Clouds On The Horizon For Claim Purchasers In The Third Circuit

In a decision of significance to the distressed claims trading community, the US Court of Appeals for the Third Circuit in In re KB Toys Inc.1 recently held that any risk or "cloud" of disallowance under the Bankruptcy Code resulting from a creditor's receipt of an avoidable transfer cannot be separated from a claim, even when such claim is in the possession of a subsequent transferee. The Third Circuit's decision not only reaffirms the decisions of the Delaware Bankruptcy and District Courts, but is the clearest and most influential ruling to date to decide this issue in a manner contrary to the decision of the US District Court for the Southern District of New York in In re Enron Corp. ("Enron II").2 In Enron II, the court held that whether the transfer of a claim separates or cleanses it from the risk of disallowance depended on whether the transfer was characterized as a "sale" or an "assignment." Given the importance of the Third Circuit with respect to large commercial chapter 11 cases, as well as the logic and clarity of the rationale in KB Toys, this decision should provide important guidance with respect to the expectations of distressed claim buyers participating in bankruptcy cases throughout the United States.

The Enron II Decision

The Enron II court held that disallowance under section 502(d) of the Bankruptcy Code constitutes a "personal disability," as the court interpreted the statute to focus on claimants, as opposed to the claims they hold. As such, according to the District Court in Enron II, the means by which a claim is transferred under applicable state law is controlling: an assignee steps into the shoes of the original claim holder and assumes both the benefits and risks associated with the claim, whereas a purchaser receives only the benefits, washing away the risk of disallowance. However, the Enron II court failed to provide meaningful guidance as to which factors would distinguish between a sale versus an assignment, and subsequent commentators as well as the Third Circuit in KB Toys have found no basis for such a distinction. As a result, claims traders have generally disregarded the Enron II decision as impractical to implement.

The KB Toys Decision

The KB Toys decision provides important clarity in the area of claims trading, holding unequivocally that a purchaser of a claim is subject to the risk of such claim's disallowance in the event that the claim seller has received an avoidable transfer of property of...