In re KB Toys: Disabilities Accompany a Transferred Trade Claim

Practical Law Legal Update 8-519-5833 (Approx. 6 pages)

In re KB Toys: Disabilities Accompany a Transferred Trade Claim

by PLC Finance

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. The Debtors' plan of reorganization became effective on August 29, 2005 and a trustee was appointed to liquidate, collect and maximize the value of certain assets, as well as to investigate and pursue avoidance actions and other claims for the benefit of creditors.

On March 15, 2004, the Debtors each filed a statement of financial affairs (SOFA) which explicitly or by reference listed the original holders of the relevant claims as creditors who received potentially avoidable transfers during the preference period. Between April 7, 2004 and May 18, 2007, ASM Capital LP and ASM Capital II, LLP (ASM) purchased nine trade claims from the original holders of the claims. Four of the assignment agreements contained indemnification clauses and five did not.

The trustee brought preference actions against the original holders of the claims at issue based on section 547 of the Bankruptcy Code. Between June 2, 2006 and June 1, 2009, the trustee obtained either default or summary judgments against the original holders of these claims. 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.

Key Litigated Issues

The issue before the court was whether the purchaser of a trade claim holds the purchased claim subject to the same rights and disabilities and is subject to the same Bankruptcy Code section 502(d) challenge as is the original holder of the claim. 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 believed 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 the current owner of the claims, ASM. The trustee made three major arguments in support:

In accordance with Enron II (which held that a disability attached to a creditor who transfers a claim travels to a transferee of the claim if the claim is assigned but not if it is sold), the trustee argued that the transfers of the claims to ASM should be viewed as assignments and not as sales.
The trustee asserted that ASM had at least constructive knowledge and possibly actual knowledge of the preferential transfers. This knowledge was evidence that ASM was not a good faith purchaser of the claims.
The trustee questioned Enron II's analysis and policy concerns.

In response, ASM made two primary arguments:

In accordance with Enron II, ASM argued that the claim transfers were sales and not assignments and that disabilities should therefore not attach to the claims.
ASM also argued that the plain language of section 502(d) of the Bankruptcy Code dictates a focus on the claimant and not the claim. Therefore, any disability rests with the original claimant and when the claim is in the possession of a new entity, the disabilities should no longer be attached to the claim.

Outcome

The court held that disabilities attach to and travel with a trade claim purchased from the original holder of that claim. In doing so, it found the Enron I decision more persuasive than the Enron II decision. It held that the Enron II exercise of distinguishing between an assignment and a sale was unhelpful and unrevealing of the appropriate outcome in this case.

The court found that the view that a claim in the hands of a transferee has the same rights and disabilities as the claim had in the hands of the original holder of the claim was all supported by:

Plain language. The language of section 502(d) states that "the court shall disallow any claim of any entity" that is a transferee of a transfer avoidable under section 547. Differences of opinion exist on this meaning and whether the focus is on the claim or the claimant.
Legislative history. The court found that section 502(d) of the Bankruptcy Code is derived from section 57g of the Bankruptcy Act of 1898. It interpreted section 57g to be more explicit than section 502(d) of the Bankruptcy Code that disabilities travel with claims.
Prior case law. The court noted that decisional law following enactment of the Bankruptcy Code continued to interpret the rights of transferees as subject to the equities and burdens of the transferor. The court found that the Enron I decision was persuasive. Enron I held that:
- section 502(d) is, in essence, an affirmative defense to a claim and an affirmative defense is not destroyed by a transfer of the claim; and
- a claim transfer does not change the nature of the claim, rather it creates a substitution of parties.
The court in Enron I also found that allowing "a transferred claim in the hands of the transferees from the transferors who received avoidable transfers and did not pay or turn over the avoidable transfer would seriously undercut the purpose and policy of section 502(d)." It would permit participants in the distribution process before the avoidance action is resolved and any payment is made to the estate.
In addition, the court in Enron I said that participants in the market for postpetition transfers of claims should be aware of its inherent risks and uncertainties. The court in KB Toys said buyers of debt are highly sophisticated and capable of performing due diligence before any acquisition. It did not agree that subjecting transferred trade claims to section 502(d) would disrupt the claims trading market because claims purchasers are aware of the ever-present possibility of avoidance actions based on preference liability or fraudulent conveyances.
In reaching its conclusion, the court in KB Toys was careful to note that the claims at issue were trade claims purchased from the original holders of those claims. It noted it made no determination that this disallowance will not cause a disruption in the claims trading market for other types of transferred claims.

The court in KB Toys found:

Because of the SOFA, ASM and all other potential buyers of the trade claims were on constructive notice, if not actual notice, of potential preference actions against the original claim holders and the potential for disallowance of the claims under section 502(d). ASM could have found this out through due diligence and factored it into the price for the claims.
ASM protected itself in certain of the trade claim purchases by including indemnity clauses in the transfer agreements.
A claims purchaser in a bankruptcy is not entitled to the protections of a good faith purchaser because it should be aware that these claims may be allowed or disallowed.

For these reasons, the court held that the disabilities traveled with the trade claims. Because of the existing preference liability, the trustee's claim objection to disallow the claims was sustained.

Practical Implications

As a result of the court'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.
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 preferential transfers, see Practice Note, Preferential Transfers: Overview and Strategies for Lenders and Other Creditors.

For more information on filing a proof of claim in a Chapter 11 bankruptcy case, see Practice Note, Filing a Proof of Claim in a Chapter 11 Bankruptcy Case.

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