District court decides that equitable subordination runs with claimant, not with claim
Springfield Associates, L.L.C. v. Enron Corp. (in re Enron Corp., et al.), 2007 WL 2446498 (S.D.N.Y. August 27, 2007)
In a case of interest to the financial community in light of the significant number of debt claims that are transferred either before or during a bankruptcy proceeding, and as evidenced by amici curiae having been filed by several organizations  that are active in the trading of debt securities, Judge Scheindlin from the United States District Court for the Southern District of New York, sitting in an appellate capacity, vacated orders previously entered by the bankruptcy court <> which called for the equitable subordination and disallowance of certain transferred claims. The decision deals with the equitable subordination of claims under Section 501(c) of the Bankruptcy Code (for inequitable conduct) and the disallowance of claims in a bankruptcy case under Section 502(d) of the Bankruptcy Code (because the claimant failed to return property that was recoverable by the bankruptcy estate – usually due to the claimant having received an avoidable preference or a fraudulent transfer). In each instance, the District Court held that equitable subordination under Section 510(c) and disallowance under Section 502(d) is a function of “personal disabilities” that do not inhere in the claim. As a result, where the claim has been transferred by assignment, the personal disabilities of the transferor may travel with the claim and result in either equitable subordination or disallowance or both. In contrast, where the claim has been transferred by sale before the filing of the bankruptcy case and the personal disabilities are those of the transferor and not the transferee, there is no basis to subordinate or disallow the claim. The result is that equitable subordination or disallowance of a transferred claim will depend upon how and when the claim was transferred.
The facts in the Enron cases are not unique. Before the filing of the Enron Chapter 11 cases, certain banks held claims against Enron or against its various affiliate and subsidiaries. Many of those claims were transferred before the Enron Chapter 11 filing, apparently as a result of credit default swap contracts. According to Enron, those same banks had engaged in inequitable conduct and had property from Enron that they should be ordered to return to the Enron estate, on the basis that the property had been transferred to them in either a preferential or fraudulent transfer that is avoidable in bankruptcy. During the Chapter 11 cases, Enron filed complaints against the transferors seeking equitable subordination of their claims, the disallowance of their claims, and both compensatory and punitive damages, based on allegations that the transferors aided and abetted fraud and breach of fiduciary duty, and had engaged in an unlawful civil conspiracy with Enron insiders. Those cases are still ongoing.
Enron also filed complaints against the transferees seeking to equitably subordinate the claims, based upon the inequitable conduct of the transferors, and also asking that the claims be disallowed because the transferors had not returned the property that had allegedly been improperly transferred. However, nowhere was it alleged that the transferees had engaged in any inequitable conduct or had received property of the debtor via preferential or fraudulent transfers. The transferees therefore moved to dismiss the complaints on the basis that they had not engaged in any inequitable conduct and had not received any property from Enron that they were obligated to return. In two rulings, the Bankruptcy Court held for Enron and ordered first the equitable subordination and then disallowance of the transferred claims, in each case based upon the actions of the transferors. In the view of the Bankruptcy Court, the infirmities of the transferor banks traveled with the claim into the hands of the transferors. Interlocutory appeals followed to the District Court.
On appeal, Judge Scheindlin disagreed with the Bankruptcy Court’s analysis. She found, in the words of the statute, in the legislative history, and in the policy underlying the laws, no reason to believe that Congress, when it passed Sections 510(c) and 502(d) of the Bankruptcy Code, intended to have equitable subordination or disallowance foisted upon the transferee of a claim who has not engaged in any equitable conduct or itself has property that it is obligated to return to the debtors. In the Court’s view, both equitable subordination under Section 510(c) and disallowance under Section 502(d) are “personal disabilities” of the claimant/transferors and, under certain circumstances, the claims can be transferred without these “personal disabilities.”
The court then examined the differences between an assignment and a sale of a debt claim. With an assignment, subject to limited exceptions, the assignee steps into the shoes of the assignor and is, therefore, at risk for any challenges that could have been asserted against that claim as if it were still held by the transferor. In such an instance, the “personal disabilities” travel with the claim. The exceptions to this rule include (i) when the assignment is of a negotiable instrument and the assignment is made to a holder in due course (see UCC §3-104), and (ii) when the third-party latent-equities doctrine, that is alive in a limited number of jurisdictions, applies. The assignment consequences, i.e., the transfer of a claim subject to all “personal disabilities,” also apply to a surety that acquires the claim by subrogation, as well as to the FDIC when it acquires a claim in its capacity as the receiver of a failed financial institution.
However, the court determined that a sale is a different animal and the purchaser of a claim in a sale transaction can obtain more that the seller had. In the court’s view, “[A] personal disability that has attached to a creditor who transfers its claim will travel to the transferee if that claim is assigned, but will not travel to the transferee if the claim is sold” (emphasis in original). Therefore, when the claim is sold in an open market transaction and the buyer is not aware of any “disabling” actions of the seller, is otherwise acting in good faith and has not acted inequitably, then the claim in the hands of the purchaser is not capable of being equitably subordinated or disallowed based solely upon the actions of the seller.
The decision is significant. A decision to put purchasers of claims at risk for the actions of the seller is likely to inhibit the transfer of debt claims where there is any inkling the transferor might have a “personal disability” and, given the difficulty of knowing much about the actions of the transferor in an open market transaction, could conceivably produce a negative impact on all claims trading. This was the concern of the amici curiae. The Federal Rules of Bankruptcy Procedure were amended in 1991 to limit the bankruptcy court’s involvement in the process by which parties can transfer debt claims. The only action in the bankruptcy case is the filing of a notice of the transfer of the claim. No court approval is needed. Perhaps as a result, the transfer of secured and unsecured debt claims held by financial institutions grew in subsequent years and is now a regular occurrence and big business, with transfers of debt claims occurring at any time after a loan is made and both before and after the filing of a bankruptcy case.
Whatever the reason for the burgeoning business of claims trading and, specifically, the distressed debt trading industry, it is not uncommon for a claim against a debtor in bankruptcy to be held by someone other than the original maker of the loan. If the decision holds  , parties interested in acquiring a claim will be able to structure the acquisition as a purchase and sale, and be reasonably comfortable that the claim will not be at risk for the actions of the original holder of the claim, as long as the purchaser does not have notice of the actions, is acting in good faith, and has not itself been guilty of a “personal disability.” This could increase the risk of “claims washing,” which would occur if a claim holder with a “personal disability” sells its claim with an innocent purchaser for value and without knowledge of the “personal disability,” and without having a “personal disability” on its own accord.
If you have any questions or require further information regarding these or other related matters, please contact Mark Berman at firstname.lastname@example.org or 617-345-6037, or any member of Nixon Peabody’s Financial Restructuring and Bankruptcy Team. Portions of the foregoing were extracted from an article originally published by Bloomberg L.P. and reprinted by permission. © Bloomberg 2007
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