Seller Beware: Yet Another Cautionary Tale For Distressed-Debt Traders

Participants in the multibillion-dollar market for

distressed claims and securities had ample reason to keep a

watchful eye on developments in the bankruptcy courts during

each of the last three years. Controversial rulings handed down

in 2005 and 2006 by the bankruptcy court overseeing the chapter

11 cases of failed energy broker Enron Corporation and its

affiliates had traders scrambling for cover due to the

potential that acquired claims/debt could be equitably

subordinated or even disallowed, based upon the seller's

misconduct. Although the severity of the cautionary tale writ

large in the bankruptcy court's Enron decisions

was ultimately ameliorated on appeal in the late summer of 2007

by district court judge Shira A. Scheindlin, the 20-month

ordeal (and the uncertainty it spawned) left a bad taste in the

mouths of market participants. 2008 has so far proved to be

little better in providing traders with any degree of comfort

with respect to claim or debt assignments involving bankrupt

obligors. This time, moreover, the trouble concerns standard

provisions contained in nearly every bank loan-transfer

agreement, which have rarely been subject to challenge or

analysis in the courts. In In re M. Fabrikant & Sons,

Inc., a New York bankruptcy court recently took a hard

look at the standard transfer forms and definitions to

determine whether a seller's reimbursement rights were

transferred along with the debt.

Distressed Claims/Debt Trading

Although the distressed-securities market is largely

unregulated, industry participants and trade

consortia—such as the Loan Syndications and Trading

Association ("LSTA"); the Securities Industry

Association; the International Swaps and Derivatives

Association, Inc.; and the Bond Market Association—have

implemented standards, forms, and procedures to govern purchase

and sale transactions. LSTA's standardized Purchase and

Sale Agreement for Distressed Trades, LSTA Standard Terms and

Conditions (the "LSTA Standards"), provides a fairly

comprehensive boilerplate for most sale/assignment

transactions. Even so, as demonstrated by the bankruptcy

court's ruling in In re M. Fabrikant & Sons,

Inc., parties relying on the LSTA Standards must be

vigilant to ensure that transfer documentation unambiguously

distinguishes between rights that are being transferred and

rights that are to be retained by the seller/assignor.

Background

M. Fabrikant & Sons, once one of the world's largest

manufacturers and distributors of diamonds, filed for chapter

11 protection together with its subsidiary Fabrikant-Leer

International, Ltd. (collectively referred to as

"Fabrikant"), in New York on November 17, 2006.

Shortly thereafter, the bankruptcy court entered an order

authorizing Fabrikant to use cash collateral pledged to a

consortium of bank lenders (collectively, the "original

lenders") as security for nearly $162 million in

pre-petition loans. The cash collateral order, which conferred

administrative-priority status upon claims asserted by the

original lenders for reimbursement of certain expenses (the

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