In a recent decision, the U.S. Bankruptcy Court for the Southern District of New York held that claim disallowance issues under Section 502(d) of the Bankruptcy Code "travel with" the claim, and not with the claimant. Declining to follow a published district court decision from the same federal district, the bankruptcy court found that section 502(d) applies to disallow a transferred claim regardless of whether the transferee acquired its claim through an assignment or an outright sale. See In re Firestar Diamond, 615 B.R. 161 (Bankr. S.D.N.Y. 2020).

Background

Firestar Diamond, Inc., Fantasy, Inc. and A. Jaffe, Inc. (the debtors) filed for protection under Chapter 11 of the Bankruptcy Code in the Southern District of New York. The debtors were jewelry wholesalers that did business with major U.S. retailers. After the filings, an examiner appointed in the debtors’ cases found "substantial evidence to support the knowledge and involvement by the debtors and their senior officers and directors" in certain alleged fraudulent conduct. Events flowing from this investigation led to the appointment of a Chapter 11 trustee to administer the debtors’ bankruptcy estates.

In the course of their pre-bankruptcy dealings, the debtors incurred accounts payable indebtedness to three non-debtor entities: Firestar Diamond International, Firestar Diamond BVBA, and Firestar Diamond FZE. These nondebtor entities, in turn, had financial dealings with four separate banks. Pursuant to those dealings, the non-debtor entities either (a) pledged to the banks their debtor-related accounts receivable, or (b) sold to the banks certain invoices that had been issued to the debtors. The banks had otherwise had no prior direct dealing with either of the debtors.

After the bankruptcy filing, the banks filed proofs of claim for the accounts receivable that had been transferred to them. The trustee objected to the banks’ claims, seeking to have the  claims disallowed under Section 502(d) of the Bankruptcy Code. Under Section 502(d), a court "shall disallow any claim of any entity from which property is recoverable under section 542, 543, 550, or 553 … or that is a transferee of a transfer avoidable under section 522(f), 522(h), 544, 545, 547, 548, 549, or 724(a) …, unless such entity or transferee has paid the amount, or turned over any such property, for which such entity or transferee is liable …"

The trustee contended that the debtors, in their pre-bankruptcy dealings with the nondebtor entities, had paid the nondebtor entities millions of dollars in fraudulent and preferential transfers, i.e., transfers avoidable under Chapter 5 of the Bankruptcy Code (in this case, Sections 544, 548 and 547), and that these sums had not been repaid. Consequently, the trustee interposed these chapter 5 defenses to the banks’ claims. He argued that even though the banks’ claims were based upon the debtors’ original dealings with the nondebtor entities, any defenses to those claims should "run with" the claims and be applicable to any transferee of the claims.

The banks opposed the trustee’s objections, arguing that disallowance under Section 502(d) is a "personal disability" that "travels" with the claimant, not the claim, citing to In re Enron, 379 B.R. 425 (S.D.N.Y. 2007). The banks argued that, under the Enron holding, their claims were not subject to disallowance under Section 502(d) because the banks had acquired these claims from the nondebtor entities through outright sales as opposed to assignments.

Court's Analysis

The bankruptcy court considered, but declined to follow, Enron, in which the district court held that disallowance under Section 502(d) is "personal" to the claimant, and is not an attribute of the claim itself. In particular, the Enron court held that under principles of assignment law, since an assignee stands in the shoes of its assignor, an assignee of a claim will take the claim with "whatever limitations it had in the hands of the assignor," while a purchaser of the same claim would not be "subject to any personal disabilities of the transferor." Consequently, the district court in Enron concluded that a claim acquired by assignment would be subject to disallowance under section 502(d), while a claim acquired through a sale would not.

Not persuaded by the reasoning of Enron, the bankruptcy court instead concurred with decisions and scholarly articles in which the opposite conclusion was reached. Most notably, the court quoted at length from a decision of the U.S. Court of Appeals for the Third Circuit Court in In re KB Toys, 736 F.3d 247 (3rd Cir. 2013), in which the appellate court determined that because section 502(d) "focuses on claims – and not claimants – claims that are disallowable under [section] 502(d) must be disallowed no matter who holds them."  To hold otherwise, the KB Toys court reasoned, "would contravene the aims of [section] 502(d), the first of which is to ensure equality of distribution of estate assets."  Specifically, if a claimant could sell its claim and thereby "wash"—or "cleanse"—the claim of any disability under Section 502(d), then bankruptcy trustees would be deprived of a tool that the Bankruptcy Code provides them to achieve the recovery of avoidable transfers. The court in KB Toys, moreover, disagreed with Enron’s distinction between a sale and an assignment, finding it "problematic," and noting that the state law upon which the Enron court relied made no distinction between the sale of a claim or the assignment of a claim.

The bankruptcy court also cited other decisions in which courts reached the same conclusion, including one in which the court noted that the Bankruptcy Code does not distinguish between an assignment and a sale; rather, the definition of "transfer" in section 101(54)(D) arguably includes both. The court also looked to a decision more than century old that was in accord with KB Toys: Swarts v. Siegel, 117 F. 13 (8th Cir. 1902). The court in Swarts, a case decided under the Bankruptcy Act of 1898, cited to Section 502(d)’s predecessor section for the proposition that "the disqualification of  a claim for allowance created by a preference inheres in and follows every part of the claim, whether retained by the original creditor or transferred to another, until the preference is surrendered."

In addition to its citations to case law, the bankruptcy court referenced several bankruptcy scholars who have concluded, contrary to the reasoning of the court in Enron, that section 502(d) "follows the claim, not the claimant," and that no real distinction exists between the sale of a claim and the assignment of a claim.

Finally, the court considered the banks’ argument that the "equities" weighed against disallowance of their claims. Specifically, the banks contended that they were innocent victims of allegedly fraudulent transactions perpetrated by the debtors and the debtors’ insiders. The court rejected this argument, agreeing with the trustee that it would be inequitable to favor the banks over other creditors in the case. The court likewise rejected the banks’ contention that an adverse ruling would "wreak havoc in the claims trading market," instead framing the operative question as "who should bear the risk under these circumstances?"

Concurring again with the rationale of KB Toys, the court found that claims purchasers should be the ones to bear the risk since they make the conscious business decision to engage in the bankruptcy process, are (or should be) aware of the attendant risks, and "can mitigate their risk through due diligence and indemnity clauses in the transfer agreement." It contrasted these sophisticated claims traders with average creditors in a bankruptcy case, who would be otherwise powerless to protect their distributions from claims that might be "washed clean by a sale."

Based on this rationale, the court granted the trustee’s objections to the banks’ claims.

Conclusion

Firestar Diamond presents a cautionary tale for anyone who purchases a claim in a bankruptcy case. As the bankruptcy court suggested, a transferee of a claim can mitigate the risk of disallowance under Section 502(d), through indemnification provisions in the claims transfer agreement, through representations and warranties provided by the transferor of the claim, or through the claim purchaser’s due diligence into the nature of the claim and any defenses to payment that might apply. Ultimately, however, as Firestar Diamond makes clear, there is risk of disallowance to a less-than-diligent transferee of claims by virtue of events in which the transferee played no role.

Rudolph J. Di Massa, Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors’ rights.

Geoffrey A. Heaton, special counsel at the firm, practices in the area of business reorganization and financial restructuring, concentrating on representation of secured creditors, Chapter 11 and Chapter 7 trustees, creditors’ committees and unsecured creditors. 

Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.