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KB Toys: Don’t Play with Clouded Claims

In a recent decision by the influential Third Circuit Court of Appeals, In re KB Toys Inc., 2013 U.S. App. LEXIS 23083 at *17 (3d Cir. Nov. 15, 2013), the Court decided that “the cloud on the claim” stemming from a preferential payment made to the original claimant continues with the claim, which then could be disallowed. KB Toys stands in contrast to the District Court opinion in Enron Corp. v. Springfield Assocs., L.L.C., where a claim purchaser was not subject to the cloud on the claim it acquired.

In KB Toys, ASM Capital, an entity in the business of acquiring claims, purchased claims from various trade creditors of the debtors. These creditors had received allegedly preferential payments from the debtors. Eventually, the Chapter 11 trustee sought and obtained judgments against each of the original claimants. However, because all of the original claimants had gone out of business, the judgments were uncollectable. The trustee then objected to the claims, now held by ASM, on the grounds that such claims should be disallowed under Section 502(d) of the Bankruptcy Code, which provides for a disallowance of a claim if the claimant has failed to return any voidable payment that it had received. The trustee contended that ASM’s claims should be disallowed because the preferences received by the original claimants were not returned.

The Court affirmed disallowance of the claims by both lower courts and, while limiting its analysis to only trade claims, agreed with the bankruptcy court that under section 502(d) “[d]isabilities attach to and travel with the claim,” at *7. Thus, a claim in the hands of a purchaser is subject to the same challenges that could be brought against the original claimant. Section 502(d) provides that “any claim of any entity” who received an avoidable transfer shall be disallowed. The Court found this section renders “a category of claims disallowable – those that belonged to an entity who had received an avoidable transfer…. Because the statute focuses on claims — and not claimants – claims that are disallowable under § 502(d) must be disallowed no matter who holds them,” at *9-10. To hold otherwise, explained the Court, would allow the original claimant to “wash” the claim of its disability by selling it for value. This scenario would deny the estate the money that should have been returned to it for the avoidable transfer, and further, the estate would have to pay on a claim that would have been otherwise disallowed.

The Court also refused to apply a “good faith purchaser” standard to the claims acquisitions by ASM. As a frequent trader in claims, ASM should have known about the possible preference exposure of these claims — the debtors’ statement of financial affairs had disclosed the possible avoidable payments — and could have protected itself from the risk of claim disallowance.

The Court in KB Toys reached the opposite conclusion from a decision of the District Court for the Southern District of New York in Enron Corp. v. Springfield Assocs., L.L.C. (In re Enron Corp.), 379 B.R. 425 (S.D.N.Y. 2007). In Enron, Id. at 443, the court viewed the language of Section 502(d) as focusing “on the claimant as opposed to the claim” and “conclu[ded] that disallowance is a personal disability of a claimant, not an attribute of the claim” acquired through a sale. The different results reached in these two opinions in important jurisdictions for claims trading are noteworthy.

The KB Toys decision emphasizes the need for claim buyers – at least within the Third Circuit – to conduct thorough due diligence before buying claims and serves as a warning that a buyer must protect itself in the acquisition documents from adverse results – as noted by the Court, “a claim purchaser’s opportunity to profit is partly created by the risk inherent in bankruptcy.” In re KB Toys, supra, at *20.

If you have any questions about this decision or its implications, please call your principal Mintz Levin attorney or one of the attorneys noted on this advisory.

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Kevin J. Walsh is a Mintz bankruptcy attorney whose practice encompasses restructurings, workouts, and commercial financing transactions. Kevin works with debtors and creditors, including bondholders, trustees, financial institutions, and insurers. He works on cases in courts around the country.

Ella Shenhav