January 10, 2014

Written By: Matthew B. Heimann

Attention claims traders: In the Third Circuit, claims that would be subject to disallowance in the hands of an original claimant remain subject to disallowance in the hands of a purchaser of those claims. As the Court of Appeals for the Third Circuit recently held, claims that are disallowed under the Bankruptcy Code “must be disallowed no matter who holds them,” and the purchaser of a claim cannot “wash the claim of any disability” from that of the original claimant. The decision, In re KB Toys Inc., 736 F.3d 247 (3d Cir. 2013), carries importance not only because it was a matter of first impression for the Third Circuit, but also because it diverges from case law in the Southern District of New York.

KB Toys involved a national claims trader (“ASM Capital”) who purchased various claims held by trade creditors of KB Toys Inc. and its affiliated entities (collectively, the “Debtors”). These trade creditors (or “original claimants”) were listed on the Debtors’ statement of financial affairs as having received potentially avoidable transfers. After obtaining judgments against the original claimants to avoid certain transfers, the liquidating trustee for the Debtors’ estates sought to disallow, under section 502(d) of the Bankruptcy Code, the claims held by ASM Capital. Section 502(d) provides that a court shall disallow “any claim of any entity” that received an avoidable transfer unless the avoidable transfer is repaid. The lower courts agreed with the liquidating trustee that section 502(d) applied to ASM Capital and disallowed ASM Capital’s claims. ASM Capital appealed.

Hinging its analysis on section 502(d) and the phrase “any claim of any entity,” the Third Circuit affirmed the holding that section 502(d) applies to a category of “claims”—e.g., those belonging to one who received an avoidable transfer—and not directly to the “claimants” who received an avoidable transfer. Section 502(d) thus creates “disabilities [that] attach to and travel with the claim,” and there can be no “claim washing” of these disabilities through the transfer of a claim. As such, the Third Circuit held that “claims that are disallowable under § 502(d) must be disallowed no matter who holds them.”

The Third Circuit reinforced its decision, in part, by turning to the policy aims of section 502(d): “to ensure equality of distribution of estate assets” and to “coerc[e] compliance with judicial orders.” To hold differently, remarked the court, would allow—indeed, incentivize—claimants and claims traders to transfer disallowable claims and yet remain eligible to receive a distribution. At the same time, this process would harm a bankruptcy estate and other creditors by not having an avoidable transfer returned, by removing a trustee’s leverage to compel compliance with a judgment for the return of an avoidable transfer, and, ultimately, by issuing payment on a claim that would otherwise be disallowed.

The Third Circuit also rejected ASM Capital’s argument that it was entitled to protection under section 550(b) of the Bankruptcy Code as a “good faith” purchaser of the claims. That provision, held the court, was inapplicable as it applies to purchases of estate property, not purchases of claims against a debtor. In the same vein, the court declined to extend the “principles” of section 550(b) to ASM Capital’s circumstances, noting that ASM Capital had assumed the risk of disallowance by voluntarily entering into the bankruptcy process by purchasing claims. ASM Capital thus could have (or should have) reviewed the Debtors’ statement of financial affairs, which revealed the original claimants’ potential exposure to avoidance actions.

In so holding, the Third Circuit disagreed with a decision reached by the Southern District of New York in Enron Corp. v. Springfield Assocs., L.L.C., 379 B.R. 425 (S.D.N.Y. 2007). In that case, the district court concluded that the focus of section 502(d) is on the claimant, not the claim, such that any “disallowance is a personal disability of a claimant, not an attribute of the claim.” State law and whether a claim transfer was a sale or an assignment would then dictate if this “personal disability” was imputed on the purchaser of the claims. The Third Circuit did not agree with this holding and criticized the decision’s underlying reasoning.

Bottom line: Although claims traders should always research and investigate a debtor’s bankruptcy schedules, statements, and related filings before purchasing claims—along with including indemnification and restitution provisions in their transfer agreements—claims traders must know that claims purchased from bankruptcy cases pending in the Third Circuit will be subject to the same disallowance and defenses that a debtor (or trustee) can assert against the original claimant.

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