Claims Based on Avoidable Transfer Cannot be “Washed Clean” in the Secondary Market
Disagreeing with the much-critiqued SDNY opinion in Enron, the SDNY bankruptcy court disallowed claims brought by secondary transferees because the original claimants allegedly received millions of dollars in fraudulent transfers and preferences from the Debtors that have not been repaid. Deepening the district split on the nature of Section 502(d) of the Bankruptcy Code, the Court held that the defense barring fraudulent transfer-tainted claims focuses on claims—not claimants—and cannot be “washed clean” by a subsequent transfer in the secondary market. In re Firestar Diamond, Inc., et al., Debtors, No. 18-10509 (SHL), 2020 WL 1934896 (Bankr. S.D.N.Y. Apr. 22, 2020).
The Debtors in the Firestar Diamond Chapter 11 bankruptcy cases are three U.S. wholesalers of finished jewelry indirectly owned by Nirav Modi. According to the Indian Central Bureau of Investigation, Mr. Modi used fraudulently obtained Letters of Understanding (“LOUs”) to perpetrate an alleged bank fraud and obtained approximately $4 billion from an Indian bank through the fraudulently issued LOUs, while approximately $1 billion worth of LOUs remain unpaid.
Concerned that the Debtors might have been involved with the alleged fraud, the Bankruptcy Court appointed an examiner who ultimately concluded that substantial evidence support the knowledge and involvement by the Debtors and their senior officers and directors in the criminal conduct alleged by the Indian authorities. In light of the examiner’s report and certain subsequent events, a trustee (the “Trustee”) was appointed to administer the Debtors’ estates.
Amid these events, the Trustee objected to certain proofs of claim filed by four Indian banks (the “Banks”). None of the Banks’ claims were based on their dealings with the Debtors. Rather, the claims reflected amounts owed by the Debtors to three non-debtor entities who pledged their receivables or sold invoices to the Banks for amounts owed by the Debtors.
The Trustee’s Objections under Section 502(d) of the Bankruptcy Code
The Trustee argued that all of the Banks’ claims were barred under Section 502(d) of the Bankruptcy Code, which prescribes that “the court shall disallow any claim of any entity from which property is recoverable…or that is a transferee of [an avoidable transfer], unless such entity or transferee has paid the amount, or turned over any such property, for which such entity or transferee is liable” (emphasis added).
The Trustee asserted that the initial holders of the Banks’ claims have each received millions of dollars in fraudulent transfers and preferences from the Debtors that have not been repaid. The Banks’ claims, the Trustee argued, were based on the Debtors’ dealings with the initial holders and therefore subject to disallowance in the same way as if the claims were filed by the initial holders.
Does the Disability “Run With the Claim”?
In opposing the Trustee’s objections to their proofs of claim, the Banks relied heavily on In re Enron Corp., 379 B.R. 425 (S.D.N.Y. 2007) (“Enron II”). They argued that, as held in Enron II, disallowance under Section 502(d) is a personal disability that does not travel with the “claim,” but with the “claimant.” Indeed, the Enron II Court held that disallowance under Section 502(d) is a personal disability of the specific claimant and not an attribute of a claim. The Enron II Court distinguished between an assignment and a sale, and concluded that any disallowance under Section 502(d) of a transferee’s claim depends on “the nature of the transfer:” while a transfer by assignment will not grant the assignee more rights than possessed by the assignor, these principles of assignment law do not apply to a purchase.
In other words, according to the Enron II Court, an assignee “stands in the shoes of the assignor” and takes the claim with “whatever limitations it had in the hands of the assignor,” but a purchaser of the same claim is not subject to any personal disabilities of the transferor. The Court reasoned that Section 502(d)’s power to coerce the return of assets obtained by preferential transfer “would not be served if a claim in the hands of a claimant could be disallowed even where that claimant never received the preference to begin with, and as a result, could not be coerced to return it.” The Enron II Court further explained that applying Section 502(d) to purchasers of claims “would be punitive because they have no option to surrender something they do not have, which means they have not personally obtained any advantage that they could surrender,” which was not the intended result of the statute.
The Firestar Diamond Court Disagrees and Favors the Third Circuit’s Contrary Position
The Firestar Diamond Court found Enron II unpersuasive. Instead, it favored the Third Circuit’s view expressed in In re KB Toys Inc., 736 F.3d 247 (3d Cir. 2013), where the Court concluded that because Section 502(d) “focuses on claims—and not claimants—claims that are disallowable under [Section] 502(d) must be disallowed no matter who holds them.”
The Third Circuit cautioned that the contrary view—i.e., that Section 502(d) focuses on claimants rather than claims—would permit an original claimant who received a voidable transfer to then “sell” the claim to a transferee, thereby allowing the original claimant to “wash” the claim of disabilities and get a (discounted) value for it. In return, the transferee of the original claimant would be able to take the property at issue free and clear of the trustee’s powers. “To allow the sale to wash the claim entirely of the cloud would deprive the trustee of one of the tools the Bankruptcy Code gives trustees to collect assets—asking the bankruptcy court to disallow problematic claims.”
As the Firestar Diamond Court observed, the Third Circuit found Enron II’s distinction of “assignment” and “sale” to be “problematic,” specifically because the state law on which it relied “does not provide a distinction between assignments and sales...[and because] resort to state law in a bankruptcy case must be done with care.”
A long line of courts and commentators expresses similar views. The Delaware Bankruptcy Court in the KB Toys case, for example, emphasized that the distinction in Enron II between “assignment” and “sale” has no support under the Bankruptcy Code. Rather, the “Code definition of ‘transfer’ arguably includes both.” In re KB Toys, Inc., 470 B.R. 331, 340 (Bankr. D. Del. 2012) (citing 11 U.S.C. § 101(54)(D), which defines the term “transfer” broadly to mean “each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with (i) property; or (ii) an interest in property”). Some of the scholarly articles collected by the Firestar Diamond Court expressed the practical concern that “sale” and “assignment” are perceived as synonymous and used interchangeably in the market.
The Firestar Diamond Court concluded that Section 502(d) focuses on claims, not claimants, and granted the Trustee’s objections. The transfer of the claims to the Banks in the secondary market could not “wash clean” their disability.
A Different Result Would be Inequitable
The Court denied the Banks’ alternative argument that disallowing their claims would be inequitable, and rejected the notion that their claims “should be allowed because a decision against them will wreak havoc in the claims trading market or unfairly punish good faith transferees.” To the contrary; the Court found that claim purchasers should be the ones to bear the risk under such circumstances.
Relying again on the Third Circuit’s opinion in KB Toys, the Court cited two reasons for this risk allocation rule: First, claim purchasers “voluntarily choose to take part in the bankruptcy process” and are aware of the risks associated therein, and it is incumbent “on prospective assignees to take into account possible claim defenses when they negotiate the terms of their assignments.” Second, claim purchasers can mitigate their risk through due diligence and indemnity clauses in the transfer agreement. While informed claim traders have the ability to reduce and mitigate risk, the Court explained, “creditors in a bankruptcy have no way to protect themselves against the risk that claims with otherwise avoidable transfers will be washed clean by a sale or assignment.”
Firestar Diamond deepened the split in the Southern District of New York regarding the nature of Section 502(d)—whether it “runs with the claim,” or is a personal disability attributed only to the so-called “initial holders.” While the uncertainty created by this split will likely only be eliminated by a clear message from the Second Circuit, it appears that the weight of authority is with the Third Circuit and Firestar Diamond, not Enron II.
In order to minimize their risk secondary market purchasers of claims should be vigilant and conduct disallowance-related due diligence. Purchasers should also include indemnification language in their transaction documents, to be triggered in case the purchased claims are disallowed on fraud or avoidability grounds. At the same time, purchasers should prepare for the possibility of a ruling under the principles of Enron II, and to the extent possible structure the transaction as a sale rather than an assignment or a secured loan, since under Enron II only a sale will be protected from a Section 502(d) disallowance objection.