Taint What You Do: New York Court Adopts Majority Taint Travels Rule

A New York Bankruptcy Court has adopted the majority rule in holding that a transferred claim can be disallowed or subordinated based on actions of the initial claim holder, siding with the Third Circuit Court of Appeals and rejecting a contrary decision of a New York District Court. The decision, In re Firestar Diamond, Inc., provides uniformity in a disputed area of the law, and raises interesting due diligence questions for claims traders and lenders.

Background

Firestar Diamond was a wholesaler of finished jewelry that was accused by its bankers of being involved in what the bank called “the largest bank fraud in Indian history.” Proofs of claim were submitted by or on behalf of four banks, based on financing arrangements with related non-debtor entities under which amounts owed by the debtor to those non-debtor entities had been pledged or factored to the banks. The trustee alleged that the non-debtor entities had each received millions of dollars in fraudulent transfers and preferences from the debtor, and objected to the banks’ claims under Bankruptcy Code section 502(d), which disallows claims of entities that have received avoidable transfers. The banks responded that the avoidable transfers had gone to the non-debtor entities, not the banks, and cited to the 2007 district court decision in In re Enron, 379 B.R. 425 (S.D.N.Y. 2007), reversing and remanding (In re Enron Corp.), 340 B.R. 180 (Bankr. S.D.N.Y. 2006), which is described below.

“Taint Travels” Cases

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 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 Enron district court’s distinction between sales and assignments was not based on any express provision of the Bankruptcy Code and has been much criticized. No subsequent reported case has adopted the distinction or its result. In In re KB Toys, Inc., as discussed in our prior alert, the Third Circuit termed the Enron sale/assignment distinction “problematic,” and instead reached the same result as the Enron bankruptcy court.

Firestar Diamond Decision

The Firestar Diamond court first determined that it was not bound to follow Enron. It then surveyed the Taint Travels cases and adopted the reasoning and result of KB Toys and the Enron bankruptcy court. It rejected the banks’ equitable argument that they were innocent victims of the Firestar Diamond fraud, holding that there is no equitable exception to the applicability of section 502(d), and further determining that the banks’ equities were not more compelling than those of the Firestar Diamond general unsecured creditors.

Analysis

While the Enron district court decision has not been formally overruled or rejected by a higher court, it increasingly appears to be a dead letter. The Firestar Diamond decision has the effect of bringing the law of the Southern District into agreement with that of the District of Delaware, providing clear guidance to the secondary markets for bankruptcy claims as to the prevailing governing standard.

As purchasers of claims will likely be unable to assert a defense that they are innocent purchasers immune from the acts of their sellers, it is all the more important for them to consider how to minimize their exposure to the risk that acquired claims might be subordinated or disallowed under section 502(d). Purchasers of trade claims can negotiate for recourse protection from sellers. On the other hand, purchasers of bank debt should understand that the standard terms of bank debt trade documentation do not provide recourse against sellers or upstreams for claim objections that apply to all lenders under a syndicated loan (as opposed to claim objections that apply solely to the claim of a single lender but not to the claims of other lenders under such syndicated loan). Traders and analysts may wish to consider including the risk of section 502(d) exposure as part of their due diligence and determination of an appropriate purchase price for a loan.

The risk of section 502(d) Taint Travels exposure is not limited to claims purchasers. Indeed, the affected creditors in Firestar Diamond were not distressed debt purchasers but rather lenders whose collateral included pledges of receivables. Those who lend against receivables, especially receivables against entities that are related to the borrower, should consider robust diligence and possibly additional protections such as obtaining a guaranty or additional collateral or requiring a higher interest rate from the borrower.

While fraud was the cause of the “taint” in Firestar Diamond, a purchaser’s exposure to section 502(d) risk is not limited to fraud situations. For example, in KB Toys the “taint” was traceable not to bad acts or fraud but instead merely to alleged preferences received by the original claimants.

Consider a hypothetical situation in which a piece of a syndicated loan is purchased from a lender (not the agent) and in which the agent bank is accused of receiving a voidable preference with regard to a separate loan facility with the same borrower/debtor. The borrower/debtor could object under section 502(d) to the syndicated loan claim. Because the section 502(d) objection applies to the entire syndicated loan, the purchaser will not have recourse against its seller. Furthermore, depending upon the scope of the provisions of the credit agreement, the purchaser may not have recourse against the agent.

Purchasers of claims and interests in bank loans should consider, as part of standard due diligence review with respect to the purchase of claims and loans, reviewing not only the credit agreement but also other background factors that could lead to section 502(d) exposure, such as the relationships between agent lenders and the borrower and structure of the underlying claims and collateral securing the loans.