Inequitable Subordination?

To conclude that transferred claims remain subject to subordination, the court stands on the basic legal principle that an assignee steps into the shoes of the assignor for determination of rights and obligations. The court supports this legal rationale by focusing on policy concerns, namely efficiency. Unfortunately, this approach is deeply flawed as it applies to this particular context.

The court expressed concern that a transferee would enjoy greater rights than the transferor unless the claim remains subject to subordination, thereby violating the traditional rule that an assignee steps into the shoes of the assignor. Contrary to the court's statement, however, if the court refused to subordinate transferred claims, the transferee would not receive any greater rights than the transferor possessed. Rather, the rights associated with the claim at the time of the transfer remain the same ' the claim remains subject to equitable subordination if the claimholder engaged in inequitable conduct. The transferee's claim would still be subject to equitable subordination if that particular transferee engaged in inequitable conduct.

100-Year-Old Case

As authority for the court's conclusion that transferees' claims remain subject to equitable subordination, the court looks to the 100-year-old case of Shropshire, Woodlife & Co. v. Bush, 204 U.S. 186 (1907). In that case, the court found that a claim for wages, voluntarily assigned prepetition, remained entitled to the wage priority. The court determined that the statutory priority attached to the claim as the debt was incurred by the wage-earner, and the right to priority did not depend on whether that wage-earner was the actual party asserting the claim. On the petition date, the assignee held a claim for wages and was thus entitled to priority.

This authority has limited utility, however, in the context of equitable subordination of transferred claims. Shropshire stands for the proposition that the assignment of a claim does not eliminate statutory characteristics already associated with a particular claim at the time of the transfer. For example, if a court equitably subordinated a claim before the creditor assigned that claim, Shropshire would require the claim to remain subordinated in the hands of the assignee because the legal characteristic of subordination had already been associated with that claim. In other words, characteristics presently associated with the claim at the time of the transfer necessarily pass into the hands of the assignee. The case does not stand for the principle that a court may retroactively associate characteristics or status with a claim and then find that those retroactively associated rights traveled to the assignee.

The only characteristics associated with the claims in Enron at the time of the transfer ensured that, if the holder engaged in inequitable conduct, the claim was subject to subordination. This characteristic passed along to the assignee; if the assignee engaged in inequitable conduct, the claim held by the assignee could be subordinated. Therefore, as the court described at length, the transferee steps into the shoes of the transferor at the time of the transfer; however, nothing in the law governing assignments would require the transferee to stay in the transferor's shoes interminably. Allegations of wrongdoing against the transferor asserted after the time of the transfer, which are personal to that transferor, simply have no bearing on a previously transferred claim, and the court erred by retroactively associating those allegations with the previously transferred claim.

The Court's Rationale

The court's primary policy rationale for subordinating claims in the transferee's hands appears to be that requiring the debtor to rely on traditional litigation methods to recover damages from the inequitable transferor, rather than subordinating the claim in the transferee's hands, could delay or dilute the distribution to other creditors. If the court could not subordinate the claim in the transferee's hands, the debtor would be required to recover any damages to the estate caused by the transferor through other, supposedly more protracted means.

The court's assumption that equitable subordination of the transferee's claim will always be more efficient than other remedies against the wrongful actor is questionable. The two proceedings would likely involve the same lengthy discovery and factual determination to reveal the allegedly inequitable conduct. Furthermore, because the court can subordinate claims only to the extent the estate was harmed, the court will be required to make precisely the same calculation of damages.

In fact, the equitable subordination proceedings may turn out to be far more complicated than straightforward litigation between debtor and the alleged wrongdoer. If the claim transferee is required to litigate on behalf of the transferor whether that transferor engaged in inequitable conduct, any litigation would quickly spiral into a complicated multiparty dispute. As the Enron court itself witnessed in the litigation still pending before it, the additional parties and their individual defenses, claims, and contribution or indemnification agreements could delay any resolution far longer than the alternative litigation involving only two parties ' the debtor and the alleged wrongdoer. This dubious efficiency rationale simply cannot outweigh as a matter of equity the harm wrought on a claim transferee whose claim is suddenly subject to subordination despite the absence of any allegation of misconduct, or even knowledge of misconduct, by that transferee.

Indemnification Agreements

Perhaps the most troubling aspect of the Enron opinion, however, is the court's reliance on indemnification agreements in place between some of the parties to justify subordinating transferred claims. Even where the court notes that indemnification agreements may not be available for certain holders of distressed debt, the court leaves to the market the issue of how to value such debt. Unfortunately, without indemnification, this type of debt is now virtually impossible to value considering the debtor can seek to subordinate such claims long after the information available at the time of the sale has become obsolete. Even in standard distress assignments, where indemnification agreements remain common, the drastic increase in post-transfer exposure may have unforeseeable effects on valuation. Without the slightest ability to assess the potential risk of future subordination for each individual investment, especially with respect to non-insider transferors, the cost of such risk must assumedly be spread across the entire market, causing significant devaluation of all claims.

Conclusion

The Enron court's opinion unfortunately creates more problems than it resolves. Hopefully, this opinion does not represent a harbinger of decisions to come in the remaining counts of the complaint against the claims transferees. If the court is willing to violate ' 502(d) by disallowing claims transferred post-petition by parties that received avoidable transfers from the debtors, claims traders should expect a turbulent market ahead.

In an article in last month's issue, we questioned the desirability of equitably subordinating or disallowing claims transferred post-petition, and explored the implications that a decision pending in the Enron bankruptcy court might have on distressed debt markets. Now, in an expansively reasoned opinion, the Enron court partially answered those questions. The court denied a motion to dismiss certain counts seeking to equitably subordinate certain bank claims in the hands of post-petition assignees on the basis of allegedly inequitable prepetition conduct engaged in by Enron's pre-petition lenders.

Alarming Decision

The Enron court's decision is alarming not only because the court wrongly finds that claims transferred post-petition may be subordinated based on the transferor's pre-petition conduct, but also because the decision may foreshadow the court's position on Enron's related allegations still under advisement in the adversary proceeding ' that claims transferred post-petition remain subject to disallowance under ' 502(d) in the hands of the transferee as a result of avoidable pre-petition transfers made to the transferor. Disallowing and subordinating claims transferred post-petition on the basis of the transferor's pre-petition conduct could create vast uncertainties and incalculable risk in distressed debt markets. This article describes some of the flawed reasoning underlying the court's opinion that could lead to disturbances in the market.

To conclude that transferred claims remain subject to subordination, the court stands on the basic legal principle that an assignee steps into the shoes of the assignor for determination of rights and obligations. The court supports this legal rationale by focusing on policy concerns, namely efficiency. Unfortunately, this approach is deeply flawed as it applies to this particular context.

The court expressed concern that a transferee would enjoy greater rights than the transferor unless the claim remains subject to subordination, thereby violating the traditional rule that an assignee steps into the shoes of the assignor. Contrary to the court's statement, however, if the court refused to subordinate transferred claims, the transferee would not receive any greater rights than the transferor possessed. Rather, the rights associated with the claim at the time of the transfer remain the same ' the claim remains subject to equitable subordination if the claimholder engaged in inequitable conduct. The transferee's claim would still be subject to equitable subordination if that particular transferee engaged in inequitable conduct.

100-Year-Old Case

As authority for the court's conclusion that transferees' claims remain subject to equitable subordination, the court looks to the 100-year-old case of Shropshire, Woodlife & Co. v. Bush , 204 U.S. 186 (1907). In that case, the court found that a claim for wages, voluntarily assigned prepetition, remained entitled to the wage priority. The court determined that the statutory priority attached to the claim as the debt was incurred by the wage-earner, and the right to priority did not depend on whether that wage-earner was the actual party asserting the claim. On the petition date, the assignee held a claim for wages and was thus entitled to priority.

This authority has limited utility, however, in the context of equitable subordination of transferred claims. Shropshire stands for the proposition that the assignment of a claim does not eliminate statutory characteristics already associated with a particular claim at the time of the transfer. For example, if a court equitably subordinated a claim before the creditor assigned that claim, Shropshire would require the claim to remain subordinated in the hands of the assignee because the legal characteristic of subordination had already been associated with that claim. In other words, characteristics presently associated with the claim at the time of the transfer necessarily pass into the hands of the assignee. The case does not stand for the principle that a court may retroactively associate characteristics or status with a claim and then find that those retroactively associated rights traveled to the assignee.

The only characteristics associated with the claims in Enron at the time of the transfer ensured that, if the holder engaged in inequitable conduct, the claim was subject to subordination. This characteristic passed along to the assignee; if the assignee engaged in inequitable conduct, the claim held by the assignee could be subordinated. Therefore, as the court described at length, the transferee steps into the shoes of the transferor at the time of the transfer; however, nothing in the law governing assignments would require the transferee to stay in the transferor's shoes interminably. Allegations of wrongdoing against the transferor asserted after the time of the transfer, which are personal to that transferor, simply have no bearing on a previously transferred claim, and the court erred by retroactively associating those allegations with the previously transferred claim.

The Court's Rationale

The court's primary policy rationale for subordinating claims in the transferee's hands appears to be that requiring the debtor to rely on traditional litigation methods to recover damages from the inequitable transferor, rather than subordinating the claim in the transferee's hands, could delay or dilute the distribution to other creditors. If the court could not subordinate the claim in the transferee's hands, the debtor would be required to recover any damages to the estate caused by the transferor through other, supposedly more protracted means.

The court's assumption that equitable subordination of the transferee's claim will always be more efficient than other remedies against the wrongful actor is questionable. The two proceedings would likely involve the same lengthy discovery and factual determination to reveal the allegedly inequitable conduct. Furthermore, because the court can subordinate claims only to the extent the estate was harmed, the court will be required to make precisely the same calculation of damages.

In fact, the equitable subordination proceedings may turn out to be far more complicated than straightforward litigation between debtor and the alleged wrongdoer. If the claim transferee is required to litigate on behalf of the transferor whether that transferor engaged in inequitable conduct, any litigation would quickly spiral into a complicated multiparty dispute. As the Enron court itself witnessed in the litigation still pending before it, the additional parties and their individual defenses, claims, and contribution or indemnification agreements could delay any resolution far longer than the alternative litigation involving only two parties ' the debtor and the alleged wrongdoer. This dubious efficiency rationale simply cannot outweigh as a matter of equity the harm wrought on a claim transferee whose claim is suddenly subject to subordination despite the absence of any allegation of misconduct, or even knowledge of misconduct, by that transferee.

Indemnification Agreements

Perhaps the most troubling aspect of the Enron opinion, however, is the court's reliance on indemnification agreements in place between some of the parties to justify subordinating transferred claims. Even where the court notes that indemnification agreements may not be available for certain holders of distressed debt, the court leaves to the market the issue of how to value such debt. Unfortunately, without indemnification, this type of debt is now virtually impossible to value considering the debtor can seek to subordinate such claims long after the information available at the time of the sale has become obsolete. Even in standard distress assignments, where indemnification agreements remain common, the drastic increase in post-transfer exposure may have unforeseeable effects on valuation. Without the slightest ability to assess the potential risk of future subordination for each individual investment, especially with respect to non-insider transferors, the cost of such risk must assumedly be spread across the entire market, causing significant devaluation of all claims.

Conclusion

The Enron court's opinion unfortunately creates more problems than it resolves. Hopefully, this opinion does not represent a harbinger of decisions to come in the remaining counts of the complaint against the claims transferees. If the court is willing to violate ' 502(d) by disallowing claims transferred post-petition by parties that received avoidable transfers from the debtors, claims traders should expect a turbulent market ahead.