Client Alerts

Taint Necessarily So: Third Circuit Holds that Taint Travels with Claim

Client Alerts | November 21, 2013

A new decision by the Third Circuit Court of Appeals, In re KB Toys, Inc., may strongly influence the debate regarding whether a bankruptcy claim transferred on the secondary market is subject to disallowance based on acts of the original holder of the claim.

As discussed in our prior alert, KB Toys concerned from objections filed by a plan trustee to nine claims that had been purchased post-petition by ASM Capital. In each case, before filing the claim objection the trustee had brought a preference action against the original claimant, and then obtained an unsatisfied judgment (due to default or uncontested summary judgment).[1]

Bankruptcy Code section 502(d) provides for the disallowance of any claim of any entity that has received an avoidable transfer if the avoided transfer has not been repaid to the estate. ASM argued that section 502(d) is applicable to claims held by the avoidance defendant only, and also that section 550 of the Bankruptcy Code does not permit the disallowance of a claim of a good faith transferee. The Court of Appeals ruled for the trustee, reading the language of the statute as focusing on the claim rather than the claimant, and concluding that a transferred claim can be disallowed under section 502(d) the same as a claim that was never transferred. The Court further determined that the good faith transferee protections of section 550 do not apply to purchases of claims against an estate.

The Court supported its conclusion on policy grounds, reasoning that the statutory purpose of enhancing the estate and inducing compliance with avoidance orders would be undercut if claims could be “washed” when transferred. It further reasoned that it was fair to subject ASM to claim disallowance because (1) ASM voluntarily exposed itself to the risks of the bankruptcy process and could have performed due diligence, (2) ASM could have negotiated for indemnifications from the transferors (and indeed had obtained indemnities from several of them), and (3) claim purchasers can better assess and bear the risk of insolvency of the original claim holders than can the debtor’s estate.

This issue previously arose in a pair of decisions several years ago in the Enron bankruptcy. See Enron Corp. v. Ave. Special Situations Fund II, LP (In re Enron Corp.), 340 B.R. 180 (Bankr. S.D.N.Y. 2006), reversed and remanded, Enron Corp. v. Springfield Associates, LLC (In re Enron Corp.), 379 B.R. 425 (S.D.N.Y. 2007). In Enron the debtor brought suit against several banks and the current holders of claims originally held by the banks, alleging pre-petition misconduct by the banks and seeking, among other things, to avoid pre-petition transfers made to the banks and, in the alternative, to disallow under section 502(d) or to equitably subordinate the claims. The bankruptcy court reasoned that the claims were tainted by the alleged bad acts, and that subsequent holders of the claims acquired them subject to the taint. Accordingly, the bankruptcy court denied the defense that the claims were held by innocent transferees, and held that the claims could be disallowed under section 502(d) or equitably subordinated. The district court reversed and remanded, holding that whether a claim can be disallowed in such circumstances depends upon whether the claim was “sold” or “assigned,” as well as whether the claim transferee had knowledge of the taint. The Enron litigation was settled before any determinations were made on remand.

The KB Toys opinion noted that the Enron district court read the statutory language differently, seeing it as focusing on the claimant rather than the claim, but did not discuss further why it reached a diametrically opposite reading of the same text. Instead, it termed the district court’s sale/assignment distinction “problematic,” and concluded that any such distinction in state law would be preempted by federal bankruptcy law.

The Enron situation may be distinguishable from KB Toys in several respects:

    Enron involved bank debt, while KB Toys involved trade claims. Bank debt often trades pre-bankruptcy, while trade claims are almost exclusively post-petition trades. In bank debt trades the purchaser often does not know the identity of the original holder of the claim, while this is normally known for trade claims. Thus some of the policy rationales cited in KB Toys may not be applicable in the bank debt context, where the buyer may have less opportunity to conduct due diligence with respect to the original claimant, and where the taint may not be known or knowable at the time of the trade.

    • In Enron the debtor sought the alternative remedy of equitable subordination, which was not raised in KB Toys. While the policy arguments in favor of equitable subordination are generally similar to those for section 502(d) disallowance, the statutory textual analysis is necessarily different. Accordingly, it is not clear whether courts will follow KB Toys in considering whether equitable subordination taint travels.

    • In KB Toys the “taint” was less subject to dispute than in Enron, and information about the existence of potential taint was publically available earlier in the process. Indeed, in KB Toys the potential preferences were listed in the debtor’s statements of financial affairs, and the judgments were uncontested. By contrast, Enron concerned strongly contested allegations of wrongdoing on the part of banks, which allegations did not become public until months after the Enron bankruptcy petitions were filed, by which time the claims had already been transferred.

While the KB Toys court expressly limited its decision to trade claims, the sweeping nature of its decision, and the broad policy grounds used in support, could easily be applied to other types of claims, including bank debt, and to equitable subordination cases. The Enron district court decision has been much criticized, and now is even less likely to be followed. The KB Toys decision is the first time the issue of whether taint travels has been addressed by a circuit court of appeals, and it is likely that trustees and other estate representatives will aggressively seek to take advantage of it. Purchasers of claims should consider obtaining indemnities from sellers as well as doing broad due diligence regarding the subject claims and the credit-worthiness of the seller before purchasing bankruptcy claims.

[1] Indeed, all of the original claimants went out of business.