Bolstering the Majority Rule: Bankruptcy Court Holds that Adjudication of Avoidance Liability Is Prerequisite to Disallowance of Transferee's Claim Under Section 502(d)

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The U.S. Bankruptcy Court for the Eastern District of North Carolina recently added some weight to the majority rule on an issue that has long divided bankruptcy and appellate courts. In In re Southern Produce Distributors, Inc., 2020 WL 1228719 (Bankr. E.D.N.C. Mar. 11, 2020), the bankruptcy court held that the claim of a recipient of an avoidable transfer cannot be disallowed under section 502(d) of the Bankruptcy Code, which disallows such claims unless the transferee returns the transferred assets to the estate, until the transferee's avoidance liability has been finally adjudicated.

Disallowance of Claims of Avoidable Transfer Recipients

Section 502(d) of the Bankruptcy Code creates a mechanism to deal with creditors who have possession of estate property on the bankruptcy petition date or are the recipients of pre- or postbankruptcy asset transfers that can be avoided because they are fraudulent, preferential, unauthorized, or otherwise subject to forfeiture by operation of a bankruptcy trustee's avoidance powers. Section 502(d) provides as follows:

Notwithstanding subsections (a) and (b) of this section, the court shall disallow any claim of any entity from which property is recoverable under section 542, 543, 550, or 553 of this title or that is a transferee of a transfer avoidable under section 522(f), 522(h), 544, 545, 547, 548, 549, or 724(a) of this title, unless such entity or transferee has paid the amount, or turned over any such property, for which such entity or transferee is liable under section 522(i), 542, 543, 550, or 553 of this title.

As noted by the U.S. Court of Appeals for the Fifth Circuit in In re Davis, 889 F.2d 658, 661 (5th Cir. 1989), "[t]he legislative history and policy behind Section 502(d) illustrates that the section is intended to have the coercive effect of insuring compliance with judicial orders." See also H.R. Rep. No. 95-595, at 354 (1978); S. Rep. No. 95-989, at 64 (1978); accord In re Odom Antennas, Inc., 340 F.3d 705, 708 (8th Cir. 2003). The provision "is designed to foster the 'restoration' of assets to a debtor's estate, thereby assuring 'equality of distribution' … by precluding anyone who has received a voidable transfer from sharing in any distribution … unless he first pays back any preference that he has received." In re Chase & Sanborn Corp., 124 B.R. 368, 371 (Bankr. S.D. Fla. 1991) (citations omitted). Section 502(d) was "not [intended] to punish, but to give creditors an option to keep their transfers (and hope for no action by the trustee) or to surrender their transfers and their advantages and share equally with other creditors." In re Enron Corp., 379 B.R. 425, 435 (S.D.N.Y. 2007) (citations and internal quotation marks omitted).

Much of the controversy in recent years concerning section 502(d) has focused on whether a claim sold or assigned by the recipient of an avoidable transfer is still subject to disallowance in the hands of a "blameless" assignee or acquirer. Compare In re Arctic Glacier Int'l, Inc., 901 F.3d 162, 168 (3d Cir. 2018) (when a claim is transferred, "the transferee assumes the same limitations as the transferor…. Otherwise, buyers could revive disallowed claims, laundering them to receive better treatment in new hands."); In re KB Toys Inc., 736 F.3d 247, 252 (3d Cir. 2013) ("because § 502(d) permits the disallowance of a claim that was originally owned by a person or entity who received a voidable preference that remains unreturned, the cloud on the claim continues until the preference payment is returned, regardless of whether the person or entity holding the claim received the preference payment"); In re Firestar Diamond, Inc., 615 B.R. 161 (Bankr. S.D.N.Y. 2020) (agreeing with KB Toys and other courts holding that claim disallowance under section 502(d) rests on the claim and not the claim holder) with Enron Corp. v. Springfield Associates, L.L.C. (In re Enron Corp.), 379 B.R. 425, 439 (S.D.N.Y. 2007) (absent a pure assignment or other basis for the transferee to step into the shoes of the transferor, as distinguished from a sale of a 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").

However, courts also disagree over whether a claim may be disallowed under section 502(d) prior to a final adjudication of the claimant's avoidance liability. Most courts take the approach that the underlying avoidance claims must be adjudicated fully before a claim can be disallowed under section 502(d). See, e.g., In re Odom Antennas, Inc., 340 F.3d 705, 708 (8th Cir. 2003) (the language of section 502(d) indicates that the provision "should be used to disallow a claim after the entity is first adjudged liable; otherwise, the court could not determine if the exception applies"); accord In re Atlantic Computer Sys., 173 B.R. 858, 862 (S.D.N.Y. 1994); In re Damon's Int'l, Inc., 500 B.R. 729, 739 (Bankr. W.D. Pa. 2013); In re West, 474 B.R. 191, 201 (Bankr. N.D. Miss. 2012); In re Metiom, Inc., 301 B.R. 634, 641-42 (Bankr. S.D.N.Y. 2003); In re Lids Corp., 260 B.R. 680, 684 (Bankr. D. Del. 2001); see generally Collier on Bankruptcy ¶ 502.05 (16th ed. 2020).

Some courts, noting that the statute refers to property that is "recoverable" or a transfer that is "avoidable," find that colorable allegations to that effect are sufficient to trigger temporary disallowance for certain purposes (e.g., voting on a plan of reorganization or to receive distributions of estate property), subject to later reconsideration. See, e.g., Thaler v. Korn, 2014 WL 1154059, at *8 (E.D.N.Y. Mar. 19, 2014); In re Circuit City Stores, Inc., 426 B.R. 560, 571 (Bankr. E.D. Va. 2010); In re Enron Corp., 340 B.R. 180, 192-93 (Bankr. S.D.N.Y. 2006), vacated on other grounds, 379 B.R. 425 (S.D.N.Y. 2007); see also Ames Dep't Stores, Inc. v. ASM Capital LP (In re Ames Dep't Stores), 06 Civ. 0471 (LAK) (S.D.N.Y. Mar. 9, 2006) (unpublished order dismissing appeal of interlocutory order of bankruptcy court providing for temporary disallowance of claims under section 502(d) pending either adjudication of underlying avoidance claims or surrender of property transferred); In re Miller, 2019 WL 1112335, at *9 (Bankr. N.D. Ga. Mar. 8, 2019) ("section 502(d) merely requires an objecting party to make a prima facie showing the claimant received an unauthorized transfer and, once an avoidable transfer is shown, the court is required to disallow the claim even though the transfer could not be challenged due to the statute of limitations").

The bankruptcy court weighed in on this debate in Southern Produce.

Southern Produce

In April 2018, potato grower, packer, and shipper Southern Produce Distributors, Inc. ("SPD") filed for chapter 11 protection in the Eastern District of North Carolina. Both before and after filing for bankruptcy, SPD did business with other potato growers (collectively, "Growers"), some of which filed claims against SPD for amounts due under prepetition contracts.

Alleging that the Growers failed to satisfy their obligations under postpetition contracts, SPD commenced adversary proceedings against the Growers seeking, among other things, an order pursuant to section 542 of the Bankruptcy Code directing the defendants to turn over estate property in the form of postpetition payments improperly applied to satisfy a portion of the Growers' prepetition claims. SPD also objected to the Growers' claims and sought an order under section 502(d) disallowing the claims. The Growers argued that disallowance was premature because section 502(d) requires, as a prerequisite to disallowance, a ruling that they are subject to turnover liability under section 542.

The Bankruptcy Court's Ruling

Judge Stephani W. Humrickhouse of the U.S. Bankruptcy Court for the Eastern District of North Carolina ruled that SPD's objections to the Growers' claims under section 502(d) "shall be held in abeyance pending final adjudication of the adversary proceedings." In so ruling, she adopted the majority position on the disallowance of claims under section 502(d).

The court acknowledged the split of authority on this issue but concluded that the minority approach is "not consistent with the spirit of the rule," which is "to foster the 'restoration' of assets to a debtor's estate, thereby assuring 'equality of distribution'" by precluding the recipients of avoidable transfers to share in estate distributions until they return transferred assets to the estate (citations omitted). Considering the intended coercive effect of section 502(d), the court reasoned that the provision "cannot be invoked to ensure the Grower Defendants comply with a judicial order to turn over property to the bankruptcy estate where there has been no such order entered." Thus, because there had been no adjudication of the Growers' liability under section 542, the court continued, "denying the Growers' claims against the debtor's estate is premature."

Outlook

Southern Produce adds to the majority position against pre-adjudication disallowance of claims under section 502(d). This approach is consistent with the purpose of the provision to compel creditors who wish to share in the distribution of bankruptcy estate assets to disgorge any avoided transfers they received as a condition to receiving any recovery on their claims.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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