Caveat Emptor: Bankruptcy Claims Buyers Beware as Third Circuit Affirms KB Toys

Due to inconsistent decisions in the Second Circuit and Third Circuit, there has been some uncertainty as to whether a purchaser of a bankruptcy claim is subject to defenses that a debtor would have against the original creditor. Recently, this issue was settled with respect to cases filed in the Third Circuit. As we expected, the Court of Appeals for the Third Circuit in In re KB Toys Inc.1  held that claims subject to disallowance and defenses in the hands of the original creditor are likewise subject to such disallowance and defenses in the hands of a purchaser of such claim. For example, if the original holder of a claim is liable to a debtor for a preference or fraudulent conveyance, then, pursuant to Section 502(d) of the Bankruptcy Code, a purchaser of such claim on the secondary market may not be entitled to distributions on such claim until the debtor’s estate receives the amount owed by the original creditor. Such disallowance and/or defenses are not personal to the original creditor and travel with the claim under KB Toys in the Third Circuit.

In reaching its decision, the Third Circuit noted that, if it were to reach a contrary result, the aims of Section 502(d) of the Bankruptcy Code would be contravened by encouraging creditors subject to liability or defenses to sell, and thereby “cleanse” claims against a debtor. The Court stated that, under such circumstances, if “the original claimant could transfer the claim for value to a transferee, the original claimant would receive value for a claim that would otherwise be disallowed and the transferee, who would receive the claim ‘washed’ of its disability, could then share in the distribution of estate assets.”

The Third Circuit held that a contrary finding would negatively affect the estate’s remaining creditors in two ways. First, the original creditor would be less inclined to return the amount owed to the debtor’s estate, and, hence, the amount of available assets to be distributed to the estate’s creditors would be reduced. Second, the estate would make distributions on account of a claim that would otherwise be disallowed if such claim had remained in the hands of the original claimant.

Unlike KB Toys, the District Court for the Southern District of New York held in In re Enron² that whether defenses or disallowance against a claim purchased from a creditor subject to a preference or fraudulent conveyance traveled with the claim depends on whether the acquisition of the claim occurred pursuant to an “assignment” or a “sale.”³ The District Court’s disparate treatment of such scenarios created uncertainty for claim purchasers because no guidance was provided by the District Court as how to differentiate between an assignment and a sale. We are unaware of any applicable difference between an “assignment” or “sale” under case law, the Uniform Commercial Code or otherwise.

Notwithstanding Enron, we believe that the KB Toys ruling will ultimately prevail as controlling law and, therefore, it continues to be important for purchasers of claims to receive representations and indemnities from its seller to protect against such defenses and disallowance of the claim. Claim sale agreements typically address such risk by providing the purchaser with representations and indemnities in the event that the acquired claim subsequently becomes disallowed or impaired. However, such representations and indemnities are only as good as the creditworthiness of the seller of the claim.⁴ In KB Toys, the claim sale agreement provided for recourse to the seller in the event of a disallowance. Yet when the disallowance arose, such provisions were valueless, because the seller was insolvent.⁵

As with the acquisition of bankruptcy claims, it is likewise important that purchasers of distressed or near distressed bank loans also receive representations and indemnities to protect themselves against disallowance or defenses related to actions of the lender selling its bank debt. The same disallowance risk affecting a purchaser of a bankruptcy claim also affects the purchaser of a distressed bank loan. Typically, distressed bank loans will be sold and assigned pursuant to a purchase and sale agreement in the form published by the Loan Syndications and Trading Association (the “LSTA”). Such LSTA agreement will include representations and indemnities to protect a purchaser from such risk, including, inter alia, a representation that the distressed loans being sold are not subject to an impairment. An “Impairment” is defined to mean “any claim, counterclaim, setoff, defense, action . . . avoidance, reduction, contractual or equitable subordination . . . the effect of which does, or would, materially and adversely affect the” loans and related rights being sold.

Market participants often purchasing bank loans will acquire loans under “par” documentation even though the underlying credit is distressed or near distressed. Par transfer documentation does not provide a purchaser of distressed or near distressed bank loans with the representations and indemnities set forth in the LSTA distressed purchase and sale agreement. A purchaser of a distressed or near distressed bank loan on par documentation will typically only receive a clean title representation from its seller, without indemnity for disallowance or impairment. Under such circumstances, a purchaser of a distressed or near distressed loan on par documentation must be mindful that it exposes itself, without recourse, to the risk of any defenses or disallowance claims against its seller.

1. In re KB Toys, Inc., No. 13-1197 (3d Cir. Nov. 15, 2013).

2. Enron Corp. v. Springfield Assocs., L.L.C. (In re Enron Corp.), 379 B.R. 425 (S.D.N.Y. 2007).

3. If the acquisition of the claim by the purchaser occurred by “assignment,” the Court held that the purchaser/assignee stepped into the shoes of the seller/assignor and was entitled to all the benefits and burdens of the claim.  Thus, if the claim was subject to disallowance in the hands of the original creditor, the claim would continue to be subject to disallowance in the hands of the purchaser.  Alternatively, in the event the acquisition of the claim occurred pursuant to a “sale” to a bona fide good faith purchaser, then the claim would not be subject to disallowance in the hands of the purchaser. 

4. In the secondary market, a claim against a debtor will often trade multiple times to subsequent transferees.  Hence, under such circumstances the end purchaser of the claim needs not only to be mindful of the creditworthiness of its immediate seller, but all the upstream sellers within the chain of title.

5. In KB Toys, the Third Circuit also pointed out that the debtor must file a Statement of Financial Affairs requiring the disclosure of all payments made within the 90 days immediately before the petition date.  Payments made during such time period are potentially subject to avoidance as preferences (such time period extended up to 1 year for payments made to insiders).  Prudent purchasers would be wise to avail themselves of such public information before agreeing to purchase claims.