In re KB Toys: Third Circuit Affirms Disabilities Cannot be "Washed" from Transferred Trade Claims

Practical Law Legal Update 5-549-4150 (Approx. 5 pages)

In re KB Toys: Third Circuit Affirms Disabilities Cannot be "Washed" from Transferred Trade Claims

by Practical Law Finance and Practical Law Bankruptcy & Restructuring

Background

KB Toys, Inc. and related entities (Debtors) filed voluntary Chapter 11 petitions on January 14, 2004 and proceeded to liquidate substantially all of their assets. On March 15, 2004, each Debtor filed a Statement of Financial Affairs (SOFA). The SOFA requires debtors to disclose all payments made within the 90-day period before the petition date. Payments received during this period are potentially avoidable preferences.

Between April 7, 2004 and May 22, 2007, ASM Capital, L.P. and ASM Capital II, LLP (ASM) purchased nine claims from the original holders of the claims. According to the SOFAs, each original holder received a payment within 90 days of the petition date. The trustee brought preference actions against the original holders of the claims at issue and eventually received a judgment in each case. These judgments were uncollectable because all of the original holders went out of business.

On July 31, 2009, the trustee filed a claim objection, seeking disallowance of, among other claims, the claims sold to ASM under section 502(d) of the Bankruptcy Code. Section 502(d) of the Bankruptcy Code provides that claims held by entities who have been ordered to return property to the estate (for example, because the property was an avoidable preference or the subject of a fraudulent transfer) but have not done so, are disallowed. The trustee argued that the ASM claims should be disallowed, even though the preference action judgments on the claims were against the original holders of the claims and were not against ASM, the current owner of the claims.

The US Bankruptcy Court for the District of Delaware held that under section 502(d), "[d]isabilities attach to and travel with the claim." It also noted that ASM, as a sophisticated entity that was aware of the bankruptcy process, was on "constructive notice" of the potential preference actions and could have easily discovered the potential for disallowance under section 502(d). For an in-depth discussion about the Bankruptcy Court's decision, see Legal Update, In re KB Toys: Disabilities Accompany a Transferred Trade Claim.

ASM appealed this decision to the US District Court for the District of Delaware. Although it believed that the plain language of section 502(d) was ambiguous, the District Court adopted the Bankruptcy Court's reasoning and affirmed its decision.

ASM appealed the District Court's decision to the Third Circuit.

Outcome

The Third Circuit affirmed the District Court's decision. The primary issue on appeal was whether a trade claim that is disallowable under section 502(d) in the hands of the original claimant is also disallowable in the hands of a subsequent transferee. The Third Circuit reasoned that the answer depends on the interpretation of the phrase "any claim of any entity" in section 502(d) of the Bankruptcy Code. Section 502(d) provides that "the court shall disallow any claim of any entity from which property is recoverable . . . or that is a transferee of a transfer avoidable" under certain provisions of the Bankruptcy Code "unless such entity or transferee has paid the amount, or turned over any such property, for which such entity or transferee is liable."

First, the Third Circuit interpreted the text of section 502(d) and held that "any claim" that belongs to an entity that received an avoidable transfer is disallowable until the avoidable transfer is returned to the estate. Because the statute focuses on claims, instead of claimants, these claims are disallowable regardless of who holds them. The Third Circuit stated that to hold otherwise would contravene the purposes of section 502(d), which are:

Ensuring equality of distribution of estate assets. For example, an original claimant who received an avoidable transfer would have an incentive to sell its claim (to receive value for a claim that would otherwise be disallowed) and a transferee would have an incentive to purchase the claim (to become eligible to receive a distribution). If this occurred, there would be a negative impact on other creditors because the estate would:
- have less money and other creditors would receive smaller distributions because the estate would not include the recoverable property; and
- pay on a claim that would have been otherwise disallowed.
Coercing compliance with judicial orders by requiring the return of the avoidable transfer as a condition of collecting on the claim. Permitting a transfer to "wash" an otherwise disallowable claim would undermine the trustee's ability to collect assets (specifically, the trustee's ability to ask the bankruptcy court to disallow questionable claims).

Furthermore, the Third Circuit explained how legislative history supported this interpretation. It also noted that ASM's conduct was consistent with its interpretation of section 502(d) because ASM included provisions in the claim transfer agreements directly dealing with the risk that disallowance could potentially travel with the claims.

Second, after analyzing the plain language of section 550(b), the Third Circuit held that ASM was not entitled to the protections of a good faith purchaser because:

Section 550(b) protects a good faith transferee who purchases estate property that is avoidable under certain provisions of the Bankruptcy Code. Here, ASM purchased claims against the Debtors' estate, which is not property of that estate.
As a claim purchaser who could ultimately profit from the Debtors' bankruptcy, ASM should have known it assumed the risks associated with the bankruptcy process.
ASM voluntarily exposed itself to the risk of disallowance and could have protected itself from this risk by:
- reviewing the Debtors' publicly available information, which would have put ASM on constructive notice of the claims' vulnerability to preference attacks; and
- performing due diligence on the original claimants.
As claims purchasers are typically sophisticated parties who voluntarily choose to participate in the bankruptcy process, the Third Circuit held that they, and not the estate, should bear the risk that the original claimant will not return avoidable transfers. Claims purchasers are also in a better position than other creditors to estimate and mitigate disallowance risk, which they can factor into the price of the claim or shift back to the original claimant through an indemnity in the transfer agreement.

Practical Implications

As a result of the Third Circuit's ruling in KB Toys, buyers of trade claims in bankruptcy should be aware that they may be treated as sophisticated trading entities with knowledge that the trade claims they are purchasing may be disallowed. To protect themselves from any disabilities that may attach to their purchased trade claims, buyers should:

Conduct careful due diligence on the claims they wish to purchase.
Include indemnification clauses in their transfer agreements, and consider sellers' ability to meet their indemnity obligations.
Factor the risk of disallowance into the price of the purchased claims.

While courts may rule differently for transfers of other types of claims, such as notes, bonds or bank debt, purchasers of these claims should take the same precautions and insist on obtaining representations, warranties and indemnification rights from sellers.

For more information on claims trading, see Practice Note, Bankruptcy Claims Trading: Basic Concepts.

In re KB Toys: Third Circuit Affirms Disabilities Cannot be "Washed" from Transferred Trade Claims | Practical Law