Buyer Beware in the Bankruptcy Claims Trading Market

The Bankruptcy Court for the District of Delaware recently held in In re Woodbridge Group of Companies, LLC that while Rule 3001 of the Bankruptcy Code provides a mechanism for transfers of claims, Rule 3001 is not a substantive provision allowing claims trading for notes with legally valid anti-assignment provisions. 

Background 

Prior to bankruptcy, Woodbridge Mortgage Investment Fund (the “Debtor”) issued three US$25,000 promissory notes to a Mr. and Mrs. Berlinger. Each note contained a provision prohibiting any assignment of the note and deeming any attempted assignment without the written consent of the Debtor to be “null and void.” The loan agreement executed in connection with the notes similarly provided that the lender “shall not assign… any of its rights hereunder” absent the Debtor’s consent. Nonetheless, two months after the Debtor filed its bankruptcy petition, the Berlingers entered into an agreement to “sell, convey, transfer and assign” the notes and the rights thereunder to Contrarian Funds, LLC (“Contrarian”). Contrarian filed a proof of claim asserting a secured claim against the Debtor in the amount of US$75,000, and the Debtor objected. 

The Opinion 

The Court began its analysis by noting that the claims trading market is “robust and fruitful,” providing liquidity for noteholders and profitability for traders. But the Court also noted that Rule 3001, which clearly contemplates the existence of a claims trading market and provides certain procedures governing claim transfers, does not preclude the Court from enforcing applicable non-bankruptcy law concerning contract provisions restricting transfers. 

The Court first found that the anti-assignment provision was a valid restriction on assignment rights under Delaware law, the law governing the notes at issue in the case. While Delaware courts recognize the importance of free assignability and generally construe anti-assignment provisions narrowly, the Court found that the anti-assignment provision at issue contained sufficiently express language stating that any subsequent assignment will be void and invalid. Similarly, under section 322 of the Restatement (Second) of Contracts, the anti-assignment provision survives because it is a clear and unambiguous manifestation of the intention to prevent assignment of the notes, regardless of whether Contrarian purchased only the rights under the notes rather than the notes themselves. The Court also rejected Contrarian’s argument that, even if the anti-assignment provision is legally valid, the Debtor cannot enforce a note containing this clause because of its prior breach of the note. The Court held it axiomatic that the party may not have better rights post-breach than it had pre-breach. 

Finally, the Court engaged in a thorough analysis of the Uniform Commercial Code and held that it does not override and nullify clauses restricting assignment of promissory notes. Finding little precedent on the issue, the Court held that UCC sections 9-408 and 9-406 which render anti-assignment provisions unenforceable in varying degrees, apply by their terms to creation of security interests in the notes, not to their outright sales. The Court therefore found the anti-assignment provision in the promissory note to be valid and enforceable, the transfer from the Berlingers to Contrarian void, and sustained the Debtor’s objection to the proof of claim. 

Looking Ahead 

The Court took pains to underscore that it was not convinced, and that the record did not support, that its holding would “cause disruption in the claims trading market.” However, parties actively trading in this market should beware of state laws governing debt instruments containing clear and unambiguous anti-assignment provisions. Furthermore, the Court’s treatment of the UCC suggests that while the UCC does not protect outright purchases of notes containing such assignment restrictions, traders buying such notes may well fare better in bankruptcy if they were to structure their purchase so as to include a back-up security interest in their favor, as is commonly granted to buyers of assets in securitization transactions of the type UCC Section 408 was designed to support.