Asked how buyers can avoid known but latent risks in investments in financial products, law and business students often respond by suggesting contractual hedges of one sort or another. But they often overlook the meta-risk of insolvency.
A contractual right to reimbursement has little value against an insolvent counterparty. A recent ruling from a prominent U.S. Court of Appeals places a particularly acute insolvency risk squarely on the shoulders of purchasers of trade claims in large bankruptcy cases.
When KB Toys initiated its first Chapter 11 bankruptcy case in Delaware in 2004, the writing was likely on the wall that the company’s “reorganization” would involve at least a partial liquidation. The case would likely drag on for years before the liquidation proceeds were distributed, however, so hedge fund ASM Capital saw an opportunity for arbitrage in purchasing the claims of trade creditors anxious to liquidate their claims for ready capital.
A sophisticated bankruptcy claim investor, ASM hedged against a potential latent defect in these investments. It knew that some claims are disallowed by the bankruptcy court for a variety of reasons, so its purchase contracts called for the trade creditor sellers to make immediate restitution of any disallowed portion of the purchased claims. Five years later, when the time came for the court to evaluate claims against KB Toys’ liquidation estate, ASM’s investments began to fall apart.
Section 502(d) of the US Bankruptcy Code disallows “any claim of any entity” who has received a transfer of value from the debtor company that can be recovered by the trustee for the bankruptcy estate using a variety of “avoidance power” provisions of the Code, such as extraordinary payments to creditors within the suspect period of 90 days before the bankruptcy filing (preferences) or transfers of property from the debtor for less than reasonably equivalent value (fraudulent conveyances).
This is more than a set-off provision. If a claimant contends that the bankruptcy estate owes it a certain sum, one would expect that claim to be reduced by any amount that the claimant owes back to the bankruptcy estate as a result of these avoidance powers. But section 502(d) disallows the entirety of any claim of such a claimant until and unless the claimant “has paid the amount … for which such entity … is liable.”
Relying on section 502(d), KB Toys’ liquidating trustee sought to disallow ASM’s claims. They were originally claims of entities, the trade creditors, who had been adjudicated liable to the bankruptcy estate for having received preferential payments in the suspect period preceding KB Toys’ filing. Indeed, ASM could have anticipated this, as each of the trade creditors from whom ASM purchased its claims was identified in the debtor’s initial Statement of Financial Affairs as having received potential preferential payments. Moreover, ASM purchased one of its claims after the trade creditor seller had already been adjudicated liable to the bankruptcy estate to return a preferential payment.
ASM’s contractual hedge allowed it to demand restitution from the original claimant-sellers of these disallowed claims. But all of the creditors whose claims ASM had purchased had gone out of business in the five years since KB Toys initiated its case. The estate was unable to collect on the preference judgments against these defunct creditors, which led to disallowance of their claims, and ASM was unable to collect on its contractual restitution rights.
In a last ditch attempt to salvage the value of its purchased claims, ASM fell back on a peculiar interpretation of section 502(d) that had been adopted several years earlier by a New York District Court in the Enron Chapter 11 case. Based on a simplistic “plain language” analysis, the New York court had held that section 502(d) disallowance is a “personal disability” of a particular claimant; it does not travel with the claim into the hands of a claims purchaser. Applying this reasoning to its case, ASM asserted that it bore no liability to the estate, unlike its trade creditor-sellers, so the claims as advanced by ASM should not disallowed.
The Delaware Bankruptcy Court, the Delaware District Court and finally the Third Circuit Court of Appeals all rejected the interpretation suggested by ASM and the New York District Court. The Third Circuit is the first Court of Appeals to address this issue, and its approach to the statute makes eminently more statutory and practical sense.
As for “plain language,” section 502(d) disallows claims, not claimants, and the Third Circuit concluded that such claims “must be disallowed no matter who holds them.”
Moreover, the notion that a claim could be laundered of the section 502(d) disallowance risk simply by transferring it to a third-party buyer (perhaps collusively) flies in the face of the obvious purposes of that section and of the Bankruptcy Code in general. The bankruptcy estate would be unduly denuded of precious value if it were forced to pay a claim in full without collecting or offsetting the countervailing liability of the original claimant. Allowing claim buyers to avoid the compromise imposed on the original claimant runs directly contrary to the philosophy of shared pain that lies at the heart of bankruptcy policy.
The Third Circuit observed that this question fundamentally concerns proper allocation of the risk of insolvency of the original claim sellers. ASM’s position would place that risk on the bankruptcy estate and other creditors, who had no opportunity to evaluate or hedge against such risk. The Third Circuit’s approach places that risk squarely on the party most able to evaluate and respon d to it. Buyers like ASM have ample opportunity to evaluate claims and their sellers and hedge appropriately against potential disallowance and seller insolvency.
This is particularly so in a case like this, where ASM bought a claim knowing for a certainty that its seller was already subject to a final judgment for return of a preferential payment.
The Third Circuit’s position is fairly clearly the right one, likely to be adopted by other Courts of Appeals, including the one for New York. When investing in trade receivables and other claims against a U.S. bankruptcy estate, a proper hedging strategy should rely not on protection from either contracts or courts, but from careful claim pricing, incorporating the particular insolvency risk illustrated in the KB Toys case.