Reversal Of Enron Ruling On Claims Transfers - Reevaluating The Risks Of Equitable Subordination

In a decision in In re Enron Corp., et al., 2007 U.S. Dist. LEXIS 63129, No. 05-01025 (S.D.N.Y. August 27, 2007), the Honorable Shira Scheindlin, United States District Judge for the Southern District of New York, held that the sale of a claim that is subject to equitable subordination under section 510(c) or disallowance under section 502(d) of the Bankruptcy Code may insulate the claim from subordination and disallowance when asserted against the buyer of the claim. At first blush the decision may be, and has been, read by some to offer relief and clarity to distressed debt investors. However, study and review of the decision raises and leaves unanswered critical questions for the distressed debt market. All may be vetted further in the context of an appeal to the Second Circuit. However, any appeal to the Second Circuit will have to wait for another day. The District Court denied a motion for leave to appeal the interlocutory order to the Second Circuit. In re Enron Corp., et al., Nos. 01-16034, 05-01025, slip op. (S.D.N.Y. Sept. 24, 2007).

Judge Scheindlin overturned two decisions rendered in Enron by the Honorable Arthur J. Gonzalez, United States Bankruptcy Judge. In one decision, Judge Gonzalez held that the transfer of a claim subject to equitable subordination will not free the claim from subordination in the hands of the ultimate holder. Enron Corp. v. Springfield Assocs., L.L.C., 2005 WL 3873893, Nos. 01-16034, 05-01025, slip op. (Bankr. S.D.N.Y. Nov. 28, 2005). In the second decision, Judge Gonzalez held that where a claim is not allowable because the creditor had not returned a preference or other avoidable transfer, a transferee of the claim takes subject to disallowance on the same ground. Enron Corp. v. Avenue Special Situations Fund II, LP, 340 B.R. 180 (Bankr. S.D.N.Y. 2006). The District Court noted that the "unnecessary breadth of the bankruptcy court's decisions threatened to wreak havoc on the markets for distressed debt." The District Court reasoned that legal precedent providing "consistent protection of bona fide purchasers for value" outweighs the harm to other creditors in the context of a "sale" of a claim. However, the District Court made a distinction between the legal effect of a "sale" of a claim and the legal effect of an "assignment," stating that in the case of an assignment, the assignee takes the claim subject to the risks of equitable subordination or disallowance based on conduct of a prior holder of the claim. The...