Section 502(d) Roulette

The allowance of claims in a bankruptcy case is governed by section 502 of the Bankruptcy Code. Section 502(a) provides that a filed proof of claim is deemed allowed unless a party-in-interest objects. If an objection to a claim is filed, the court will allow or disallow the claim in an appropriate order after notice and a hearing. Section 502(d) carves out an exception from the deemed allowance operation of the statute. It states in part that “the court shall disallow any claim of an entity” from whom property is recoverable because the entity is the recipient of preferential, fraudulent or certain other types of voidable transfers. Such a recipient of an avoidable transfer can redeem the otherwise allowed nature of its claim by returning the property to the debtor.

Unfortunately, the provisions of section 502 are seemingly incongruous in one respect: while the statute does not expressly state that the allowance of a claim (either by court order or the absence of an objection) precludes a challenge to avoidable transfers made to the claimant, it could be interpreted to require a court to resolve all avoidance actions prior to the allowance of a claim. This has engendered a fair amount of confusion in the courts. In fact, the preclusive effect of section 502(d) has been the subject of no less than six decisions issued in the last 20 months by the Delaware bankruptcy court, and the judges involved have sometimes reached inconsistent conclusions.

In Ampace Freightlines, Inc. v. TIC Financial Systems (In re Ampace Corp.), 279 B.R. 145 (Bankr. D. Del. 2002), Chief Bankruptcy Judge Peter J. Walsh found that section 502(d) had no preclusive effect when there had been no formal objection to a claim that had been deemed allowed by operation of the statute. In LaRoche Industries, Inc. v. General American Trasp. Corp. (In re LaRoche Indus., Inc., 284 B.R. 406 (Bankr. D. Del. 2002), the debtor did object in part to a filed claim, but the claimant never responded, so the court entered an order allowing the claim in the reduced amount demanded by the objection. After the claimant received an initial distribution under the debtor's plan, the debtor commenced an adversary proceeding to recover an allegedly preferential transfer. Judge John C. Ackard ruled that section 502(d) barred the avoidance action because it was commenced after the court entered an order allowing the claim.

Judge Lloyd King issued no less than three decisions (two of which are unpublished) on this issue last year in the Chapter 11 cases of Cambridge Industries Holding, Inc. and its affiliates. In each case, a plan administrator designated to resolve disputed claims negotiated and obtained court approval of a stipulation with the creditor in question in which the parties agreed that the creditor's claim would be allowed in a reduced amount. A separate liquidating trustee separately sued all three creditors to recover allegedly preferential transfers (in one case, after the stipulation had been negotiated, but before it had been approved by the court). Judge King held in each case that the preference action was barred because the claim in question had been allowed. See Caliolo v. Saginaw Bay Plastics, Inc. (In re Cambridge Industries Holdings, Inc.), 2003 WL 22232089 (Bankr. D. Del. Sep. 25, 2003); Caliolo v. Azdel, Inc. (In re Cambridge Industries Holdings, Inc.), 2003 WL 21697190 (Bankr. D. Del. Jul. 18, 2003); Caliolo v. TKA Fabco Corp. (In re Cambridge Industries Holdings, Inc.), 2003 WL 1818177 (Bankr. D. Del. Apr. 2, 2003). The court acknowledged that the preclusive nature of the stipulated order may have come as a surprise to the liquidating trustee because another entity — a plan administrator for the debtor — was entrusted with resolving claims under the plan. Nonetheless, Judge King was not swayed by that concern because “[c]ommunication between those entities, especially before the entry of orders concerning disputed claims, will eliminate the possibility of inadvertent preclusion of avoidance actions.” Cambridge, 2003 WL 21697190 *3.

The latest decision from Delaware on this issue was recently entered by Judge Walsh in TWA Inc. Post Confirmation Estate v. City and County of San Francisco Airports Commission (In re TWA Inc. Post Confirmation Estate), 2004 WL 180420 (Bankr. D. Del. Jan. 20, 2004). The airports commission filed two administrative claims in TWA's Chapter 11 case for terminal fees and related charges. TWA objected to the claims. The parties eventually reached a compromise pursuant to which the commission's claims were reduced in amount and allowed partially as an administrative expense and partially as a pre-petition claim. After the court approved a stipulation embodying those terms, the administrator designated under TWA's liquidating plan sued the commission seeking to avoid as preferential over $1 million in landing and other fees paid to it in the 90 days before TWA filed for bankruptcy. The commission moved to dismiss, arguing that, pursuant to section 502(d), the allowance of its pre-petition claim as provided by the court-approved settlement precluded the preference suit brought by TWA's liquidating trustee.

Judge Walsh disagreed. Mindful that there is a split of authority concerning the application of section 502(d), the court distanced itself from the reasoning articulated in LaRoche Industries based upon what Judge Walsh perceived to be the practical realities of large and complex Chapter 11 cases. In these types of cases, the court emphasized, the claims resolution process occurs long before any preference analysis is undertaken, particularly where the formulation of a plan depends on the resolution of a number of large claims. If the prospects for a successful reorganization are good, the court observed, the debtor typically will not perform a preference analysis until it has resolved major claims, and will in most cases elect not to sue vendors or other creditors with whom it needs to maintain ongoing working relationships. Alternatively, Judge Walsh noted, if liquidation ultimately proves to be the best or only course of action, preference actions most assuredly will and should be brought. Even where liquidation is the goal from the outset, he explained, the debtor and its professionals may not even be involved in avoidance litigation analysis because they are preoccupied with resolving claims and developing a liquidating plan. Interpreting section 502(d) to require that potential preference issues be resolved as part of the claims resolution process, the court concluded, is totally unrealistic and would have the effect of squandering potentially valuable estate assets. Finally, the court discounted the commission's suggestion that a creditor is unfairly surprised when a preference action is filed against it after its claim has been allowed. In large Chapter 11 cases, the court remarked, “sophisticated creditors typically are well aware of prospects and risks of preference litigation.”

Where Do We Go from Here?

The split of authority described above on the interpretation and application of section 502(d) extends well beyond Delaware. On one side of the split rift stand cases such as LaRoche and Cambridge Holdings, which strictly construe section 502(d) the statute to require that a preference dispute be “resolved in tandem with the claim objection.” In addition to citing the need to give substance to the statutory provision, these courts note the administrative efficiency inherent in combining the claims objection process with avoidance litigation, and the attendant fairness and convenience to parties in knowing their net claim against, or indebtedness to, the bankruptcy estate. Many courts subscribing to this approach also reason that section 502(d) was intended as a means of coercing creditors to comply with court orders.

TWA and cases like it are emblematic of a more flexible and arguably practical approach that strives to devise a workable solution to the practical challenges of case administration and plan development confronted by debtors in large Chapter 11 cases. Other proponents of this view include the courts in Peltz v. Gulfcoast Workstation Group (In re Bridge Info. Sys., Inc.), 293 B.R. 479 (Bankr. E. D. Mo. 2003), Rhythms Netconnections, Inc. v. Cisco Systems, Inc. (In re Rhythms Netconnections), 300 B.R. 404 (Bankr. S.D.N.Y. 2003), and In re MicroAge, Inc., 291 B.R. 503 (B.A.P. 9th Cir. 2002). Many of these courts view section 502(d) as, in essence, an affirmative defense to a creditor's claim against the estate, and applies only when an objected is actually interposed to a claim. If no objection is filed, section 502(d) “is simply not at issue and does not bar a subsequent preference action against the creditor.” Bridge, 293 B.R. at 488 (citation omitted).

Either approach is defensible, but where does this leave debtors, creditors and professionals who have to make decisions on how to conduct themselves in Chapter 11 cases? Many Chapter 11 plans provide for the assignment of preference or other avoidance claims to a trust established for the benefit of unsecured creditors. It is not uncommon for these same plans to assign the responsibility for resolving claims asserted against a debtor to another entity, such as the reorganized debtor or a claims or plan administrator. The rulings on section 502(d) illustrate that this separation of case responsibilities can pose problems for the unwary. At a minimum, they highlight the need for communication and careful coordination of the claims resolution process with other litigation against creditors in a bankruptcy case.

The burden of compliance may be significant and, in large cases, not practical and even detrimental to administration of the case and the plan process. Still, coordinating the resolution of all claims held by and against creditors can serve the interests of judicial economy by forcing a comprehensive resolution of disputes. It also arguably serves fairness concerns because it spares claimants the inconvenience of litigating (or negotiating) the resolution of their claims on more than one front and potentially at different times — first, in the context of the claims reconciliation process that often occurs concurrently with plan development; and later, in what is often post-confirmation avoidance action litigation.

Recognition that section 502(d) may limit later options of the debtor will likely force debtors who cannot perform an avoidance analysis at the time a settlement is reached with a major creditor to insist upon claim preservation language as part of the terms of the settlement. This solution is not a novel one — savings clauses have long been recognized as a legitimate feature of post-petition financing or cash collateral agreements. As in those circumstances, the issue, then, becomes one of negotiating the duration and scope of the preservation by the debtor of the right to pursue claims against a creditor in the future. On the flip side, creditors looking for certainty should insist that any stipulation resolving a claim contains release language (most likely in the context of mutual releases) that expressly includes avoidance claims.

Case management in large and complex Chapter 11 bankruptcies has never been easy. Successfully navigating the morass of filing requirements and deadlines contained in the Bankruptcy Code, its accompanying procedural rules and various local court rules can be challenging. When added to the remaining issues that routinely need to be addressed during the course of a case — among many others, claims resolution, development of a business plan and plan of reorganization, analysis of executory contracts and investigation of potential litigation claims — the array of activities that must be carefully coordinated can be daunting.

Judging by a series of bankruptcy court decisions issued during the last 2 years, Chapter 11 debtors and their professionals may have even more cause for consternation. The rulings concern the interplay between the claims resolution process and the estate's ability to prosecute avoidance actions against its creditors. They underscore the need for careful coordination of every aspect of a case and close communication among the different entities involved, including the debtor, its professionals, plan administrators and official committees. Absent such communication, the impact of these decisions may be the loss of potentially substantial recoveries on causes of action belonging to the Chapter 11 estate.

Claims Allowance

The allowance of claims in a bankruptcy case is governed by section 502 of the Bankruptcy Code. Section 502(a) provides that a filed proof of claim is deemed allowed unless a party-in-interest objects. If an objection to a claim is filed, the court will allow or disallow the claim in an appropriate order after notice and a hearing. Section 502(d) carves out an exception from the deemed allowance operation of the statute. It states in part that “the court shall disallow any claim of an entity” from whom property is recoverable because the entity is the recipient of preferential, fraudulent or certain other types of voidable transfers. Such a recipient of an avoidable transfer can redeem the otherwise allowed nature of its claim by returning the property to the debtor.

Unfortunately, the provisions of section 502 are seemingly incongruous in one respect: while the statute does not expressly state that the allowance of a claim (either by court order or the absence of an objection) precludes a challenge to avoidable transfers made to the claimant, it could be interpreted to require a court to resolve all avoidance actions prior to the allowance of a claim. This has engendered a fair amount of confusion in the courts. In fact, the preclusive effect of section 502(d) has been the subject of no less than six decisions issued in the last 20 months by the Delaware bankruptcy court, and the judges involved have sometimes reached inconsistent conclusions.

In Ampace Freightlines, Inc. v. TIC Financial Systems (In re Ampace Corp.), 279 B.R. 145 (Bankr. D. Del. 2002), Chief Bankruptcy Judge Peter J. Walsh found that section 502(d) had no preclusive effect when there had been no formal objection to a claim that had been deemed allowed by operation of the statute. In LaRoche Industries, Inc. v. General American Trasp. Corp. (In re LaRoche Indus., Inc., 284 B.R. 406 (Bankr. D. Del. 2002), the debtor did object in part to a filed claim, but the claimant never responded, so the court entered an order allowing the claim in the reduced amount demanded by the objection. After the claimant received an initial distribution under the debtor's plan, the debtor commenced an adversary proceeding to recover an allegedly preferential transfer. Judge John C. Ackard ruled that section 502(d) barred the avoidance action because it was commenced after the court entered an order allowing the claim.

Judge Lloyd King issued no less than three decisions (two of which are unpublished) on this issue last year in the Chapter 11 cases of Cambridge Industries Holding, Inc. and its affiliates. In each case, a plan administrator designated to resolve disputed claims negotiated and obtained court approval of a stipulation with the creditor in question in which the parties agreed that the creditor's claim would be allowed in a reduced amount. A separate liquidating trustee separately sued all three creditors to recover allegedly preferential transfers (in one case, after the stipulation had been negotiated, but before it had been approved by the court). Judge King held in each case that the preference action was barred because the claim in question had been allowed. See Caliolo v. Saginaw Bay Plastics, Inc. (In re Cambridge Industries Holdings, Inc.), 2003 WL 22232089 (Bankr. D. Del. Sep. 25, 2003); Caliolo v. Azdel, Inc. (In re Cambridge Industries Holdings, Inc.), 2003 WL 21697190 (Bankr. D. Del. Jul. 18, 2003); Caliolo v. TKA Fabco Corp. (In re Cambridge Industries Holdings, Inc.), 2003 WL 1818177 (Bankr. D. Del. Apr. 2, 2003). The court acknowledged that the preclusive nature of the stipulated order may have come as a surprise to the liquidating trustee because another entity — a plan administrator for the debtor — was entrusted with resolving claims under the plan. Nonetheless, Judge King was not swayed by that concern because “[c]ommunication between those entities, especially before the entry of orders concerning disputed claims, will eliminate the possibility of inadvertent preclusion of avoidance actions.” Cambridge, 2003 WL 21697190 *3.

The latest decision from Delaware on this issue was recently entered by Judge Walsh in TWA Inc. Post Confirmation Estate v. City and County of San Francisco Airports Commission (In re TWA Inc. Post Confirmation Estate), 2004 WL 180420 (Bankr. D. Del. Jan. 20, 2004). The airports commission filed two administrative claims in TWA's Chapter 11 case for terminal fees and related charges. TWA objected to the claims. The parties eventually reached a compromise pursuant to which the commission's claims were reduced in amount and allowed partially as an administrative expense and partially as a pre-petition claim. After the court approved a stipulation embodying those terms, the administrator designated under TWA's liquidating plan sued the commission seeking to avoid as preferential over $1 million in landing and other fees paid to it in the 90 days before TWA filed for bankruptcy. The commission moved to dismiss, arguing that, pursuant to section 502(d), the allowance of its pre-petition claim as provided by the court-approved settlement precluded the preference suit brought by TWA's liquidating trustee.

Judge Walsh disagreed. Mindful that there is a split of authority concerning the application of section 502(d), the court distanced itself from the reasoning articulated in LaRoche Industries based upon what Judge Walsh perceived to be the practical realities of large and complex Chapter 11 cases. In these types of cases, the court emphasized, the claims resolution process occurs long before any preference analysis is undertaken, particularly where the formulation of a plan depends on the resolution of a number of large claims. If the prospects for a successful reorganization are good, the court observed, the debtor typically will not perform a preference analysis until it has resolved major claims, and will in most cases elect not to sue vendors or other creditors with whom it needs to maintain ongoing working relationships. Alternatively, Judge Walsh noted, if liquidation ultimately proves to be the best or only course of action, preference actions most assuredly will and should be brought. Even where liquidation is the goal from the outset, he explained, the debtor and its professionals may not even be involved in avoidance litigation analysis because they are preoccupied with resolving claims and developing a liquidating plan. Interpreting section 502(d) to require that potential preference issues be resolved as part of the claims resolution process, the court concluded, is totally unrealistic and would have the effect of squandering potentially valuable estate assets. Finally, the court discounted the commission's suggestion that a creditor is unfairly surprised when a preference action is filed against it after its claim has been allowed. In large Chapter 11 cases, the court remarked, “sophisticated creditors typically are well aware of prospects and risks of preference litigation.”

Where Do We Go from Here?

The split of authority described above on the interpretation and application of section 502(d) extends well beyond Delaware. On one side of the split rift stand cases such as LaRoche and Cambridge Holdings, which strictly construe section 502(d) the statute to require that a preference dispute be “resolved in tandem with the claim objection.” In addition to citing the need to give substance to the statutory provision, these courts note the administrative efficiency inherent in combining the claims objection process with avoidance litigation, and the attendant fairness and convenience to parties in knowing their net claim against, or indebtedness to, the bankruptcy estate. Many courts subscribing to this approach also reason that section 502(d) was intended as a means of coercing creditors to comply with court orders.

TWA and cases like it are emblematic of a more flexible and arguably practical approach that strives to devise a workable solution to the practical challenges of case administration and plan development confronted by debtors in large Chapter 11 cases. Other proponents of this view include the courts in Peltz v. Gulfcoast Workstation Group (In re Bridge Info. Sys., Inc.), 293 B.R. 479 (Bankr. E. D. Mo. 2003), Rhythms Netconnections, Inc. v. Cisco Systems, Inc. (In re Rhythms Netconnections), 300 B.R. 404 (Bankr. S.D.N.Y. 2003), and In re MicroAge, Inc., 291 B.R. 503 (B.A.P. 9th Cir. 2002). Many of these courts view section 502(d) as, in essence, an affirmative defense to a creditor's claim against the estate, and applies only when an objected is actually interposed to a claim. If no objection is filed, section 502(d) “is simply not at issue and does not bar a subsequent preference action against the creditor.” Bridge, 293 B.R. at 488 (citation omitted).

Either approach is defensible, but where does this leave debtors, creditors and professionals who have to make decisions on how to conduct themselves in Chapter 11 cases? Many Chapter 11 plans provide for the assignment of preference or other avoidance claims to a trust established for the benefit of unsecured creditors. It is not uncommon for these same plans to assign the responsibility for resolving claims asserted against a debtor to another entity, such as the reorganized debtor or a claims or plan administrator. The rulings on section 502(d) illustrate that this separation of case responsibilities can pose problems for the unwary. At a minimum, they highlight the need for communication and careful coordination of the claims resolution process with other litigation against creditors in a bankruptcy case.

The burden of compliance may be significant and, in large cases, not practical and even detrimental to administration of the case and the plan process. Still, coordinating the resolution of all claims held by and against creditors can serve the interests of judicial economy by forcing a comprehensive resolution of disputes. It also arguably serves fairness concerns because it spares claimants the inconvenience of litigating (or negotiating) the resolution of their claims on more than one front and potentially at different times — first, in the context of the claims reconciliation process that often occurs concurrently with plan development; and later, in what is often post-confirmation avoidance action litigation.

Recognition that section 502(d) may limit later options of the debtor will likely force debtors who cannot perform an avoidance analysis at the time a settlement is reached with a major creditor to insist upon claim preservation language as part of the terms of the settlement. This solution is not a novel one — savings clauses have long been recognized as a legitimate feature of post-petition financing or cash collateral agreements. As in those circumstances, the issue, then, becomes one of negotiating the duration and scope of the preservation by the debtor of the right to pursue claims against a creditor in the future. On the flip side, creditors looking for certainty should insist that any stipulation resolving a claim contains release language (most likely in the context of mutual releases) that expressly includes avoidance claims.