In Brief: Claims Trader Alert

A ruling handed down by the Third Circuit Court of Appeals on November 15, 2013, adds yet another chapter to the ongoing controversy concerning whether sold or assigned claims can be subject to disallowance under section 502(d) of the Bankruptcy Code on the basis of the seller's receipt of a voidable transfer. The decision—In re KB Toys Inc., 2013 WL 6038248 (3d Cir. Nov. 15, 2013)—is an unwelcome missive for claims traders. For the first time since the enactment of the Bankruptcy Code in 1978, a circuit court of appeals has concluded that:

because § 502(d) permits the disallowance of a claim that was originally owned by a person or entity who received a voidable preference that remains unreturned, the cloud on the claim continues until the preference payment is returned, regardless of whether the person or entity holding the claim received the preference payment.

By its ruling, which the court was careful to emphasize "only concerns trade claims," the Third Circuit has staked out what now can fairly be characterized as the majority approach to this issue. Accord In re Metiom, Inc., 301 B.R. 634 (Bankr. S.D.N.Y. 2003). But see Enron Corp. v. Springfield Associates, L.L.C. (In re Enron Corp.), 379 B.R. 425 (S.D.N.Y. 2007), vacating Enron Corp. v. Springfield Associates, L.L.C. (In re Enron Corp.), 2005 WL 3873893 (Bankr. S.D.N.Y. Nov. 28, 2005), and Enron Corp. v. Avenue Special Situations Fund II, LP (In re Enron Corp.), 340 B.R. 180 (Bankr. S.D.N.Y. 2006).

According to the Third Circuit, to hold otherwise would contravene the aims of section 502(d), which are to ensure equality of distribution of estate assets and to compel compliance with judicial orders. Allowing the recipient of a voidable transfer to "wash [a] claim of any disability," the court explained, would undermine these goals. The Third Circuit rejected the approach taken by the district court in Enron, observing that the court's reliance on "supposed state law" to draw a distinction between claims that are assigned and claims that are sold is "problematic for several reasons."

The Third Circuit rejected the claim buyer's argument that its claims should not be disallowed because it purchased the claims in "good faith" and should therefore be entitled to the protections of a good-faith purchaser under section 550(b) of the Bankruptcy Code. That provision, the court wrote, "protects a good faith transferee who purchases property of the estate," whereas the transferee of a claim...