The recent decision of the Honorable Shira Scheindlin of the United States District Court for the Southern District of New York in In re Enron Corp. (Enron Corp. v. Springfield Assoc.) , 2007 WL 2446498 (S.D.N.Y. Aug. 27, 2007), has been, on the one hand, praised for creating some certainty in the trading of bankruptcy claims when such trading is done anonymously (e.g., electronically with no disclosure of the seller or purchaser) and, on the other hand, criticized for creating some uncertainty when the seller is known to the buyer. There has been much commentary written concerning questions left unanswered by Judge Scheindlin's decision but little discussion of the practical effect thereof.
Prior to filing for bankruptcy in December, 2001, Enron entered into a short-term credit agreement with a syndicate of banks. Subsequent to the bankruptcy filing, some of the original banks transferred portions of their claims under the credit agreement to unrelated third parties. Thereafter, Enron sued certain of the banks (1) alleging that the banks engaged in inequitable conduct giving rise to equitable subordination of their claims against Enron and (2) asserting preference claims against the banks. Enron also sued the transferees of the banks' claims seeking to equitably subordinate and disallow such claims based upon the transferor's inequitable conduct and because the banks had not returned certain avoidable transfers to the debtors - despite the fact that the transferees were not alleged to have participated in or known of the transferor's alleged wrongdoing . These suits triggered significant controversy and have given rise to years of (continuing) litigation.
The practical reality of claims trading is that, as a result of an increasingly computerized global environment, transactions involving bankruptcy claims are often done quickly and anonymously via electronic means. Consequently, buyers typically do not (and likely cannot) undertake any significant due diligence in connection with the purchase of claims. In fact, such diligence is often considered, if at all, a minimal part of the risk analysis associated with purchasing a claim. Instead, buyers have often focused merely on analyzing potential recoveries under an applicable plan of reorganization and whether the plan would likely be confirmed before the buyer's costs (including the time value of money) exceeded its profit. ( See 6 Collier Bankruptcy Practice Guide , ¶¶ 94.02, 94.02 (2007)).
This approach to purchasing claims was called into question by two decisions issued by the Honorable Arthur Gonzalez of the United States Bankruptcy Court of the Southern District of New York in Enron Corp. v. Springfield Assocs., L.L.C. , 2005 W.L. 3873893, Nos. 01-16034, 05-01025, slip op. (Bankr. S.D.N.Y. Nov. 28, 2005) and Enron Corp v. Avenue Special Situations Fund II LP , 340 B.R. 180 (Bankr. S.D.N.Y. 2006). Although, as Judge Gonzalez points out in one of his decisions, the risk of buying bankruptcy claims "has been identified in the distressed debt industry for at least a decade," Judge Gonzalez's decisions sent shivers down the spine of many claims traders.
In his decisions, Judge Gonzalez found that a purchased claim may be equitably subordinated based upon the inequitable conduct of the seller and that the transferred claim may be subject to disallowance if the seller failed to return an avoidable transfer. The Bankruptcy Court found that a transferee should not enjoy greater rights than the transferor and, thus, if a claim is subject to subordination in the hands of the transferor, it is also subject to subordination in the hands of a transferee. In supporting such conclusion, the Court noted that "the equitable relief available under the doctrine of equitable subordination remains with the claim."
The Bankruptcy Court's decisions were praised by some as necessary to protect the integrity of the trading market and to prevent "claims washing" ( i.e. , the transfer of claims by a creditor to avoid the consequences of its bad faith), and criticized by others as decisions which would "wreak havoc in the markets for distressed debt" by, among other things, discouraging trading, causing the price of claims to decrease dramatically, and increasing associated costs because of the perceived need to conduct due diligence as to the transferor's conduct as related to the debtor. Levitin, Adam J., Finding Nemo: Rediscovering the Virtues of Negotiability in the Wake of Enron , 2007 COLUM. BUS. L. REV. 83 (2007) .
On appeal to the District Court, Judge Scheindlin reversed the lower court's decisions and held that the principles of equitable subordination and disallowance, as applied to claims, are personal to the claimant and are not characteristics of a claim and, thus, the claim in the hands of the transferee is not subject to equitable subordination or disallowance based upon the prior misconduct of the transferor. However, the District Court made a distinction between claims transferred by a "sale" and claims transferred by "assignment," in ruling that an assignee of a claim takes the claim subject to the risks of equitable subordination and disallowance, while the purchaser of a claim does not. The Court emphasized that where claims are traded anonymously, subordination would not be appropriate given that the purchaser has "no way of ascertaining whether the seller (or a transferee up the line) has acted inequitably." In such a case, the Court continued, "[n]o amount of due diligence on [the buyer's] part will reveal that information and it is unclear how the market would price such unknowable risk." The District Court remanded the case to the Bankruptcy Court for a determination of whether the claims in question were transferred by a sale or assignment. (The District Court has since denied a motion for leave to appeal its interlocutory order to the Second Circuit.)
In part, the District Court in its decision seems to have recognized the reality of the current marketplace for trading in bankruptcy claims (i.e., that a vast number of such claims are traded anonymously, making any due diligence impractical if not impossible). In fact, claims traders with whom this author has spoken have indicated that, with respect to anonymous claims trades, the District Court's decision makes a lot of sense. However, for some, the decision raises significant questions and concerns. For example, from a practical standpoint, Judge Scheindlin does not provide explicit criteria for lower courts to apply in distinguishing between a sale and an assignment. Commentators and Bankruptcy Judges alike have indicated that the decision will be difficult to apply in light of a common perception that a sale is no different from an assignment in the claims trading arena (in fact, the terms are often used interchangeably). In addition, Judge Scheindlin notes that the Court's analysis "would not apply to bad faith purchasers." However, it is unclear what this language actually means and what burden, if any, it imposes on purchasers to conduct due diligence.
Nevertheless, the practical effect of Judge Scheindlin's decision is that it has given people who trade in bankruptcy claims some comfort that if they do so anonymously (e.g., via electronic means), they will not be subject to potential subordination claims based upon the wrongful conduct of their transferor. Any such comfort had virtually been extinguished by the Bankruptcy Court's decision, so distressed claims traders breathed a collective sigh of relief upon reading the District Court's decision. Moreover, even where the identity of the seller and buyer are disclosed, claims traders have indicated that, as a practical mater, the distinction between a sale and an assignment highlighted by Judge Scheindlin is academically troubling but can be managed in the claims trading process. This is so because, in most such situations, the buyer typically extracts an indemnity agreement from the seller in connection with the transfer which protects the buyer against, among other things, any claims of subordination that may be subsequently asserted against the claim. As a result, in order to protect against the risk of a court subsequently determining a transfer of a claim to have been an assignment rather than a sale, in completing claims trades other than on an anonymous basis, buyers of claims will no doubt insist (if they were otherwise not inclined to do so) upon receiving an indemnification agreement from the applicable seller. As a result, following Judge Scheindlin's decision, if the transaction is later deemed by the bankruptcy court to be an assignment rather than a sale, the claim will be subject to subordination based upon the wrongful conduct of the seller and the buyer will no doubt seek to exercise its rights under the indemnification agreement with the seller. Given this likely shifting of risk from buyers to sellers, it will be interesting to see how (if at all) this new landscape changes the pricing of bankruptcy claims to account for such increased risk being assumed by the seller.
As a final point, it is worth noting that it remains unclear whether - when a creditor does take advantage of the trading process to avoid the consequences of equitable subordination or disallowance of a claim - the impact on all of the other creditors of the estate can indeed be minimized. A free and active trading market means that the identity of the creditors of a debtor is often in flux. However, some have argued that the court-sanctioning of the process of "claims washing" threatens to diminish or, at the very least, delay distributions to the larger creditor group. This could potentially have other consequences, including complicating resolution of a bankruptcy case resulting from the inability of the debtor to negotiate with a stable creditor body.On the other hand, trading claims often leads to efficiency and liquidity in the bankruptcy market.
George B. South III is a Partner in King & Spalding's Financial Restructuring Group in New York. His practice includes both in- and out-of-court restructurings and the rehabilitation of financially distressed businesses. He regularly represents corporate debtors, creditors' committees, bondholders' committees, debtor-in-possession lenders, investment partnerships that buy and sell distressed securities, businesses and third parties seeking to invest in and/or acquire the assets and businesses of financially troubled companies, as well as liquidating trustees under Chapter 11 plans.