Claims Traders Alert: Another Bankruptcy Court Rules that a Traded Claim Can Be Disallowed if the Seller Received a Voidable Transfer

The U.S. Bankruptcy Court for the Southern District of New York recently added some weight to the majority rule on a hot-button issue for claims traders. In In re Firestar Diamond, Inc., 615 B.R. 161 (Bankr. S.D.N.Y. 2020), the court ruled that a transferred claim can be disallowed under section 502(d) of the Bankruptcy Code even if the entity holding the claim is not the recipient of a voidable transfer. According to the court, claim disallowance under section 502(d) "rests on the claim and not the claim holder."

Disallowance of Claims of Avoidable Transfer Recipients

Section 502(d) of the Bankruptcy Code creates a mechanism to deal with creditors that have possession of estate property on the bankruptcy petition date or are the recipients of pre- or postbankruptcy 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.

As noted by the U.S. Court of Appeals for the Fifth Circuit in In re Davis, 889 F.2d 658, 661 (5th Cir. 1989), "[t]he legislative history and policy behind Section 502(d) illustrates that the section is intended to have the coercive effect of insuring compliance with judicial orders." See also H.R. Rep. No. 95-595, at 354 (1978); S. Rep. No. 95-989, at 64 (1978); accord In re Odom Antennas, Inc., 340 F.3d 705, 708 (8th Cir. 2003). The provision "is designed to foster the 'restoration' of assets to a debtor's estate, thereby assuring 'equality of distribution' … by precluding anyone who has received a voidable transfer from sharing in any distribution … unless he first pays back any preference that he has received." In re Chase & Sanborn Corp., 124 B.R. 368, 371 (Bankr. S.D. Fla. 1991) (citations omitted). Section 502(d) was "not [intended] to punish, but to give creditors an option to keep their transfers (and hope for no action by the trustee) or to surrender their transfers and their advantages and share equally with other creditors." In re Enron Corp., 379 B.R. 425, 435 (S.D.N.Y. 2007) (citations and internal quotation marks omitted).

A body of case law has developed regarding the impact of the sale or transfer of a claim to a third party on the applicability of section 502(d). Some courts, representing the majority view, have held that a transferred claim must be disallowed under section 502(d) even if the transferee is not the entity from which property is recoverable—ruling, in effect, that a claim is not cleansed when it is sold or assigned. See In re KB Toys Inc., 736 F.3d 247, 254 (3d Cir. 2013) ("the cloud on the claim continues until the preference payment is returned, regardless of whether the person or entity holding the claim received the preference payment"); In re Metiom, Inc., 301 B.R. 634, 643 (Bankr. S.D.N.Y. 2003) (citing Swartz v. Siegel, 117 F. 13 (8th Cir. 1902), for the proposition that "[t]he disqualification of a claim from allowance created by a preference inheres in and follows every part of the claim, whether retained by the original creditor or transferred to another, until the preference is surrendered"); see also In re Arctic Glacier Int'l, Inc., 901 F.3d 162, 168 (3d Cir. 2018) (stating that, when a claim is transferred, "the transferee assumes the same limitations as the transferor [and that] [o]therwise, buyers could revive disallowed claims, laundering them to receive better treatment in new hands").

The U.S. District Court for the Southern District of New York adopted a more nuanced approach in Enron Corp. v. Springfield Associates, L.L.C. (In re Enron Corp.), 379 B.R. 425 (S.D.N.Y. 2007) ("Enron II"), holding that infirmities travel with an assigned claim for purposes of section 502(d), but not if the claim is sold. In so ruling, the district court vacated a bankruptcy court decision finding that a claim transferred by means of sale or assignment can be disallowed under section 502(d), even if the assignee/buyer did not receive a voidable transfer. See Enron Corp. v. Avenue Special Situations Fund II, LP (In re Enron Corp.), 340 B.R. 180 (Bankr. S.D.N.Y. 2006) ("Enron I"), vacated, 379 B.R. 425 (S.D.N.Y. 2007).

In Enron II, the district court examined the distinction between the legal concepts of "sale" and "assignment." Although each is a form of transfer, the court explained, the terms are not synonymous and have very different legal consequences for the transferee:

With respect to assignments, "[a]n assignee stands in the shoes of the assignor and subject to all equities against the assignor." In other words, "an assignee of a claim takes with it whatever limitations it had in the hands of the assignor … By contrast, these assignment law principles do not apply to sales. A purchaser does not stand in the shoes of the seller and, as a result, can obtain more than the transferor had in certain circumstances.

These distinctions apply with the same force to transfers of debt and claims. An assignee of a claim takes no more than the assignor had to give. A purchaser of a claim may take more. Although characteristics that inhere in a claim may travel with the claim regardless of the mode of transfer, the same cannot be said for personal disabilities of claimants. A personal disability that has attached to a creditor who transfers its claim will travel to the transferee if the claim is assigned, but it will not travel to the transferee if the claim is sold.

Enron II, 379 B.R. at 435-36 (citations omitted). The district court rejected the argument that "all rights among competing claims to a bankruptcy estate are fixed and determined" as of the bankruptcy petition date, such that the claims transferred were "forever tainted" as of that point in time. The plain language of section 502(d), the court explained, indicates that: (i) court action is necessary before a claim will be disallowed; (ii) disallowance is completely contingent on the recipient's refusal or failure to return an avoidable transfer; and (iii) disallowance can be based solely on the postpetition receipt of and failure to return an avoidable transfer.

The district court wrote that the "language and structure of [section 502(d)] is plain and requires the entity that is asserting the claim be the same entity (i.e., 'such entity') that is liable for receipt of and failure to return property." This result, the court emphasized, comports with one of the provision's primary purposes in coercing the return of assets obtained by means of an avoidable transfer. This goal would not be served if a claim could be disallowed in the hands of an entity that is not the recipient of an avoidable transfer and could therefore not be compelled to return the assets conveyed. Such a result, the court reasoned, would also be inconsistent with the statute's coercive, rather than punitive, nature. Applying section 502(d) to purchasers of claims would be punitive "because they have no option to surrender something they do not have."

The district court downplayed concerns that its ruling would "wreak havoc in the markets for distressed debt" and acknowledged that, although claim "washing" might be possible in some cases, "the risk of that scenario is outweighed by the countervailing policy at issue, namely the law's consistent protection of bona fide purchasers for value."

Other courts have found Enron II's distinction between "assignment" and "sale" to be "problematic" because it is not supported by either the Bankruptcy Code or applicable non-bankruptcy law, which make no such distinction. See KB Toys, 736 F.3d at 252, 254 n.11 (stating that "[t]o allow the sale to wash the claim entirely of the cloud would deprive the trustee of one of the tools the Bankruptcy Code gives trustees to collect assets—asking the bankruptcy court to disallow problematic claims"); In re Motors Liquidation Corp. Co., 529 B.R. 510, 572 n.208 (finding that the assignment-sale distinction in Enron II was "problematic").

Commentators have also criticized the Enron II assignment-sale approach as being unsupported by applicable law and practice. See, e.g., Adam J. Levitin, Bankruptcy Markets: Making Sense of Claims Trading, 4 Brook. J. Corp. Fin. & Com. L. 67, 92 (2009) ("The district court held that the answer depended on whether the claim was 'sold' or 'assigned,' a novel distinction that flew against the long-standing interchangeability of these terms in legal practice."); Jennifer W. Crastz, Can a Claims Purchaser Receive Better Rights (Or Worse Rights) Than Its Transferor in a Bankruptcy?, 29 Cal. Bankr. J. 365, 373 (2007) ("While the [Enron II ] court went a long way to support the claims trading industry in terms of shielding buyers from liability for creditor misconduct, the district court created a new conundrum for the claims trading industry by turning its decision on the sale versus assignment analysis—terms that the financial world has always used interchangeably."); Tally M. Weiner & Nicholas B. Malito, On the Nature of the Transferred Bankruptcy Claim, 12 U. Pa. J. Bus. L. 35, 49 (2009) ("The District Court's [Enron II] ruling is unusual … [because] it draws a distinction between the consequences of transferring a claim through a sale, as opposed to an assignment, that neither the parties that appealed to the District Court nor the amici curiae thought carried any significance.").

The bankruptcy court weighed in on this debate in Firestar Diamond.

Firestar Diamond

Three U.S. corporations indirectly owned by fugitive Indian businessman Nirav Modi (collectively, the debtors") filed for chapter 11 protection in the Southern District of New York in 2018. The bankruptcy court appointed a chapter 11 trustee for the debtors after a court-appointed examiner found that the debtors and their senior management were involved in Modi's alleged bank fraud.

The trustee objected to claims filed by four different banks (collectively, the "banks"), each of which was based on pledged receivables or invoices assigned or sold to the banks by three non-debtor companies (collectively, the "transferees") that did business with the debtors. The trustee alleged that the transferees received millions of dollars in avoidable fraudulent transfers from the debtors prior to their bankruptcy filings that had not been returned. He accordingly sought an order disallowing the banks' claims under section 502(d). Citing Enron II, the banks argued that, because they acquired their claims by means of sale rather than assignment, the claims should not be disallowed. The trustee countered that the court should be guided by KB Toys and other similar rulings, rather than Enron II. Alternatively, the trustee argued that the banks' claims should be disallowed even under the approach articulated in Enron II.

The Bankruptcy Court's Ruling

The bankruptcy court ruled in the trustee's favor. Rejecting the banks' argument that it was bound by principles of stare decisis to follow Enron II, the bankruptcy court found "more persuasive the analysis of courts that have reached the opposite result." Like the courts in KB Toys, Enron I, Metiom, and other similar decisions, the court in Firestar Diamond concluded that claim disallowance under section 502(d) rests on the claim rather than the claimant. This conclusion, the court explained, comports with the language, purpose, and underlying policy of the provision.

The court dismissed the banks' argument that their claims should not be disallowed because they were innocent victims of the fraudulent schemes orchestrated by Modi and the debtors and engaged in no inequitable conduct themselves. "Given the Court's determination that Section 502(d) applies to the Banks' claims," the court wrote, "the question becomes whether the claims are disallowed under the applicable law." Such was the case, the court explained, because the trustee "demonstrated … [that] the claims are based on amounts owed to the entities that received fraudulent transfers from the Debtors in amounts exceeding their claims." Therefore, the court concluded that there was "no equitable basis to bypass Section 502(d)." Moreover, the court found that it would be inequitable to favor the banks over the debtors' other creditors.

Finally, the bankruptcy court rejected the banks' argument that disallowing their claims "would wreak havoc in the claims trading market or unfairly punish good faith transferees." According to the court, claims traders should bear the risk of disallowance under these circumstances because, unlike ordinary creditors: (i) they voluntarily choose to take part in the bankruptcy process and are aware of the associated risks; and (ii) they can mitigate their risk through due diligence and indemnity clauses in transfer agreements.

In dicta, the bankruptcy court noted that, although it declined to decide whether the banks acquired their claims by means of sales rather than assignments, "there are reasons to think that some or all of these transactions might not even be 'sales' protected from disallowance under Enron II."


Fireside Diamond does not break new ground on the disallowance of transferred claims under section 502(d). Even so, it bolsters the majority view on the question and underscores the importance of rigorous due diligence and indemnity protections in connection with claims transfers—items that have been on traders' radar screens for many years.

Although it is the most prominent dispute concerning section 502(d), the disallowance of traded claims is not the only controversy regarding the provision making its way through the courts. For example, courts disagree as to whether a transferee's avoidance liability must be finally adjudicated (as distinguished from alleged) as a condition to disallowance of the transferee's claim under section 502(d). Compare In re Southern Produce Distributors, Inc., 616 B.R. 667 (Bankr. E.D.N.C. 2020) (transferee's avoidance liability must be finally adjudicated) with Thaler v. Korn, 2014 WL 1154059 (E.D.N.Y. Mar. 19, 2014) (colorable allegations are sufficient to trigger temporary disallowance subject to later reconsideration). Interestingly, the court in Fireside Diamond skirts this issue, noting merely that the trustee "demonstrated" in his objection to the banks' claims that the transferors received fraudulent transfers.

Insights by Jones Day should not be construed as legal advice on any specific facts or circumstances. The contents are intended for general information purposes only and may not be quoted or referred to in any other publication or proceeding without the prior written consent of the Firm, to be given or withheld at our discretion. To request permission to reprint or reuse any of our Insights, please use our “Contact Us” form, which can be found on our website at This Insight is not intended to create, and neither publication nor receipt of it constitutes, an attorney-client relationship. The views set forth herein are the personal views of the authors and do not necessarily reflect those of the Firm.