One of your customers sends you notice it has filed for chapter 7 or chapter 11 bankruptcy protection rather than the payment for goods or services provided that you were expecting. You understand that you now have a “claim” against the “debtor,” in bankruptcy parlance. You are not quite sure you want to deal with the bankruptcy process and delay only to get a partial recovery of what you are owed. When a bankruptcy claims purchaser [i] offers to purchase your bankruptcy claim from you for cash, you accept. You metaphorically light a cigar for cash collected and troubles avoided after selling a bankruptcy claim.
[Editor’s Note: For more information, please see An Introduction to Bankruptcy Claims Trading.]
Sixteen months or so later, the debtor (or its successor under a chapter 11 plan, or a chapter 7 trustee) sues you to avoid and recover so-called preferential transfers you received in the 90-day period just before the debtor filed for bankruptcy protection. Under Bankruptcy Code section 502(d), a claim may be disallowed if its holder fails to pay into the estate the amount of any liability for having received a “preferential transfer.” Preference actions rankle, but you know these things happen and phone your attorney to begin dealing with it.
The preference action also affects the claims purchaser. After the filing of such a preference lawsuit, the claims purchaser can be barred from receiving any distribution on the claim until the preference lawsuit (against the prior “holder” of the same claim) is resolved. Under the claims sale contract, the claims purchaser may declare that the claim is “impaired” or potentially impaired and, if the impairment is not resolved by a certain date, the claims purchaser is entitled to return of the purchase price plus interest from the date of the claims purchase at the somewhat high to outrageous interest rate provided in the agreement.
In order to protect your interests, three principal facts must be borne in mind before selling a bankruptcy claim.
[Editor’s Note: For further information, please see An Introduction to Bankruptcy Claims Trading: Part 2.]
Claims purchasers gamble to win, but sometimes face big losses when cases crater and distributions on claims plummet. Claims purchasers in the latter scenario would identify claims sellers that had become defendants in preference actions because the claims purchase agreements could present opportunities for the claims purchasers to get out of bad claims bets in good or at least less terrible shape–by clawing back amounts paid to the claims seller.
[Editor’s Note: Please also see Bankruptcy Claims Trading.]
First, the agreement should contain the claims purchaser’s representation that it has performed due diligence with respect the validity of the claim, including, specifically, the likelihood that the claim will be subjected to objection on section 502(d) grounds. Any indemnity given by the claims seller should be limited to claims seller’s gross negligence or intentional nondisclosure of relevant information actually sought by claims purchaser with respect to section 502(d) issues. The claims seller should not insure the claims purchasers’ investment.
Second, the agreement may well key purchase price claw-back provisions to the occurrence of an “Impairment” or a “Potential Impairment” (or similar term). A claims seller must strive to narrow the breadth of these terms. An Impairment or Potential Impairment might start a clock running, whereby a claw-back will occur if the Potential Impairment is not resolved within a set period of time. A claims seller should recognize that factually intensive preference actions are very difficult to resolve within 180 days or even 360 days. Therefore, in addition to tightly circumscribing the Impairment or Potential Impairment, the claims seller should maximize the duration of such time period.
It would be best to limit claw-backs to actual Impairments on the claim, like a court order disallowing a claim under section 502(d), or at least a judgment in a preference action on which such disallowance might be based that provides that a transfer is avoidable and property is recoverable from the preference transferee (i.e., the claims seller).
A Potential Impairment should be carefully defined to limit its application to actual objections to allowance of the claim based upon pending preference actions. The claims seller would like to avoid triggering a Potential Impairment by an “objection” like one filed in the Delphi cases, which sought merely to preserve the debtors’ rights to object at a later date when transfers were avoided and became recoverable.
One author of this piece has encountered claims purchase agreements which provided that, after 180 days passed from the occurrence of a Potential Impairment without a resolution of it, the claims purchaser was entitled to a claw-back of the purchase price of the claim plus 10% interest from the date of purchase. Where a Potential Impairment occurs years after the purchase, the accumulated interest alone is very substantial. The agreements further provided that a later resolution of the Potential Impairment would entitle claims seller to recapture the purchase price plus interest at 10%, but only from the date of the claw-back. In sum, the claims purchaser would make out extremely well under the claw-back-only scenario and not too shabbily under the post-claw-back-return scenario. The claims seller would not.
At the very least, a claims seller should ensure that the interest rate on a claw-back compensates for no more than the lost opportunity to collect market interest on the cash, which would be much less than 10% at present. Further, a post-claw-back return of purchase price to claims seller should include all of the interest paid as part of the claw-back to claims purchaser. Another caution: avoid fee-shifting provisions, which build in an advantage for the claims purchaser, who is far more likely to initiate litigation under the agreement.
Courts in the two leading bankruptcy venues have taken divergent positions on whether a claims purchaser’s claim should be subject at all to section 502(d) disallowance when such disallowance would apply to a claim in the hands of its original holder. In Enron Corp. v. Springfield Assocs., L.L.C., 379 B.R. 425 (S.D.N.Y. 2007), the district court for the Southern District of New York held that section 502(d) imposes a liability personal to the recipient of the recoverable transfer, and that section 502(d) disallowance is not imposed upon a claims purchaser unless the purchaser took the claim by assignment, i.e., expressly received a complete and unqualified transfer of the entire interest of the claims seller in the claim.
The Enron analysis was implicitly upheld by the Second Circuit Court of Appeals in Longacre Master Fund, Ltd. v. ATS Automation Tooling Systems, Inc., in which the court reversed — on factual grounds only — a district court ruling granting summary judgment to a claims seller against a claims purchaser.[ii] The district court ruling was premised in part upon the Enron distinction between sale and assignment, and upon a finding that the claims sale agreement effected a sale and not an assignment.[iii] The Second Circuit found disputable the lower court’s finding that the claims sale agreement effected a sale and not an assignment.[iv] The good news for claims sellers is that the Second Circuit implicitly applied the Enron analysis. Thus, it continues to make sense to negotiate the claims sale agreement to characterize itself as a sale, and not an assignment, and thus (if the court applies the Enron analysis), insulate the claims purchaser’s right to a distribution on the claim from impairment by operation of section 502(d)
In In re KB Toys, Inc., 470 B.R. 331 (Bankr. D.Del. 2012), the bankruptcy court for the District of Delaware ruled that section 502(d) applied to purchased claims irrespective of whether such claims had been assigned or merely sold. The KB Toys Inc. case was appealed to the Third Circuit Court of Appeals, which upheld the lower court’s’ rulings[v] and expressly rejected the Enron analysis.[vi] The question is thus settled in the Third Circuit, which includes the leading United States Bankruptcy Court for the District of Delaware. The KB Toys Inc. decision is good news for claims purchasers who may wish to exploit a section 502(d)-related impairment in order to undo a deal that did not pan out as hoped.
Thus, where a claims seller negotiates a claims purchase agreement that expressly reserves to seller any part of the claim (and it would further help to denominate the transaction exclusively as a “sale” and not an “assignment”), the claims seller might – in jurisdictions where the court follows Enron and Longacre – avoid suffering any Impairment or Potential Impairment of the claim at all on account of the debtor seeking avoidance and recovery of allegedly preferential transfers. The claims purchaser may be deprived of any colorable entitlement to a claw-back. With that outcome after selling a bankruptcy claim, one might metaphorically light that cigar.
A recent decision of the United States Bankruptcy Court for the District of Delaware has highlighted another hazard that can complicate the sale of a bankruptcy claim: the anti-assignment clause. [vii] In the Woodbridge case, retail investors Elissa and Joseph Berlinger, lured by aggressive sales tactics and the promise of generous, risk-free returns, made three loans of $25,000 each to a fund controlled by the Woodbridge Group of Companies LLC. Unfortunately for the Berlingers, the Woodbridge funds turned out to be part of a massive Ponzi scheme, which the SEC claims bilked over 8,400 investors nationwide out of more than $1.2 billion.[viii] The Woodbridge scheme ultimately collapsed, and the Woodridge companies sought protection in chapter 11 bankruptcy.
During the bankruptcy case, the Berlingers sold their claims against Woodbridge to Contrarian Funds, LLC (“Contrarian”), a distressed investing hedge fund active in the bankruptcy claims trading market. Contrarian filed a proof of claim asserting a right to payment on account of the Berlingers’ loans to Woodbridge.
Woodbridge objected to Contrarian’s proof of claim, arguing that the promissory notes and related loan agreements contained an anti-assignment clause prohibiting any assignment of the debt without Woodbridge’s consent, and providing that any attempted assignment would be null and void.
The bankruptcy court found that the anti-assignment provision in the Woodbridge loan documents contained clear and unambiguous language that restricted the Beringers’ power to sell or assign the note. Accordingly, under generally applicable principles of Delaware law, the attempted assignment of the debt by the Beringers to Contrarian was null and void, and “Contrarian did not have the right to file a proof of claim.”[ix]
In ruling on this case, Bankruptcy Judge Kevin Carey noted that the “modern claims trading industry is robust and fruitful, allowing for, among others, liquidity for noteholders on the one hand and profitability for traders on the other.”[x] However, the economic benefits of claims trading do not confer any exemption to claims traders from “applicable non-bankruptcy law concerning contract provisions which may restrict transfers of claims.”[xi] Claims traders, the court explained, “are highly sophisticated entities fully capable of performing due diligence before any acquisition.”[xii]
Sellers and buyers of bankruptcy claims should heed the lesson of the Woodbridge case and carefully determine whether the claim in question is subject to an enforceable anti-assignment clause. Trying to assign an unassignable claim could lead to disallowance of the claim or demand by the claims purchaser for a refund of the purchase price (with interest) on account of an “Impairment” of the claim.
The market for selling a bankruptcy claim will continue to be robust. Sellers will look to minimize the time it takes to recover on a claim and purchasers will always look to make money by purchasing the claims at a discounted rate. If you plan on selling a bankruptcy claim, make sure you do your due diligence with regards to potential preference actions and anti-assignment clauses to protect your interest and avoid any potential claw-backs.
[Editor’s Note: This article updates and supersedes two articles: one originally published in May 2013 and one published in January 2014]
Mr. Cahill is counsel with Lowis & Gellen LLP, in Chicago, Illinois. He guides secured lenders, creditors, debtors, creditors’ committees, potential purchasers and others through bankruptcy cases, out-of-court workouts, assignments for the benefit of creditors, and receiverships. Mr. Cahill has substantial mega-case experience at national law firms representing very large debtors, and has counseled and…
Mr. Peterson is of counsel with Lowis & Gellen LLP, in Chicago, Illinois. He represents clients in a broad range of credit and insolvency related matters, including all aspects of creditors’ rights and bankruptcy litigation. Mr. Peterson has represented secured and unsecured creditors, creditors’ committees, commercial landlords, indenture trustees, debtors, and other participants in litigation,…
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Claims Trading of Notes of a Debtor Might Become More Difficult After Woodbridge
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