Purchasers of Bankruptcy Claims Beware: “Disabilities” of Purchased Claims Could Limit Your Recovery

Josef Mintz

Josef W. MintzRecently, a Delaware bankruptcy court denied a purchaser of claims its recovery because of judgments against the original holders of the claims from whom the claims were purchased.  The case, In re KB Toys, Inc., et al., 470 B.R. 331 (Bankr. D. Del. 2012), held that section 502(d) of the Bankruptcy Code applies to claims purchasers and original claim holders alike.  Section 502(d) disallows a claim against a debtor until the claimant first pays any money owed to the debtor as a result of certain bankruptcy recovery actions such as turnover, avoidance and setoff.  For example, if a claimant files a claim for $10,000, but the claimant owes the debtor $5,000 on account of a preference, the court should disallow the $10,000 claim under 502(d) unless and until the preference liability is satisfied.  According to KB Toys, a hypothetical purchaser of that $10,000 claim will face the same disallowance as the original holder of the claim unless and until the hypothetical $5,000 judgment is paid.  KB Toys thus held that the “disability” of the $10,000 claim travels with the claim to subsequent holders.

KB Toys is an important case for at least two reasons.  First, the case created a new rule of law concerning disallowance of bankruptcy claims in Delaware.  Second, KB Toys’ holding differs from the current view on the same issue in New York.  In New York, under Enron Corp. v. Springfield Assocs. (In re Enron), 379 B.R. 425 (S.D.N.Y. 2007), whether a disability travels with a transferred claim depends upon whether the transfer is structured as a sale or an assignment.  According to Enron, a claim purchaser who buys a claim at a sale will generally take the claim free from any disability that would affect the seller, but an assignee will stand in the shoes of the assignor and will take the claim with the same limitations of the assignor.  KB Toys criticizes Enron’sdistinction between a sale and assignment of a claim, finding that such a distinction is not contemplated by the Bankruptcy Code.  Instead, according to KB Toys, the Bankruptcy Code employs a simpler concept of a “transfer” to uniformly describe both sale and assignment transactions, thus erasing the distinction.

Additionally, KB Toys reached several other conclusions that should serve as cautionary tales to entities engaged in the bankruptcy claims trading business.  First, the court found that the claim purchaser did not undertake sufficient diligence before purchasing the claims in question because it had knowledge of the possibility of disallowance at the time of its purchases.  Specifically, the claim purchaser had notice of potential and actual avoidance action liabilities by virtue of the publically available court filings in the case.  Also, the claim purchaser included indemnification language in some of its transfer agreements, which demonstrated its capacity to negotiate around this very issue at the time of purchase.  Second, the court was not persuaded by the purchaser’s argument that it had purchased the claims in good faith.  Instead, the court noted that the purchase of claims in bankruptcy carries inherent risk and, as a result, purchasers of bankruptcy claims are not entitled to the traditional protections of a good faith purchaser that might be available in non-bankruptcy contexts.

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