Insights

Good Tidings for Claims Traders: Second Circuit Rules That Purchased Administrative Claims Not Disallowed by Operation of Section 502(d)

Participants in the multibillion-dollar market for distressed claims and securities had ample reason to keep a watchful eye on developments in the bankruptcy courts during each of the last four years. Controversial rulings handed down in 2005 and 2006 by the bankruptcy court overseeing the chapter 11 cases of failed energy broker Enron Corporation and its affiliates had traders scrambling for cover due to the potential for acquired claims/debt to be equitably subordinated or even disallowed, based upon the seller’s misconduct. The decisions had players in the distressed-securities market rushing to devise better ways to limit their exposure by building stronger indemnification clauses into claims-transfer agreements. 

The rulings’ “buyer beware” approach, moreover, was greeted by a storm of criticism from lenders and traders alike, including the Loan Syndications and Trading Association; the Securities Industry Association; the International Swaps and Derivatives Association, Inc.; and the Bond Market Association. According to these groups, if caveat emptor is the prevailing rule of law, claims held by a bona fide purchaser can be equitably subordinated even though it may be impossible for the acquiror to know, even after conducting rigorous due diligence, that it was buying loans from a “bad actor.”

The severity of the cautionary tale writ large in the bankruptcy court’s Enron decisions was ultimately ameliorated on appeal in the late summer of 2007. District judge Shira A. Scheindlin vacated both of the rulings, holding that “equitable subordination under section 510(c) and disallowance under section 502(d) are personal disabilities that are not fixed as of the petition date and do not inhere in the claim.” The key determination, she explained, is whether the claim transfer is in the form of an outright sale or merely an assignment. Despite Judge Scheindlin’s holding, the 20-month ordeal (and the uncertainty it spawned) left a bad taste in the mouths of market participants.

2008 proved to be little better in providing traders with any degree of comfort with respect to claim or debt assignments involving bankrupt obligors. In In re M. Fabrikant & Sons, Inc., a New York bankruptcy court took a hard look for the first time at the standard transfer forms and definitions contained in nearly every bank-loan transfer agreement, ruling that a seller’s reimbursement rights were transferred along with the debt. The ruling indicates that the rights assigned to a buyer using the standard transfer forms are broad and include both contingent (and even post-petition) claims. The decision also fortifies the conventional wisdom that transfer documents should be drafted carefully to spell out explicitly which rights, claims, and interests are not included in the sale.

The latest development in the bankruptcy claims trading ordeal was the subject of a ruling handed down by the Second Circuit Court of Appeals in September 2009. Addressing the matter before it as an issue of first impression, the court of appeals held in ASM Capital, LP v. Ames Department Stores, Inc. (In re Ames Department Stores, Inc.) that section 502(d) of the Bankruptcy Code does not mandate disallowance, either temporarily or otherwise, of administrative claims acquired from entities that allegedly received voidable transfers.

 

Allowance and Disallowance of Claims in Bankruptcy

Section 502 of the Bankruptcy Code sets forth procedures governing the allowance or disallowance of a “claim or interest” in a bankruptcy case. Section 502(a) provides that a claim or interest, proof of which is filed with the court, “is deemed allowed,” unless a party-in-interest objects. Under section 502(b), the bankruptcy court is obligated to resolve any objection in accordance with delineated criteria by ruling to allow or disallow the claim (in whole or in part). Section 502(c) directs the court in certain circumstances to estimate for the purpose of allowance certain contingent or unliquidated claims and any right to payment arising from an equitable remedy for breach of performance.

Section 502(d) creates a mechanism to deal with creditors who have possession of estate property on the bankruptcy petition date or are the recipients of pre- or post-bankruptcy asset transfers that can be avoided because they are fraudulent, preferential, unauthorized, or otherwise subject to forfeiture by operation of a bankruptcy trustee’s avoidance powers. Section 502(d) provides as follows:

 

Notwithstanding subsections (a) and (b) of this section, the court shall disallow any claim of any entity from which property is recoverable under section 542, 543, 550, or 553 of this title or that is a transferee of a transfer avoidable under section 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 section 522(i), 542, 543, 550, or 553 of this title.

 

The purpose of the provision is to promote the pro rata distribution of the bankruptcy estate among all creditors and to coerce payment of judgments obtained by the trustee.

The allowance of post-petition administrative claims is governed by a different section of the Bankruptcy Code. Section 503 provides that “administrative expenses,” such as post-petition employee wages, taxes, professional fees, rent under assumed nonresidential real-property leases, and other specified expenses, “shall be allowed” by the court after notice to affected parties and a hearing. 

The focus of the courts’ inquiry in Enron concerned whether transferred claims can be disallowed under section 502(d) even though the assignee or purchaser of the claim was not the transferee of an avoidable transfer. The Second Circuit confronted a different but related issue in Ames—whether the language “any claim” in section 502(d) includes administrative expense claims allowed under section 503 that have been acquired from a creditor-transferee of a voidable transfer.

 

Ames Department Stores

Former nationwide retailer Ames Department Stores, Inc. (“Ames”), filed for chapter 11 protection in August 2001 in New York. Given Ames’ inability to reorganize, the company’s board of directors determined in August 2002 that the best course of action under the circumstances was to effect an orderly liquidation of the company.

ASM Capital, LP (“ASM”), is an investor in distressed debt. In 2002 and 2003, ASM purchased claims against Ames’ estate from various creditors, including two claims held by G&A Sales, Inc. (“G&A”), one of Ames’ suppliers. The claims consisted of an administrative claim in the amount of approximately $360,000 for post-petition goods and a reclamation claim in the amount of approximately $33,000, which, in accordance with the version of section 546(c) in effect at the time, the bankruptcy court granted administrative expense status in lieu of permitting G&A to exercise its reclamation rights.

Ames suspended payment of its administrative claims in 2002 when it decided to liquidate. Sometime afterward, Ames sued several of its former suppliers, including G&A, to avoid as preferential payments made to G&A on the eve of Ames’ chapter 11 filing. In 2004, while these actions were still pending, Ames began making partial distributions to administrative creditors. It refused, however, to make distributions to preference defendants or creditors that acquired claims from preference defendants. ASM sought a court order allowing its administrative claims and directing Ames to pay them. Ames opposed the motion, arguing that section 502(d) barred any payments in respect of ASM’s claims until the entities from which ASM acquired its claims disgorged the payments that were the subject of the preference litigation. According to Ames, it made no difference that ASM itself had not received preferential payments.

Ames and defendants other than G&A settled the preference litigation before the bankruptcy court ruled on ASM’s motion. Thereafter, the court allowed administrative claims held by ASM that had been acquired from the settling defendants. However, it ruled that section 502(d) barred allowance of claims acquired from G&A until such time as the avoidance litigation against it was settled or G&A disgorged the payments.

In 2006, the preference litigation against G&A was finally resolved by the entry of a default judgment. Because G&A later filed for bankruptcy and surrendered all of its assets to a secured creditor, the bankruptcy court ruled that disallowance of ASM’s remaining administrative claims “will likely be permanent.” The district court affirmed this ruling on appeal, observing that it was “in complete agreement” with the bankruptcy court that section 502(d) applies to administrative expense claims.

 

The Second Circuit’s Ruling

ASM fared better on appeal to the Second Circuit. Noting that it was addressing the question as a matter of first impression, the court of appeals examined the plain language of section 502(d) to divine whether administrative expenses under section 503 qualify as “claims.” It concluded that they do not. 

First, the court explained that the Bankruptcy Code’s definition of “claim” in section 101(5)(A) as any “right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured,” does not distinguish between pre-petition and post-petition rights to payment. However, the court emphasized, section 101(10) defines “creditor” in terms that include only holders of pre-petition claims (and certain post-petition claims deemed to be pre-petition claims) and not holders of post-petition claims for administrative expenses under section 503. Moreover, section 348(d), which deals with the treatment of post-order for relief, pre-conversion claims, expressly applies to any post-petition claim “other than a claim specified in section 503(b).”

The Second Circuit agreed with the Delaware bankruptcy court’s reasoning in Camelot Music, Inc. v. MHW Adver. & Public Relations, Inc. (In re CM Holdings, Inc.) that “the express exclusion of administrative expense claims from section 348(d), and the exclusion of administrative claim holders from the definition of ‘creditor,’ lend ‘support to the view that administrative expense claims are claims that are separate and apart from pre-petition, or deemed pre-petition, creditor claims.’ ” The court rejected the view espoused by some courts, including a Ninth Circuit bankruptcy appellate panel in MicroAge, Inc. v. Viewsonic Corp. (In re MicroAge, Inc.), that “Congress viewed expenses of administration as merely one specialized type of claim” and that lawmakers thus intended such expenses to be subject to section 502(d). Instead, the court of appeals concluded, “The structure and content of section 502(d) suggests that Congress intended it to differentiate between claims and administrative expenses, and not to apply to the latter.”

In conjunction with section 501, the court explained, section 502 provides a procedure for the allowance of claims that is “entirely separate from the procedure for allowance of administrative expenses under section 503.” In particular, the court noted, section 502 governs allowance of claims for which proof is filed under section 501. Because claims for administrative expenses cannot be filed under section 501, they are not subject to the deemed allowance and objection procedures set forth in sections 502(a) and 502(b).

The mechanism for filing and payment of administrative expense claims, the Second Circuit emphasized, is governed by section 503, which establishes procedures “independent from the procedures for filing and allowance of prepetition claims under sections 501 and 502, and differs in significant respects.” Specifically, the court of appeals explained: (i) whereas section 501 allows only “creditors” to file proofs of claim, any “entity” may file a request for payment of an administrative expense; (ii) while section 502 requires notice and a hearing for a pre-petition claim only if there is an objection filed to the claim, section 503(b) requires notice and a hearing on all requests for allowance of an administrative expense, regardless of whether an objection has been made; and (iii) section 503(b), which enumerates the types of administrative claims, excludes “claims allowed under section 502(f)” (i.e., deemed pre-petition claims in an involuntary case that are subject to sections 501 and 502). “[W]ith respect to the allowance of claims,” the Second Circuit wrote, “sections 502 and 503 are separate and independent.”

The court of appeals explained that the language of section 502(d) “suggests that it applies only in the context of section 502, and not to claims addressed by section 503.” Among other things, the Second Circuit noted, the provision’s language “introduces section 502(d) as an exception to the automatic allowance” of filed claims under sections 502(a) and 502(b) “and suggests that the subsection’s scope is limited to that process and does not extend to claims allowable under section 503.” According to the court, “That suggestion is reinforced by the absence from section 502(d) of any reference to section 503.” Moreover, the remaining subsections of section 502 ((e) through (i)) “explicitly bring certain postpetition claims within the scope of section 502” by providing that such claims “shall be allowed under subsection (a), (b), or (c) of this section, or disallowed under subsection (d) . . . the same as if such claim had become fixed before the date of the filing of the petition.” The express invocation of section 502(d), the Second Circuit remarked, “suggests that the section did not already apply to such claims before they were within section 502’s reach, and that it does not apply to postpetition claims remaining outside section 502, such as the requests for administrative expenses addressed by section 503(b).” Finally, the court emphasized, the mandatory terms in which section 503(b) is drafted (expenses “shall be allowed” by the court) conflict with section 502(d)’s equally mandatory disallowance of claims.

According to the Second Circuit, the “Bankruptcy Code establishes a clear division between an entity in its pre- and post-petition states.” “More importantly,” the court explained, the statute gives higher priority to administrative expense claims than to pre-petition claims in order to encourage parties to supply goods and services to the estate, to the benefit of all stakeholders. That intent, the court concluded, “would be frustrated by allowing a debtor automatically to forestall or avoid payment of administrative expenses by alleging that the vendor had been the recipient of a fraudulent transfer.”

 

Outlook

The Second Circuit’s Ames decision carefully parses the language of sections 502 and 503 and thoroughly examines the purpose underlying each of the relevant provisions. Moreover, the court’s policy observation is accurate―post-petition suppliers would be more reluctant to deal with debtors if they faced the prospect of disallowance of their claims in the event that they were later sued in avoidance litigation.

Although the ruling is a positive development for claims traders, the Second Circuit skirted the $64,000 question on claims transfers: in view of its conclusion, the court stated that “we find it unnecessary to reach ASM’s alternative argument that, even if section 502(d) did extend to administrative expenses under section 503(b), it could be invoked only against the recipient of the alleged preferential transfer and not against a subsequent holder of a claim that originated with the alleged transfer.” Thus, we are left to speculate whether the Second Circuit, like the district court in Enron, would have made any distinction between assigned and purchased claims in this context.
_____________________________

 

ASM Capital, LP v. Ames Department Stores, Inc. (In re Ames Dept. Stores, Inc.), 582 F.3d 422 (2d Cir. 2009).

 

In re M. Fabrikant & Sons, Inc., 385 B.R. 87 (Bankr. S.D.N.Y. 2008).

 

In re Enron Corp., 379 B.R. 425 (S.D.N.Y. 2007).

 

Enron Corp. v. Avenue Special Situations Fund II, LP (In re Enron Corp.), 333 B.R. 205 (Bankr. S.D.N.Y. 2005), rev’d and remanded, 379 B.R. 425 (S.D.N.Y. 2007).

 

In re Enron Corp., 340 B.R. 180 (Bankr. S.D.N.Y. 2006), rev’d and remanded, 379 B.R. 425 (S.D.N.Y. 2007).

 

Camelot Music, Inc. v. MHW Adver. & Public Relations, Inc. (In re CM Holdings, Inc.), 264 B.R. 141 (Bankr. D. Del. 2000).

 

MicroAge, Inc. v. Viewsonic Corp. (In re MicroAge, Inc.), 291 B.R. 503 (Bankr. 9th Cir. 2002).

 

We use cookies to deliver our online services. Details of the cookies and other tracking technologies we use and instructions on how to disable them are set out in our Cookies Policy. By using this website you consent to our use of cookies.