Section 502(d) of the Bankruptcy Code provides that “any claim of any entity from which property is recoverable” by a debtor’s estate shall be disallowed unless the entity has turned over such property to the estate. As we previously discussed in Can A Claims Purchaser Acquire Claims Free of Defects? in the International Restructuring Newswire (June 2012), the District Court for the Southern District of New York in Enron Corp. v. Springfield Associates, LLC (In re Enron Corp.), 379 B.R. 425 (S.D.N.Y. 2007) vacated an order of the bankruptcy court and held that a disability travels with a claim to a purchaser if the claim is transferred by way of an “assignment” and does not travel if the claim is transferred by way of a “sale.” Thereafter, the Delaware District and Bankruptcy Courts held, in the KB Toys Inc. chapter 11 case, that a disability travels with the claim regardless of how the claim is transferred. Citing to the bankruptcy court’s decision in Enron (former Bankruptcy Judge Arthur J. Gonzalez, presiding), the Court of Appeals for the Third Circuit recently affirmed the lower courts’ decisions and held that a claim that is subject to disallowance under section 502(d) of the Bankruptcy Code in the hands of the original claimant remains subject to disallowance in the hands of the transferee. In re KB Toys Inc., No. 13-1197 (3d Cir. Nov. 15, 2013).

Factual Background

During the KB Toys’ bankruptcy case, ASM Capital, L.P. and ASM Capital II, LLP purchased nine claims from various trade claimants (the “Original Claimants”) pursuant to certain assignment agreements. Prior to ASM’s acquisition of the claims, KB Toys disclosed in its schedules that each Original Claimant was the recipient of payments made by KB Toys within 90 days of the bankruptcy filing. Thus, the payments to the Original Claimants were potentially subject to avoidance and recovery by the estate as preferences under the Bankruptcy Code.

Pursuant to KB Toys’ plan of reorganization, a liquidating trustee was appointed to pursue claims for the benefit of creditors. Ultimately, the liquidating trustee obtained judgments against the Original Claimants for the avoidance of the preference payments they received from KB Toys. The Original Claimants, however, did not pay the judgments. As a result, the liquidating trustee filed an objection to the claims acquired by ASM under section 502(d). According to the liquidating trustee, the claims should be disallowed because each Original Claimant received a preference before transferring its claims to ASM. The Bankruptcy Court and, on appeal, the District Court for the District of Delaware agreed. Thereafter, ASM appealed the lower courts’ decision to the Third Circuit.

Third Circuit’s Rationale

On appeal, the Third Circuit focused on the language of section 502(d) and, in particular, on “any claim of any entity.” According to the Third Circuit, this provision renders any claim that belonged to an entity that received an avoidable transfer disallowable, unless the avoidable transfer is returned to the estate. “Because the statute focuses on claims—and not claimants—claims that are disallowable under § 502(d) must be disallowed no matter who holds them.” Holding otherwise would permit the transfer of disallowable claims to negate the two aims of section 502(d): equality of distribution of estate assets and coercing compliance with court orders. In addition, according to the Third Circuit, its conclusion was consistent with the relevant legislative history and prior case law under the predecessor statute.

Take-Away

In concluding that a claim that is subject to disallowance under section 502(d) in the hands of the original claimant remains subject to disallowance in the hands of a transferee, the Third Circuit cited favorably the analysis of the bankruptcy courts for the Southern District of New York, including the decision of former Bankruptcy Judge Arthur J. Gonzalez in the Enron case. The district court in New York, however, has drawn a distinction between an assignment, which would result in disallowance, and a sale, which would not necessarily result in disallowance. The Second Circuit has not yet addressed the issue. Indeed, no circuit, other than the Third Circuit, has analyzed whether a claim that is subject to disallowance under section 502(d) remains subject to disallowance after it has been transferred. Accordingly, a purchaser of a claim against a debtor should be cognizant of the risk that its claim may be disallowed if the original claimholder is the recipient of an avoidable transfer.

Regardless of where the bankruptcy case is pending, a purchaser should make every effort to protect itself by requiring the seller to pay restitution if the transferred claim is later disallowed because of an avoidable transfer received by or the conduct of the original claimant. Such protection, however, will not be sufficient where, as in KB Toys, the original claimant does not subsequently have the wherewithal to satisfy its restitution obligation. Accordingly, buyers should beware and purchase only after evaluating the risks.