In a large Chapter 11 bankruptcy case, claims against the debtor are actively traded in the secondary markets. A debtor’s original creditors may lack the liquidity to wait for uncertain payment at the end of the bankruptcy case (which could be years from the commencement date) and are often inclined to promptly “cash out” by selling their positions, even at a discount. Purchasers of claims, usually hedge funds and other seasoned participants in the bankruptcy process, are rewarded if the ultimate recovery on the transferred claims is greater than the purchase price. Moreover, the acquisitions of claims can, if purchased in sufficient quantities, give the buyer a meaningful voice in the strategic direction of the underlying Chapter 11 case.
These investments, however, are not without legal risk. A number of recent judicial decisions addressed (i) whether a taint that could render a claim worthless in the hands of the original creditor continues to travel to a buyer and (ii) the circumstances under which a court may disregard the votes of a claim purchaser in connection with the balloting on the debtor’s plan of reorganization.
Does a Taint Travel to a Buyer?
Section 502(d) of the Bankruptcy Code prohibits distributions by the estate on account of “any claim of any entity” that has failed to return a voidable transfer to the estate. 11 U.S.C. § 502(d). The United States Bankruptcy Court for the Southern District of New York considered the “statutory reference [in section 502(d) applicable] ... to any claim.” Enron Corp. v. Avenue Special Situations Fund II, LP (In re Enron Corp.) (“Enron I”), 340 B.R. 180, 194 (Bankr. S.D.N.Y. 2006). “[T]he transfer of a claim subject to section 502(d) disallowance in the hands of the transferor remains subject to disallowance in the hands of a transferee. A claim in the hands of a transferee, either as an initial transferee or subsequent transferee, remains subject to a section 502(d) disallowance defense, just as if such claim was still held by the transferor. The claim and the section 502(d) disallowance defense are linked, and such relationship is not severed by a transfer.” Id. at 183-84.
On appeal, the United States District Court for the Southern District of New York took the opposing position, finding instead that “[t]he plain language of section 502(d) focuses on the claimant as opposed to the claim and leads to the inexorable conclusion that the disallowance is a personal disability of a claimant not an attribute of the claim.” Enron Corp. v. Springfield Assocs., LLC (In re Enron Corp.) (“Enron II”), 379 B.R. 425, 443 (S.D.N.Y. 2007). The District Court also drew a distinction between “sale” and “assignment” of claims, noting that “[a]n assignment is a contractual transfer of a right, interest, or claim from one person to another. The word ‘assignment’ is not synonymous with ‘sale,’ although each is a type of transfer …. ” Id. at 435-36. From there, the District Court deduced that
[T]he outcome of this case depends on whether the principle that an assignee has no greater rights than its assignor applies to equitable subordination and disallowance. That issue raises a threshold question of law[:]… are equitable subordination [and disallowance] … attributes of a claim or are they personal disabilities of particular claimants. If they are attributes of the claim, they will travel with the claim regardless of the method of transfer, whereas if they are personal disabilities, their application to transferees depends on whether the transfer was by way of a sale or assignment . . . . [E]quitable subordination and disallowance are both personal disabilities that do not inhere in the claim. Thus, unless there was a pure assignment (or other basis for the transferee to step in the shoes of the transferor), as opposed to a sale of the claim, the claim in the hands of the transferee is not subject to equitable subordination or disallowance based solely on the conduct of the transferor.”
Id. at 439. See also id. at 436-37 (suggesting “holder in due course” status may provide assignee with defense).
In In re KB Toys, Inc., 470 B.R. 331 (Bankr. D. Del. 2012), the United States Bankruptcy Court for the District of Delaware considered whether a claim would still be subject to disallowance upon its purchase by a third party which does not have an obligation to return a voidable transfer. The KB Toys court ultimately sided with the New York Bankruptcy Court’s decision in Enron I (i.e., not the decision of the United States District Court for the Southern District of New York in Enron II), concluding that the bar imposed by section 502(d) follows a claim to its new owner. Id. at 343.
KB Toys and its affiliates filed Chapter 11 petitions in 2004 and liquidated substantially all of their assets under court supervision. The plan established a litigation trust to, among other things, prosecute avoidance actions on behalf of the estate. The trust commenced preference lawsuits against a host of targets, including parties set forth in the debtor’s Statement of Financial Affairs (the “SOFA”) as having received payments during the 90-day preference window that preceded the bankruptcy filing. However, at least nine defendants, which were trade creditors of the debtor, had sold their claims to an investor (the “Investor”) and defaulted on the trust’s preference actions. Invoking section 502(d), the trust eventually sought to disallow each of the Investor’s claims where the trust had a corresponding judgment against the original trade creditor. Id. at 332-34.
The Investor argued that the plain language of section 502(d) linked disallowance to the claimant, such that only claims that are still in the hands of the entity that received, but did not return, a voidable transfer at the time of distribution by the estate, would be subject to the section 502(d) bar. In response, the trust contended that the statute disallowed any claim originally held by the voidable transfer recipient, even if that claim had been transferred to an “innocent” third party. Id. at 335.
The KB Toys court did not dwell on the plain meaning of section 502(d). It instead focused on section 57(g) of the Bankruptcy Act of 1898, the predecessor to section 502(d). In the view of the KB Toys court, section 57(g) clearly stated that disallowance followed claims by identifying “the claims of creditors” which had made voidable transfers and mandating disallowance unless the creditors returned the voidable transfers. Id. at 335-36. The KB Toys court also examined case-law that interpreted section 57(g). Those cases generally held that assignees and sureties could collect payment only if the original claimant could as well. Id. at 336-37.
The KB Toys court analyzed section 502(d) from the vantage point of the estate as opposed to that of the affected creditor. The court read the statute as giving the estate an affirmative defense to an otherwise valid claim, and held this defense cannot be rendered moot by a transfer of the claim from one creditor to another. Id. at 338. The transferring of a claim merely substitutes one party for another and does not confer any right upon the transferee that was not originally available to the transferor. Id. at 339. According to the KB Toys court, the long-standing Congressional policy goal of preventing the recipient of a voidable transfer from collecting a distribution unless the recipient returns the voidable transfer, as articulated in both section 57(g) and section 502(d), would be seriously undermined if such creditor could circumvent the statutory restriction by simply selling a tainted claim, and thereby cleanse it. Id. In a footnote, the KB Toys court arguably limited the scope of its decision by observing that it was making “no determination about whether the same result should ensue in circumstances involving other types of transferred claims [other than trade claims]. It seems the drafters of the Bankruptcy Code also recognized when public markets might be effected.” Id. at 342 n.14.
As part of its legal analysis, the KB Toys court declined to adopt the sale vs. assignment distinction espoused by the Enron II court. According to the KB Toys court, as had been recognized by numerous commentators, these two terms are not easily distinguishable and are not defined in the Bankruptcy Code. Id. at 340-41. The KB Toys court also dismissed the argument that its ruling could unleash chaos in the distressed debt markets, describing that possibility as a “hobgoblin without a house to haunt” because buyers of claims are highly sophisticated entities capable of performing due diligence and are presumed to appreciate the risk that a purchased claim may be disallowed in whole or in part by a bankruptcy court. Id. at 341-42.
The KB Toys court further observed that the SOFA put the Investor on notice of the potential disallowance of the claims it bought. Id. at 342. In addition, the presence of indemnity provisions in four of the nine sales contracts in the event the claims acquired were disallowed demonstrated that the Investor understood the risk of disallowance and knew how to bargain with the sellers of claims for contractual protection against prospective disallowance. Id. The court would not force the estate to be the Investor’s insurer where the Investor elected not to obtain indemnification from a seller. Finally, the KB Toys court rejected the Investor’s argument that their purchases were made in “good faith,” finding that the “good faith” defense was not applicable where the purchaser knew that the claims being purchased could be disallowed as part of the bankruptcy process. Id. at 343.
The Second Circuit declined in Longacre Master Fund Ltd. v. ATS Automation Tooling Systems, Inc., No. 11–3413–cv, 2012 WL 4040176 (2d Cir. September 14, 2012), an opportunity to definitely determine whether the bar to payment set forth in section 502(d) travels to a new owner of the claim. In its decision, the court sustained broad contractual remedies granted to a purchaser/assignee (the “Purchaser”) against the seller/assignor (the “Seller”) in a claim transfer agreement (the “Agreement”). Id. at *2-*3.
Under the Agreement, the Seller agreed to transfer to the Purchaser claims against Delphi Automotive Services, LLC (“Delphi”), a Chapter 11 debtor (the “Claim”). The Agreement required the Seller to repurchase the Claim with interest if (1) “all or any part of the Claim is . . .objected to, disallowed, . . . in whole or in part, in the Case for any reason whatsoever,” or (2) the Purchaser received notice of a possible impairment against the Claim, and such possible impairment was not fully resolved within 180 days. The Agreement also contained a representation (the “Representation”) that “to the best of [the Seller]’s knowledge, the Claim is not subject to any defense, claim or right of setoff, reduction, impairment, avoidance, disallowance, subordination or preference action. . . .” Id. at *2.
Delphi sued the Seller following the execution of the Agreement, alleging that the Seller had received approximately $17.3 million in preferential transfers from Delphi within the 90 days before bankruptcy and that such amounts were avoidable under the Bankruptcy Code. Invoking section 502(d) of the Bankruptcy Code, Delphi also filed an objection to the Claim. Delphi and the Seller eventually reached a global settlement and the objection to the Claim was withdrawn. Id. at *1. However, the withdrawal occurred more than 180 days after the filing of the objection. Id. at *2.
The Purchaser commenced an action seeking a determination that the Seller was obligated to pay it over $800,000 in interest because (i) Delphi’s objection was an impairment of the Claim under the Agreement and (ii) the Seller breached the Representation. Id. The United States District Court for the Southern District of New York ruled against the Purchaser, holding that Delphi’s objection to the Claim did not constitute under the Agreement an impairment. In the District Court’s view, the objection to the Claim merely “preserved the Debtor’s right to object ” and did not constitute a formal objection under section 502(d). Longacre Master Fund, Ltd. v. ATS Automation Tooling Sys. Inc., 456 B.R. 633, 640 (S.D.N.Y. 2011). After the withdrawal of the objection, “no vehicle exist[ed] through which such an objection could be raised, filed, or formally commenced in the future.” Id.
The District Court further observed that the language of the Agreement evidenced a sale, not an assignment, of the Claim. Relying upon the distinction drawn between sales and assignments by the Enron II court, the District Court observed that “no section 502(d) objection (even if one were to have been made) would have constituted an Impairment in the first instance.” Id.
On appeal, the Second Circuit vacated the District Court’s decision. It determined that the objection filed by Delphi against the Claim constituted an Impairment and a Possible Impairment as those terms were defined under the Agreement because:
Delphi stated that it was “objecting to” the claim, and the Bankruptcy Court issued an order stating that the “Objection” was preserved. These steps are all that the purchase agreement requires in order to trigger [the Seller]’s obligations under Paragraphs 7 and 16. These paragraphs do not exclude objections intended to be withdrawn after the resolution of some other pending issue. Thus, even if the objection was in effect only a reservation of rights rather than an objection they intended to pursue immediately, it still constituted an objection under the purchase agreement. And the parties had good reason to draft the contract in this way, because the pendency of the objection limited [the Purchaser]’s ability to transfer or obtain payment on the claim.
2012 WL 4040176 at *2.
The Second Circuit also addressed the sale vs. assignment distinction in the context of the alleged breach of the Representation. The District Court had dismissed that claim based on the Purchaser’s concession that the transaction was a sale, which would have, in the District Court’s view and consistent with Enron II, “negat[ed] the possibility that the claim could be impaired by a preference action.” Id. at *3. But the Second Circuit observed that the Seller “had no reason at the time of the transfer to anticipate [the Purchaser]’s litigating position that the transfer was a ‘sale’ rather than an ‘assignment.’” Id. Moreover, the Agreement repeatedly referenced the transaction as an “assignment.” Id. The Second Circuit ruled that because “language in the agreement strongly suggests that it was an assignment, we conclude that [the Purchaser] has shown a material issue of fact as to [the Seller]’s knowledge of a possible preference action and related objection.” Id.
The Acquisition of Claims Does Not Ensure the Unfettered Right to Vote Them
Holders of claims or interests that are impaired by a plan (and that are slated to receive a distribution) are eligible to cast a vote on that plan. This is one of the most important statutory rights a creditor has in a Chapter 11 case. However, section 1126(e) of the Bankruptcy Code empowers a court to designate, i.e., disregard, the votes of “any entity whose acceptance of rejection of such plan was not in good faith.” The Bankruptcy Code provides no guidance as to how good faith should be defined, but the purpose of section 1126(e) is to deter a creditor from extracting an undue or inequitable advantage for itself in the Chapter 11 process.
In In re DBSD North America, Inc., 634 F.3d 79 (2d Cir. 2011), the Second Circuit affirmed the decision of the bankruptcy court to designate the votes of DISH Network Corporation (“DISH”). DISH was an indirect competitor of the debtor and a part-owner of a direct competitor of the debtor. DISH was not a pre-existing creditor of the debtor. The bad faith finding appeared to stem from the purchase by DISH of an entire class of claims at par after the debtor had proposed their plan and while solicitation for the plan’s acceptance was ongoing. Id. at 87. DISH had a keen interest in acquiring DBSD’s spectrum rights. Id. The court found that the purpose of the purchase of the claims was not to obtain maximum recovery on the debt, but to “obtain a blocking position” to defeat the debtor’s plan and to propose its own competing plan. Id. at 104. DISH ultimately voted against confirmation and DBSD moved to designate DISH’s votes under the theory that DISH did not vote in good faith. Id. at 87. In its opinion, the Second Circuit held that votes are subject to designation if creditors attempt to receive “more than the ratable equivalent of their proportionate part of the bankruptcy assets,” or act with an “ulterior motive,” that is, with “an interest other than interest as a creditor.” Id. at 102.
The Second Circuit zeroed in on DISH’s motives. DISH was a competitor of the debtor and decided to purchase a blocking position in a class of claims after a plan had been proposed with the intention of “us[ing] [its] status as a creditor to provide advantages over proposing a plan as an outsider, or making a traditional bid for the company or its assets.” Id. at 104. “In effect, DISH purchased the claims as votes it could use as levers to bend the bankruptcy process toward its own strategic objective of acquiring DBSD’s spectrum rights, not towards protecting its claim.” Id.
The Second Circuit emphasized that its decision imposed “no categorical prohibition on purchasing claims with acquisitive or other strategic intentions.” Id. at 105. Moreover, the court also noted that it was not addressing the situation where a preexisting creditor voted with strategic intentions. The court specifically noted two situations in which designation would generally be inappropriate. First, trade creditors could vote in such a way that would allow them to continue doing business with the reorganized debtor. Id. at 102. Second, a fully secured creditor could vote to seek liquidation to allow its funds to be invested more favorably elsewhere. Id.
Three post-DBSD decisions vividly illustrate that the concept of bad faith for purposes of section 1126(e) is a dynamic one that requires an examination of the totality of the circumstances, and not just a single set of factors.
In In re Circus & Eldorado Joint Venture, No. 12-51156, (Bankr. D. Nev. Sept. 20, 2012), the United States Bankruptcy Court for the District of Nevada designated the plan votes of a noteholder after finding that the noteholder acted in bad faith when it lobbied other creditors to vote against the debtor’s plan by filing a motion to terminate exclusivity. That motion critiqued the purported defects of the debtor’s plan of reorganization and described in detail the noteholder’s alternative plan structure. The court was troubled by the failure of the noteholder to (i) obtain court approval to disseminate information pertaining to its prospective competing plan during the debtor’s exclusive solicitation period and (ii) notice its own motion for hearing. Accordingly, the court concluded that the noteholder’s true intention in filing the exclusivity termination motion was to acquire operating ownership of the debtor. That conduct fell squarely within the range of “bad faith” conduct that required designation of the noteholder’s plan votes.
In In re Windmill Durango Office LLC, 473 B.R. 762, 767 (9th Cir. B.A.P. 2012), Beal Bank was the only secured creditor of the debtor. The debtor solicited votes on a “cramdown” plan that provided for the repayment of Beal Bank’s claim over time. It was evident that Beal Bank would vote to reject the plan, while the only two remaining holders of unsecured claims had voted to accept the plan. The plan would be confirmable with the support of these creditors. Attempting to preclude confirmation, Beal Bank bought one of the two unsecured claims for about 82 percent of its face value, or $1,250. Beal Bank then sought, pursuant to Bankruptcy Rule 3018(a), to withdraw the vote that had been cast on account of the unsecured creditor’s claim and submit a substitute ballot rejecting the plan. If the motion was successful, the debtor’s plan would not have been confirmable. Id. at 769-770. The bankruptcy court denied the bank’s motion to change the vote. The bankruptcy court held that a new creditor could only change its vote upon a showing of “cause” and it was not appropriate for creditors “to wait ‘til the plans [were] balloted and then decide what claims [they were] going to buy” and that Beal Bank’s attempt to change its vote so as to block confirmation was improperly motivated and “did the [bankruptcy] process violence.” Id. at 770.
On appeal, the Bankruptcy Appellate Panel affirmed the bankruptcy court’s denial of Beal Bank’s motion. The appellate panel specifically noted its decision was a “close” one and limited its ruling to the issue of whether the bankruptcy court had “abuse[d] its discretion.” Id. at 777.
At least one case expressly refused to designate the votes of a competitor of the debtor pursuant to section 1126(e). In In re Trikeenan Tileworks, Inc., 2011 WL 2898955 at *3, *7 (Bankr. D.N.H. July 14, 2011), the debtor’s competitor purchased a claim. By virtue of that purchase, the competitor obtained standing and proposed a plan that would (i) restructure the debtor’s secured debt, (ii) provide a meaningful recovery to unsecured creditors, and (iii) invest additional capital into the reorganized debtor. The court found that the competitor “intend[ed] to maintain the [debtor] as viable entities that w[ould] create a going concern value for creditors.” Id. at *7. The court noted the amount of the purchased debt was small and the competitor’s alternative plan enjoyed significant creditor support. Id. In declining to designate the votes of the competitor, the court explained that:
Being a competitor who proposes a competing plan to take over the debtor does not equal bad faith per se. To the contrary, the Supreme Court has noted that lifting exclusivity to propose a competing plan opens the door for other parties to bid for the equity of the company . . . . There is no requirement that a competing plan must be friendly to the existing management or ownership of a debtor.
Id. (citing Bank of America v. 203 N. LaSalle St. P’ship, 526 U.S. 434, 457-58 (1999)).
“Claims trading markets are as old as our nation.” KB Toys, 470 B.R. at 341. The importance of these markets to the Chapter 11 process has grown by leaps and bounds in recent years. However, as discussed herein, market participants need to be mindful of the potential legal risk. Whether the bar to payment set forth in section 502(d) travels with a new owner of the claim is an unsettled question of law. As a result, it behooves potential buyers of bankruptcy claims to conduct due diligence by at least reviewing the SOFA filed by a debtor and to, whenever possible, obtain indemnification protection from the seller. In a development that could strengthen the hand of buyers of bankruptcy claims, the Longacre Master Fund court broadly read a contractual indemnification clause to require the seller to take back the claim upon an objection to the claim by the estate. And given that court’s oblique reliance on the sale vs. assignment distinction in which a defense to payment of a claim in bankruptcy travels with the claim to an assignee, but not to a purchaser, a claim buyer should, at least for a bankruptcy case in New York, document a transfer agreement as a purchase agreement, rather than as an assignment.
It is also clear that while good faith under section 1126(e) is not synonymous with selfless disinterest, see, e.g., In re Figter Ltd., 118 F.3d 635, 639 (9th Cir. 1997), buyers of claims who are competitors of the debtor are vulnerable to losing their voting right, especially if they are not pre-petition creditors and their goal in purchasing claims is to carry out a hostile takeover of a debtor or to use the assets of the debtor for their own benefit.