KB Toys: Hobgoblins Return To Haunt Bankruptcy Claims Traders

Participants in the multibillion-dollar market for distressed claims and securities have had ample reason to keep a watchful eye on developments in the bankruptcy courts during the last decade. That vigil appeared to have been over five years ago, after a federal district court ruled in the Enron chapter 11 cases that sold claims are generally not subject to equitable subordination or disallowance on the basis of the seller's misconduct or receipt of a voidable transfer. A ruling recently handed down by a Delaware bankruptcy court, however, has reignited the debate. In In re KB Toys, Inc., 470 B.R. 331 (Bankr. D. Del. 2012), the court, rejecting as unworkable any distinction between a sale and an assignment of a claim, held that several transferred trade claims should be disallowed under section 502(d) of the Bankruptcy Code because the transferors received voidable preferences. As expected, the ruling was appealed immediately.

ALLOWANCE AND DISALLOWANCE OF CLAIMS IN BANKRUPTCY

Section 502 of the Bankruptcy Code sets forth procedures governing the allowance or disallowance of a "claim or interest" in a bankruptcy case. Section 502(a) provides that a claim or interest, proof of which is filed with the court, "is deemed allowed," unless a party in interest objects. Under section 502(b), the bankruptcy court is obligated to resolve any objection in accordance with delineated criteria by ruling to allow or disallow the claim (in whole or in part). Section 502(c) directs the court in certain circumstances to estimate for the purpose of allowance certain contingent or unliquidated claims and any right to payment arising from an equitable remedy for breach of performance.

Section 502(d) creates a mechanism to deal with creditors who have possession of estate property on the bankruptcy petition date or are the recipients of pre- or postbankruptcy asset transfers that can be avoided because they are fraudulent, preferential, unauthorized, or otherwise subject to forfeiture by operation of a bankruptcy trustee's avoidance powers. Section 502(d) provides as follows:

Notwithstanding subsections (a) and (b) of this section, the court shall disallow any claim of any entity from which property is recoverable under section 542, 543, 550, or 553 of this title or that is a transferee of a transfer avoidable under section 522(f), 522(h), 544, 545, 547, 548, 549, or 724(a) of this title, unless such entity or transferee has paid the amount, or turned over any such property, for which such entity or transferee is liable under section 522(i), 542, 543, 550, or 553 of this title. (Emphasis added.)

As noted by the Fifth Circuit Court of Appeals in In re Davis, 889 F.2d 658 (5th Cir. 1989), "The legislative history and policy behind Section 502(d) illustrates that the section is intended to have the coercive effect of insuring compliance with judicial orders." Similarly, 5 Collier on Bankruptcy ¶ 502.05[2][a], at pp. 502–58 (16th ed. 2012), explains that the purpose of the provision is "to promote the pro-rata sharing of the bankruptcy estate among all creditors and the coercion of the payment of judgments obtained by the trustee."

CLAIMS TRADING

The market for "distressed" debt is thriving and largely unregulated. The market has grown so much in size and scope that claims trading has become commonplace in nearly every major chapter 11 case. Sophisticated players in the market are aware of most of the risks associated with acquiring discounted debt but generally focus on the enforceability of the obligation in question and its probable payout or value in terms of bargaining leverage. These risks can often be assessed with reasonable accuracy by examining the underlying documentation, applicable nonbankruptcy law, the obligor's financial condition, and its prospects for satisfying its obligations in whole or in part. Other types of risk may be harder to quantify. For this reason, most claim-transfer agreements include a blanket indemnification clause designed to compensate the transferee if a traded claim proves to be unenforceable in whole or in part.

That eventuality, in addition to other risks associated with claims trading, has been brought into sharper focus during the last decade due to a series of controversial court rulings. Some of these decisions address the disallowance of a traded claim under section 502(d) because the original holder of the claim was the recipient of a voidable transfer. At issue in rulings construing the provision is the meaning of the phrase "any claim of any entity."

THE STORY THUS FAR

Although its precursors were lurking in the background, the bankruptcy claims-trading debate with respect to section 502(d) began in earnest during 2005 and 2006, after controversial rulings by the bankruptcy court overseeing the chapter 11 cases of failed energy broker Enron Corporation and its affiliates had traders scrambling for cover due to the potential for acquired claims to be equitably subordinated or disallowed on the basis of the seller's misconduct. See Enron Corp. v. Springfield Associates, L.L.C. (In re...