Written by: Wayne M. Greenwald
Wayne Greenwald, PC; New York
Recently, in In re Enron Corp., et al., v. Springfield Associates, L.L.C. et al., (In re Enron) 2007 WL 2446498 (S.D.N.Y.), (Springfield) the U.S. District Court for the Southern District of New York differentiated between traded claims, which can be the subject of equitable subordination actions, under 11 U.S.C. §510(c) and disallowance, pursuant to 11 U.S.C. §502(d) and those that cannot. Springfield obviously impacts on claims trading in bankruptcy cases. However, as the “subprime mess” is unscrambled, Springfield may affect the balance sheets of those attempting to profit from or ameliorate the condition caused by failing subprime lenders.
This article will discuss, in two parts, an analysis of Springfield, its ramifications and its potential application in the bankruptcies of subprime lenders and borrowers.
On an interlocutory appeal, a bankruptcy court’s order denying a motion to dismiss an equitable subordination action and disallowance of that creditor’s claim, pursuant to §§510 and 502(d), was vacated. To reach this result, the court determined “whether equitable subordination under 510(c) and disallowance under 502(d) can be applied to claims held by a transferee to the same extent that they would be applied to the claims if they were still held by the transferor based on alleged acts or omissions on the part of the transferor.” The court commented that the “question, although fairly simply stated, is complex.”
The court recognized that the question has serious ramifications well beyond the parties involved in that particular appeal. Id. This article encapsulates the court’s rationale and considers ramifications of the decision.
Assignment vs. Sale
Springfield's keystone was the differentiation between transferred claims that were 1) assigned and 2) sold. Although each is a type of transfer, “assignment” and “sale” are not synonymous. Whether a particular transfer is an assignment or a sale depends on the transfer’s terms. Whether a transfer is an assignment or a sale will establish which set of rights it obtains. “An assignee of a claim takes with it whatever limitations it had in the hands of the assignor.” This concurs with the doctrine that an assignor cannot give more than it has.
However, a purchaser does not stand in its seller’s shoes. Therefore, in certain circumstances, it can obtain more than the transferor had. The stated exceptions to the law of assignments were (1) holders in due course and (2) the third-party latent-equities doctrine.
A holder of a negotiable instrument qualifies as a holder in due course if it takes the instrument “(a) for value, (b) in good faith and (c) without notice that it is overdue or has been dishonored or of any defense against or claim to it on the part of any person.” Under N.Y. UCC §3-104 (which was the applicable law), to qualify as a negotiable instrument, a writing must: (a) be signed by the maker or drawer, (b) contain an unconditional promise or order to pay a sum certain in money and no other promise, order, obligation or power given by the maker or drawer except as authorized by UCC Article 3, (c) be payable on demand or at a definite time and (d) be payable to order or to bearer.
Holders in due course take negotiable instruments “free from: (1) all claims to it on the part of any person and (2) all defenses of any party to the instrument with whom the holder has not dealt [with certain exceptions].” Thus, a purchaser of a negotiable instrument can acquire rights that its seller lacked.
The court noted that even if the claims qualify as negotiable instruments, post-petition purchasers of claims cannot qualify as holders in due course because they cannot take the instrument “without notice that it is overdue” as required by the N.Y. UCC.
The court also described the “third-party latent defense” doctrine. Under the third-party latent-equities doctrine, assignees without notice take the property free from the latent equities of third parties other than the debtor. New York State, the lex loci, did not adopt that doctrine. Apparently, for that reason, the court did not fully analyze the doctrine.
Equitable Subordination and Related Claim Disallowance Are Personal to the Holder and Do Not Attach to the Claim Pre-Petition
The court next analyzed whether (1) equitable subordination, under §510, and claim disallowance, under §502(d), are attributes of the claim and not personal disabilities of individual claimants; and (2) a transferor holding a claim that is subject to equitable subordination and/or disallowance on the date the bankruptcy petition was filed forever taints that claim.
The Taint Does Not Attach on the Petition Date
The court held that the taint does not attach on the petition date. It relied on four factors: (1) §510(c) provides that equitable subordination can occur only after “notice and a hearing.” “Notice and hearing” occurs during bankruptcy cases, not before them; (2) equitable subordination is discretionary, not mandatory. Therefore, equitable subordination cannot be granted unless a court deems it warranted; (3) equitable subordination can result from post-petition conduct. Therefore circumstances warranting subordination may not exist on the petition date; (4) equitable subordination is unavailable to creditors who suffered no injury. Creditors acquiring claims post-petition and after the alleged misconduct may not be entitled to that remedy. The circumstances of other creditors could therefore become relevant post-petition and alter the availability of equitable subordination.
The court similarly examined claim disallowance under §502(d). Like equitable subordination, disallowing a claim requires court action. Disallowing a claim under §502(d) is contingent on the post-petition failure to return the avoidable transfer by its recipient. Disallowance can be applied based solely on the post-petition receipt and retention of an avoidable transfer, which cannot be determined on the petition date. The court could also have considered that determining whether a transfer is voidable requires post-petition court action. Accordingly, the court concluded that the taint of equitable subordination and related claim disallowance attach after the petition date.
Equitable Subordination and Disallowance Are a Claimant’s Personal Disabilities, which Travel with Assigned Claims, Not Sold Claims
The court determined that §510’s legislative history and application made equitable subordination a personal disability:
[T]he legislative history states that “[t]o date, under existing law, a claim is generally subordinated only if [the] holder of such claim is guilty of inequitable conduct, or the claim itself is of a status susceptible to subordination such as a penalty or a claim for damages arising from the purchase or sale of a security of the debtor.”
It found that courts consistently focused on the claimant, rather than the claim, for purposes of applying equitable subordination.
Concerning claims eligible for §502(d) objections, the court considered the statute’s plain language and found that the statute’s language and structure require that the entity that is asserting the objectionable claim be the same entity that is liable for the receipt of and failure to return property. The court reasoned that §502(d)’s purpose would not be served and would be punitive if a claim in the hands of a claimant could be disallowed where that claimant never received the voidable transfer and, therefore, could not be coerced to return it. Accordingly, the court determined that disallowance under §502(d) is a personal disability that does not travel with a sold claim.
The district court remanded the matter to the bankruptcy court for a determination of whether the transfer at issue was an assignment or a sale, and thus, whether the transferor’s conduct may be imputed to the transferee.
The court first responded to the ramifications raised by the litigants. The debtor urged that not attaching the disability to the claim would encourage “claims washing.” Creditors could sell their claims to maximize their recovery through the claims trading market. They would thus avoid the consequences of retaining their claims and litigating whether their claims are allowed, and may share in a distribution.
The transferee asserted that a recovery could still be made from the transferor. The court responded that this is not a perfect result. It opined that transferees’ bona fides remaining open for examination protected against collusive transfers. Transferees must therefore be vigilant with whom they trade claims, the terms of those transactions and their due diligence before entering into transactions.
Springfield focused on equitable subordination under §510 and disallowance of claims under §502(d). However, §502(d) does not provide for disallowance of claims subject to equitable subordination by §510. Section 510 provides for the “subordination . . .for purposes of distribution all or part of an allowed claim to all or part of another allowed claim. . ..” For purposes of equitable subordination, the offensive claim is an allowed claim. Section 502(d) permits disallowing claims of creditors who received and retained: (1) transfers avoidable by 11 U.S.C. §§522(f), 522(h), 544, 545, 547, 548, 549 or 724(a) or (b) property of the estate. Thus, Springfield’s effect may be felt in objections to transferred claims where the transferor received a voidable transfer or improperly retained property of the bankruptcy estate.
The court expressed concern that the bankruptcy court’s decision threatened to wreak havoc on the distressed debt markets and that its decision avoided that. Springfield insulates bona fide holders in due course and assignees taking claims excepted from the general rules of assignment. However, it opens a new litigation arena, focusing on the bona fides of transferees and their awareness of their transferors’ potential misconduct or fragility of their claims. Springfield alerts claims traders to examine their practices and establish standards that facilitate claims trading transactions and protects their durability when their bona fides are challenged.
Part II on Springfield for transferred claims against a commercial entity will be in our May eNewsletter.
 Id. at fn. 63. The court’s conclusion raises an interesting question. Where a proof of claim is based on an instrument, the instrument is in default. However, purchasers of claims filed in bankruptcy cases are not buying merely the underlying, defaulted on obligation. They are purchasing a right to share in the anticipated distribution to creditors in a bankruptcy case. This conclusion is supported by Fed. R. Bank. P. 3001(e), which includes provisions for trading claims after proofs of claim are filed. The Bankruptcy Code provides the stated priorities for claims in bankruptcy cases, 11 U.S.C. §§503 and 507. Similarly, plans of reorganization in cases under chapter 11 of the Code create classes of similarly situated creditors and treatment of those claims. See 11 U.S.C. §§1122 and 1123. Thus, the expectations of payment are governed by (a) the Bankruptcy Code’s provisions and/or (b) the terms of a confirmed plan of reorganization, which must also comply with the Code. If there is a default under a plan of reorganization, it is the plan, not the claim, that has been defaulted on. In a chapter 7 liquidation, it seems that a transferred bankruptcy claim has not been defaulted on unless the Code has not been complied with. Is it possible that a proof of claim is a new form of commercial paper?
[A]fter notice and a hearing, a court may…(1) under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or part of another allowed interest…
[T]he 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, 550 or 553 of this title.