Claim traders take great risks with the hope of great returns. The U.S. Bankruptcy Court for the Southern District of New York in Enron Corp. v. Avenue Special Situations Fund II LP (In re Enron Corp.),¹ has perhaps added even more risk into that trading equation.² The bankruptcy court considered whether a transferred claim was subject to disallowance under §502(d) of the Bankruptcy Code and concluded that a claim is subject to disallowance even though the claim is not in the hands of the entity that received the avoidable transfer. In addition, the bankruptcy court explained that the "good faith" defense under §550 of the Code is not available to a transferee of a claim to defeat disallowance under §502(d).

Bankruptcy Rule 3001 governs transfers of claim. Under Rule 3001(e)(1), if a claim is transferred other than for security before the filing of a proof of claim, "the proof of claim may be filed only by the transferee or an indenture trustee." However, if a claim other than one based on a publicly traded note, bond or debenture is transferred other than for security after the filing of a proof of claim, the transferee must file evidence of the transfer. The transferor has 20 days from the mailing of notice to object to the transfer. Whether or not an objection is filed, the court finds that the claim has indeed been transferred, the transferee is "substituted" for the transferor. Bankruptcy Rule 3001(e)(2).

Under §502(d), a court shall disallow any claim of any entity from which property is recoverable under §542, 543, 550 or 553 of this title or that is a transferee of a transfer avoidable under §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 §522(i), 542, 543 or 553 of this title.³

In essence, §502(d) prevents the transferee of an avoidable transfer from participating in any distribution from the bankruptcy estate unless the transferee returns the transfer.⁴ As one leading bankruptcy commentator has explained, creditors may give back "the transferred property and share in the debtor's estate for the amount of their claims or decline to file the claim, lose the right to share in the distribution of the debtor's assets and face the risk that the trustee will take appropriate action to recover the affected property."⁵

This column will first discuss the facts of In re Enron Corp. to place the issues into a factual context, then will analyze the bankruptcy court's holdings: (1) a claim in the hands of a transferee is subject to §502(d) disallowance, and (2) a transferee cannot claim the "good-faith" defense under §550(b) to defeat a §502(d) claim objection.

Background

Enron Corp., as borrower, entered into two credit agreements—a short-term revolving credit agreement and a long-term revolving credit agreement, dated May 14, 2001, and May 18, 2001, respectively, with various banks. Fleet National Bank loaned Enron approximately $54.7 million as one of the banks participating under the short-term credit agreement. On Dec. 2, 2001, Enron and certain of its affiliated entities filed for chapter 11 protection.⁶ Citibank, in its capacity as the paying agent under both credit agreements, filed two proofs of claim on behalf of certain creditors, including Fleet.⁷

As of the petition date, Fleet was the holder of the claims asserted against Enron.⁸ However, after the petition date, Fleet transferred its claims, and the defendants in this case eventually acquired them.⁹

On Sept. 23, 2003, Enron filed an adversary proceeding against the defendants.¹⁰ In the fourth amended complaint, Enron added Fleet as a defendant and alleged that Fleet was the recipient of certain preferences and/or fraudulent transfers that related to two pre-payments that Fleet received from Enron on account of transactions separate and apart from the credit agreements.¹¹ Indeed, the bankruptcy court recognized that the transactions involving the preference and fraudulent-conveyance actions, and the claims that evolved from the short-term and long-term credit agreements, were distinct and unrelated.

Enron argued that the bankruptcy court should disallow the defendants' claims under §502(d) because, "had the claims not been transferred from Fleet to the defendants, and because the defendants are transferees who take subject to any defense, the defendants' claims should be disallowed to the same extent as if Fleet had continued to hold the claims."¹²

The defendants filed a motion to dismiss the complaint under Bankruptcy Rule 7012(b) and Federal Rule of Civil Procedure 12(b)(6) for failure to state a claim upon which relief can be granted.¹³ The defendants hung their hat on the fact that the complaint did not allege that the defendants received any preferences or fraudulent transfers.¹⁴ Thus, the defendants argued that §502(d) did not apply because "the defendants do not fit within the plain language or the conditions of [§]502(d)."¹⁵

Applicability of §502(d)

Both Enron and the defendants argued that the plain language of §502(d) supported their respective positions.¹⁶ More specifically, Enron, citing to In re Metiom Inc.,¹⁷ asserted that the plain language of §502(d) "applies to transferred claims and mandates the disallowance of the claim of any entity that owes property to the estate."¹⁸ On the other hand, the defendants argued that the focus of §502(d) is not on the claim but rather on the creditor who possesses the claim and that the Metiom court actually supports their analysis that a claim is disallowed only if "an entity received an avoidable transfer while it held the claim."¹⁹

The bankruptcy court found that Metiom supported Enron's position and recognized that the facts were similar to the facts in the present case. On May 16, 2001, Metiom filed for chapter 11 bankruptcy protection. On July 9, 2001, Intira filed a proof of claim in the amount of $752,498. Subsequent to the filing of the proof of claim, Intira entered its own chapter 11 proceeding and eventually sold substantially all of its assets—including the claim filed in Metiom's bankruptcy—to divine Acquisition Inc., an entity that eventually filed its own bankruptcy petition.²⁰ divine voluntarily reduced its claim to $659,826, asserting that it received $96,672 in the ordinary course of business after the filing of the bankruptcy case. As the court pointed out, although the trustee was happy that the claim was reduced, the trustee disagreed that the $96,672 was paid in the ordinary course of business.²¹

The trustee objected to the claim alleging that Intira received a $170,000 preference payment.²² Thus, the trustee requested the court to disallow the claim under §502(d) until Intira returned the preferential payment.²³ divine defended itself by relying upon the plain meaning of §502(d), arguing that since it did not receive an avoidable transfer, §502(d) was inapplicable.²⁴ But the court explained that the plain language of §502(d) actually supports the trustee's position:

Section 502(d) disallows the claim, provided that an entity received an avoidable transfer while it held the claim. As far as §502(d) is concerned, the fact that divine purchased the claim is irrelevant unless divine, too, received an avoidable transfer. Thus...§502(d) disallows the claim unless such entity that held the claim when it received it is liable. The claim and the defense to the claim under §502(d) cannot be altered by the claimant's subsequent assignment of the claim to another entity, like divine, that has not received an avoidable transfer. Permitting a claim assignment to destroy a claim defense under §502(d) in such fashion would be a pernicious result. The assignment should not, and does not, affect the debtor's rights vis-à-vis the claim; it is incumbent, instead, on prospective assignees to take into account possible claim defenses when they negotiate the terms of their assignments.²⁵

The defendants, however, tried to distinguish the facts and basis for the holding in Metiom from the present case, arguing that "disallowance of the transferee's claim [in Metiom] was deemed appropriate [because] the original transferor was itself in bankruptcy and the trustee had waived its rights to seek return of the avoidable transfer from that original holder."²⁶ But the bankruptcy court in Enron refused to limit Metiom's holding as suggested by the defendants. Moreover, although the Enron court suggested that the defendants did not bring any case to its attention that required a different conclusion,²⁷ the defendants cited to an unpublished decision—Committee of Unsecured Creditors v. Williams Patterson Inc. (In re Wood & Locker Inc.)²⁸—to support their argument that the holder of the claim must be the same entity against which the avoidable transfer action is brought.²⁹

In Williams Patterson Inc., on June 24, 1983, the debtor filed for chapter 11 protection.³⁰ On Oct. 21, 1983, one of the debtor's creditors, Williams-Patterson, filed a proof of claim for more than $1 million.³¹ Approximately 10 months later, Williams-Patterson transferred its assets, which included the proof of claim, to a bank in satisfaction of certain obligations.³² The unsecured creditors' committee thereafter filed a preference suit against Williams-Patterson and sought an order disallowing the claims now in the hands of the bank.³³

In short, the Williams-Patterson court explained that "[t]he [c]ommittee has a heavy burden if they are to hold a third party liable for a preference on these circumstances."³⁴ In this case, the bankruptcy court concluded that "[t]he analytic tool to unlock the mysteries of [§]502(d) is to examine the enumerated sections to determine whether the transferee has liability. Where there is no liability under [the avoidance sections], [§]502(d) is not triggered."³⁵

It seems clear that the Williams-Patterson case does indeed support the defendants' arguments. But the bankruptcy court in Enron did not find the Williams-Patterson analysis and conclusion persuasive.³⁶ The court explained that courts do not have to determine if the transferee of a claim possesses an avoidable transfer; rather, the test is whether the transferor of the claim is liable for any avoidable transfer.³⁷ If the transferor of the claim is liable for an avoidable transfer, then the claim in the hands of the transferee is subject to disallowance under §502(d).³⁸

Good-Faith Purchaser under §550(b)

The defendants further argued that since they were "innocent" transferees, they were entitled to rely upon the "good faith" defense found in §550(b), which provides that:

[t]he trustee may not recover [an avoided transfer] from—

(1) a transferee that takes for value...in good faith, and without knowledge of the voidability of the transfer avoided; or
(2) any immediate or mediate good-faith transferee of such transferee.

The defendants asserted that since they acted in good faith and paid value for the claims, §550(b) protected them from the §502(d) disallowance.

The bankruptcy court, however, disagreed with the defendants' analysis and concluded that the "good faith" defense under §550(b) is not applicable to a §502(d) claim disallowance.³⁹ The bankruptcy court explained that only a "good faith" recipient of transferred estate property that is subject to an avoidance action may assert the defense.⁴⁰ Defendants who do not receive any estate property subject to an avoidance action cannot use the defense.⁴¹ Here, since the defendants did not receive property from Fleet that was subject to an avoidance action, but rather purchased Fleet's claims against Enron, the defendants could not avail themselves of the "good faith" defense under §550(b).⁴²

Conclusion

Although the Enron bankruptcy court relied upon the plain language of §502(d) to support its conclusion that a claim in the hands of a transferee is subject to §502(d) disallowance, the bankruptcy court did not conduct a thorough "plain meaning" analysis. Rather, the bankruptcy court simply concluded that under §502(d) the focus is on the "claim," not upon the holder of an avoidable transfer.

However, a plain-language analysis of §502(d) requires a different result. Indeed, §502(d) provides that "the court shall disallow any claim of any entity from which property is recoverable" under the various Code sections.⁴³ Thus, a fair reading of this section requires the entity who received the avoidable transfer also to have the claim since "of an entity" evidences possession of "any claim." Even though such a reading may be inconsistent with the stated policy and purpose of §502(d), any interpretation that is inconsistent with the plain language of the Code is better left for Congress to fix. For a plain-language interpretation to be consistent with the bankruptcy court's analysis, the court must be reading "any claim of any entity" to refer to the entity that possessed the claim as of the petition date. But §502(d) does not say that.

In any event, the policy and purpose of §502(d)—to prevent the transferee of an avoidable transfer from participating in any distribution from the bankruptcy estate unless the transferee returns the transfer—is surely applicable even when the claim is transferred to a nonavoidance defendant. Indeed, Enron was correct; if the rule were otherwise, claimants could "claim-wash" their claims by transferring their claims for valuable consideration to other parties not subject to avoidance actions. The transferor would obtain a windfall (the price for which the claim was sold), and the transferee would be able to participate in the bankruptcy estate, with the debtor losing the ability to object to the claim under §502(d).

Whatever is the correct plain-language reading of §502(d), it is abundantly clear that purchasers of claims in a bankruptcy case have to account for Enron Corp. v. Avenue Special Situations Fund II LP and, more particularly, §502(d) when purchasing claims of debtor's in bankruptcy.

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Footnotes

1 340 B.R. 180 (Bankr. S.D.N.Y. 2006).

2 This is the second opinion issued by the U.S. Bankruptcy Court for the Southern District of New York that addressed, or more accurately, increased the risks associated with claims trading. In In re Enron Corp. v. Avenue Special Situations Fund II L.P. (In re Enron Corp.), 333 B.R. 205 (Bankr. S.D.N.Y. 2005), the bankruptcy court concluded, among other things, that a claim in the hands of a transferee is subject to equitable subordination under §510(c) of the Code. For an analysis of this case, see Kotler, Lawrence, "Claim Purchasers Beware: No Good-Faith Defense to Equitable Subordination," ABI Journal, Vol XXV, No. 1, at p. 22 (February 2006), and Saferstein, Jeffrey D. and Dearborn, Penny, "Equitable Subordination: Good-Faith Transferees Beware, ABI Journal, Vol. XXV, No. 3, at p. 46 (April 2006).

3 Emphasis added.

4 Here, the transferee refers to a transferee of an avoidable transfer and not to a transferee of a claim.

5 5 King, Lawrence P., Collier on Bankruptcy ¦502.02[2] (15th ed. rev. 2005).

6 In re Enron Corp., 340 B.R. at 184.

7 Id.

8 Id. at 185.

9 Id. Not all claims were transferred from Fleet directly to a defendant. For example, Fleet sold to Credit Suisse First Boston (CSFB) $29.5 million of its claim under the short-term credit agreement. CSFB subsequently sold $14.5 million of it to one of the defendants.

10 Id.

11 Id. at 185.

12 In re Enron Corp., 340 B.R. at 186.

13 Id.

14 Id. at 186. The defendants also argued that a claim is disallowed under §502(d) "only when that claim is asserted by an entity adjudicated to be liable for the return of property under other sections of the Bankruptcy Code and only after that entity fails to return the property." Id. Looking at the plain language of §502(d), however, the bankruptcy court concluded that since §502(d) refers to a "transfer avoidable" and not "an avoided transfer," a debtor does not have to have an avoided transfer in his pocket prior to the court adjudicating a §502(d) claim objection. The bankruptcy court made clear that the §502(d) cause of action "remains viable awaiting the determination of the underlying avoidance action against [a defendant]."

15 Id.

16 In re Enron Corp., 340 B.R. at 188 and 193.

17 301 B.R. 634 (Bankr. S.D.N.Y. 2003).

18 In re Enron, 380 B.R. at 188.

19 Id. at 193.

20 Id. at 636-37.

21 Id. at 636.

22 Id. at 637.

23 Id.

24 Id. at 642.

25 In re Metiom Inc., 301 B.R. at 642-43.

26 In re Enron Corp., 340 B.R. at 201.

27 Id. at 194.

28 Case No. 88 CA 011, 1988 U.S. Dist. LEXIS 19501 (W.D. Tex. June 20, 1988).

29 Indeed, the bankruptcy court in Enron did state, however, that one could conclude that the Williams-Patterson case supports the defendants' argument.

30 1988 U.S. Dist. LEXIS 19501, at *5.

31 Id.

32 Id. at *5-6.

33 Id. at *6.

34 Id.

35 Id. at *7.

36 In re Enron Corp., 340 B.R. at 198, fn. 15.

37 Id.

38 Id.

39 Id. at 206.

40 Id.

41 Id.

42 340 B.R. at 201. The bankruptcy court also explained that even if the "good-faith" defense under §550(b) was available in a §502(d) claim objection, a transferee of a claim could not be a good-faith transferee because the transferee would know "of a debtor's financial difficulties and the likelihood of bankruptcy." Id. at 207. Therefore, a transferee of a claim would not have taken the claim in good faith.

43 §502(d).