The U.S. Bankruptcy Court for the Southern District of New York recently added some weight to the majority rule on a hot-button issue for claims traders. In In re Firestar Diamond, Inc., 615 B.R. 161 (Bankr. S.D.N.Y. 2020), the court ruled that a transferred claim can be disallowed under section 502(d) of the Bankruptcy Code even if the entity holding the claim is not the recipient of a voidable transfer. According to the court, claim disallowance under section 502(d) "rests on the claim and not the claim holder."
Disallowance of Claims of Avoidable Transfer Recipients
Section 502(d) of the Bankruptcy Code creates a mechanism to deal with creditors that have possession of estate property on the bankruptcy petition date or are the recipients of pre- or postbankruptcy asset transfers that can be avoided because they are fraudulent, preferential, unauthorized, or otherwise subject to forfeiture by operation of a bankruptcy trustee's avoidance powers. Section 502(d) provides as follows:
Notwithstanding subsections (a) and (b) of this section, the court shall disallow any claim of any entity from which property is recoverable under section 542, 543, 550, or 553 of this title or that is a transferee of a transfer avoidable under section 522(f), 522(h), 544, 545, 547, 548, 549, or 724(a) of this title, unless such entity or transferee has paid the amount, or turned over any such property, for which such entity or transferee is liable under section 522(i), 542, 543, 550, or 553 of this title.
As noted by the U.S. Court of Appeals for the Fifth Circuit in In re Davis, 889 F.2d 658, 661 (5th Cir. 1989), "[t]he legislative history and policy behind Section 502(d) illustrates that the section is intended to have the coercive effect of insuring compliance with judicial orders." See also H.R. Rep. No. 95-595, at 354 (1978); S. Rep. No. 95-989, at 64 (1978); accord In re Odom Antennas, Inc., 340 F.3d 705, 708 (8th Cir. 2003). The provision "is designed to foster the 'restoration' of assets to a debtor's estate, thereby assuring 'equality of distribution' … by precluding anyone who has received a voidable transfer from sharing in any distribution … unless he first pays back any preference that he has received." In re Chase & Sanborn Corp., 124 B.R. 368, 371 (Bankr. S.D. Fla. 1991) (citations omitted). Section 502(d) was "not [intended] to punish, but to give creditors an option to keep their transfers (and hope for no action by the trustee) or to surrender their transfers and their advantages and share equally with other creditors." In re Enron Corp., 379 B.R. 425, 435 (S.D.N.Y. 2007) (citations and internal quotation marks omitted).
A body of case law has developed regarding the impact of the sale or transfer of a claim to a third party on the applicability of section 502(d). Some courts, representing the majority view, have held that a transferred claim must be disallowed under section 502(d) even if the transferee is not the entity from which property is recoverable—ruling, in effect, that a claim is not cleansed when it is sold or assigned. See In re KB Toys Inc., 736 F.3d 247, 254 (3d Cir. 2013) ("the cloud on the claim continues until the preference payment is returned, regardless of whether the person or entity holding the claim received the preference payment"); In re Metiom, Inc., 301 B.R. 634, 643 (Bankr. S.D.N.Y. 2003) (citing Swartz v. Siegel, 117 F. 13 (8th Cir. 1902), for the proposition that "[t]he disqualification of a claim from allowance created by a preference inheres in and follows every part of the claim, whether retained by the original creditor or transferred to another, until the preference is surrendered"); see also In re Arctic Glacier Int'l, Inc., 901 F.3d 162, 168 (3d Cir. 2018) (stating that, when a claim is transferred, "the transferee assumes the same limitations as the transferor [and that] [o]therwise, buyers could revive disallowed claims, laundering them to receive better treatment in new hands").
The U.S. District Court for the Southern District of New York adopted a more nuanced approach in Enron Corp. v. Springfield Associates, L.L.C. (In re Enron Corp.), 379 B.R. 425 (S.D.N.Y. 2007) ("Enron II"), holding that infirmities travel with an assigned claim for purposes of section 502(d), but not if the claim is sold. In so ruling, the district court vacated a bankruptcy court decision finding that a claim transferred by means of sale or assignment can be disallowed under section 502(d), even if the assignee/buyer did not receive a voidable transfer. See Enron Corp. v. Avenue Special Situations Fund II, LP (In re Enron Corp.), 340 B.R. 180 (Bankr. S.D.N.Y. 2006) ("Enron I"), vacated, 379 B.R. 425 (S.D.N.Y. 2007).
In Enron II, the district court examined the distinction between the legal concepts of "sale" and "assignment." Although each is a form of transfer, the court explained, the terms are not synonymous and have very different legal consequences for the transferee:
With respect to assignments, "[a]n assignee stands in the shoes of the assignor and subject to all equities against the assignor." In other words, "an assignee of a claim takes with it whatever limitations it had in the hands of the assignor … By contrast, these assignment law principles do not apply to sales. A purchaser does not stand in the shoes of the seller and, as a result, can obtain more than the transferor had in certain...
