit held that section 502(d) creates a deficiency in the claim itself that travels with the claim after transfer or assignment, and thus the claim may be disallowed despite transfer.

ASM Capital, L.P. (“ASM”) “purchased” nine claims (the “Claims”) via assignment agreements (the “Assignments”) with the original claimants (the “Original Claimants”). At the time of the assignments, each Original Claimant was listed on the Debtors’ Statement of Financial Affairs as having received a potentially avoidable transfer. Each Assignment included a provision shifting the risk of disallowance back to the Original Claimant by requiring the Original Claimant to pay restitution to ASM if such Claim were disallowed.

The Liquidating Trustee for the Debtors brought adversary proceedings against each of the Original Claimants to recover the payments listed on the SOFAs, eventually obtaining default judgments. However, the Trustee was unable to collect on any of the judgments because none of the Original Claimants were still operating businesses. Consequently, the Trustee filed an objection to the Claims, seeking disallowance pursuant to section 502(d).

The Delaware bankruptcy court granted the Trustee’s objection and disallowed the Claims. The bankruptcy court found that section 502(d) was concerned with the claim rather than the entity that received the avoidable transfer. Therefore, section 502(d) creates a disability that “attach[es] to and travel[s] with the Claim.” ASM appealed the decision and the district court affirmed. ASM then appealed to the Third Circuit.

The Third Circuit held that the phrase “any claim of any entity” makes the section applicable to a class of claims, rather than a class of claimants. Thus, any claim that belonged to an entity that received an avoidable transfer is subject to disallowance under section 502(d). The Third Circuit concluded that claims that are disallowable under section 502(d) must be disallowed “no matter who holds them.”

Moreover, the Third Circuit found that legislative history and policy grounds both favored this interpretation. The congressional record stated that section 502(d) “was derived from present law,” specifically section 57(g) of the Bankruptcy Act of 1898. The Third Circuit noted that under section 57(g), the disqualification of a claim due to a preference “inheres in and follows every part of the claim, whether retained by the original creditor or transferred to another, until the preference is surrendered.” Swarts v. Siegel, 117 F. 13, 15 (8th Cir. 1902). Consequently, interpreting section 502(d) as focusing on the claimant rather than the claim would create a change in practice from the Bankruptcy Act, contrary to the legislative history.

With respect to policy considerations, the Third Circuit believed that its holding advances the two main purposes of section 502(d). First, it helps ensure that claimants who receive avoidable transfers not receive a distribution on account of their claim. Second, the holding prevents claim assignments from undermining section 502(d)’s effectiveness in coercing compliance with judicial orders.

The Third Circuit noted that it followed the reasoning of the Southern District of New York bankruptcy court, but disagreed with a decision from the district court reversing that ruling. The district court ruled that section 502(d) focused on the claimant that received the avoidable transfer rather than the underlying claim. Enron Corp. v. Avenue Special Situations Fund II, LP (In re Enron Corp.), 379 B.R. 425, 434 (S.D.N.Y. 2007) (“Enron”). The Enron decision reversed the bankruptcy court’s decision by concluding that “disallowance is a personal disability of a claimant, not an attribute of the claim.” Id. at 443. The district court then held that whether the personal disability passed to the new claimant depended on whether the claim transfer constituted a sale or an assignment under state law. Id. at 435-36. In addition to disagreeing with the district court’s interpretation of the statutory language, the Third Circuit found the district court’s reliance on the sale/assignment distinction problematic for two reasons. First, because state law offered no clear guidelines to distinguish sales from assignments, having the applicability of section 502(d) turn on this unclear distinction would be problematic. Second, the circuit court was wary of relying on state law to dictate the application of section 502(d) lest the result be inconsistent with the purposes of federal bankruptcy law.

Finally, the Third Circuit dismissed ASM’s argument that it was entitled to protection as a purchaser of the claims in “good faith” under 11 U.S.C. § 550(b). Section 550(b) applied to purchases of estate property, not claims against the Debtors’ estates. The Third Circuit found no reason to extend the “principles” of section 550(b) to ASM. ASM, an experienced participant in the secondary market for claims, knew, or should have known, that the Claims were potentially subject to disallowance due to the Original Claimants’ presence on the Debtors’ SOFAs. The Third Circuit concluded that “ASM voluntarily exposed itself to a risk that it had the ability to investigate before acquiring the Claims.” Moreover, because of the indemnification and restitution provisions in the Assignments, ASM was “in a better position than the estate to protect itself against the Original Claimants going out of business.”

KB Toys is the first circuit court decision to address this issue. It is unclear how other circuit courts will rule when presented with the issue. For now, there is a distinction in how a section 502(d) objection to a claim that has been transferred will be handled in the Southern District of New York, in which Enron is the prevailing rule, and in Delaware, where KB Toys governs.