Enron Court Says Transferred Claims Remain Tainted

However, like Lady Macbeth, whose washing was in vain, the ability to purchase a claim in good faith from the initial creditor does not protect the subsequent owner of the claim from attack based on the actions or wrongdoings of the initial creditor/transferee, whether or not related to the claim itself. Thus, two recent decisions by the Bankruptcy Court for the Southern District of New York ' Enron Corp. v. Avenue Special Situations Fund II, LP, Case No. 01-16034, Adv. Pro. No. 05-01029 (Bankr. S.D.N.Y. Nov. 17, 2005) (the Equitable Subordination Decision), and Enron Corp. v. Avenue Special Situations Fund II, LP, Case No. 01-16034, Adv. Pro. No. 05-01029 (Bankr. S.D.N.Y. Mar. 31, 2006) (the Claims Disallowance Decision) ' serve to reemphasize a maxim well known to those regularly involved in the distressed debt industry. Participants in the market for distressed claims must be aware of the inherent risks and uncertainties in dealing with post-petition debtors, and they must protect themselves accordingly. Those risks include the possibility that claims purchased by third parties may be either subordinated or disallowed by the bankruptcy court due to actions and omissions on the part of the original claimants prior to the transfer of the claims. These claims might still be subordinated or disallowed even if the third party transferee purchases the claims in good faith, for value, and without actual notice of any potential taint. As the court noted in the Equitable Subordination Decision, '[t]he purchase of a claim, itself, evidences the transferee's willingness to assume the risks attendant to a bankruptcy proceeding [and t]he risk that full recovery may not be available is a risk factor that must be assessed by a purchaser.' Slip Op. at 39. In short, and at the very least, third parties who purchase distressed claims for value would be wise to ensure that the sellers have warranted that the claims are free and clear of encumbrance, and have indemnified the purchaser against subordination, disallowance, reduction or expungement of the claims.

Case Study

Both of the decisions discussed in this article, the Claims Disallowance Decision and the Equitable Subor-dination Decision, deal with the same set of underlying facts and arise out of the same adversary proceeding associated with the Enron Chapter 11 cases, currently pending in the Southern District of New York.

Facts

Prior to filing for Chapter 11 relief in December of 2001, Enron Corporation and certain of its affiliated entities (together, Enron or the Debtors) entered into a $1.75 billion short term revolving credit facility, as well as a $1.25 billion long term revolving credit facility with certain banks. As one of the banks participating in the short-term facility, Fleet National Bank (Fleet) loaned Enron approximately $54 million. Subsequently, and during the pendency of the bankruptcy, Fleet filed claims for this debt against the Debtors' estate (the Claims). Fleet ultimately sold the Claims to a group of six banks (together, the Defendants).

On Sept. 23, 2003, after Fleet had sold the Claims to the Defendants, Enron commenced an adversary proceeding against Fleet, alleging that Fleet had received partial repayments in the form of two prepaid forward transactions, and that these repayments constituted preference or fraudulent payments.

Subsequently, on Jan. 12, 2005, Enron commenced an adversary proceeding against the Defendants, seeking to disallow the Claims originally held by Fleet but subsequently transferred to the Defendants. Enron sought relief based on two causes of action. The first cause of action was based on equitable subordination under ' 510(c) of the Bankruptcy Code, which reads in relevant part, that a court may, after notice and a hearing, 'under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim ' '

The second cause of action was based on the disallowance of claims under ' 502(d) of the Bankruptcy Code, which reads in relevant part, that a court 'shall disallow any claim of any entity from which property is recoverable under ' 542, 543, 550, or 553 of this title or that is a transferee of a transfer avoidable under ' 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 ' ' The Defendants filed a motion to dismiss the causes of action for failure to state a claim. In two separate opinions, each addressing one of Enron's causes of action, the court denied the Defendants' motion.

Central to the court's holdings with respect to both causes of action is the premise that '[t]he purchase of the claims in a bankruptcy proceeding should not grant a transferee any greater rights than the transferor had. The risks inherent in bankruptcy proceedings are merely shifted to another who stands in the shoes of the original or previous claimant.' Equitable Subordination Decision, Slip Op. at 31.

Equitable Subordination

In its decision addressing Enron's cause of action grounded in the principles of equitable subordination, the court actually decided three issues. First, the court determined that it had authority to subordinate the Claims based on ' 510(c) of the Bankruptcy Code, even though the Claims themselves did not arise from any misconduct. Equitable subordination would be warranted, the court found, if a fact-finder concluded that the original claimants had engaged in inequitable conduct that disadvantaged other members of their creditor class, regardless of whether that conduct gave rise to the Claims themselves. The court reasoned that limiting subordination only to those claims directly related to injurious conduct would limit the remedy available through ' 510(c), would be inconsistent with the principles of equitable subordination, and would confer an unfair advantage on claimants who had engaged in misconduct at the expense of other members of the creditor class.

The court then determined that claims subject to subordination in the hands of the original claimant would also be subject to subordination ' to the same extent ' in the hands of a transferee. The court concluded that because the plain language of ' 510(c) deals with 'claims' and not 'claimants,' the equitable relief available under that section follows the claims themselves. Not only does this reading of ' 510(c) comport with the text of the statute, the court reasoned, but it also advances the policy rationales underlying the statute and the Bankruptcy Code as a whole, although it penalizes innocent third parties who have not engaged in any misconduct.

In arriving at this rule, the court examined the potential harm to other members of the injured creditor class an opposite rule would allow for. If a tainted claim subject to equitable subordination could be 'washed' free of the taint simply by transferring it to a third party, it would reward those creditors who engaged in inequitable behavior at the expense of the remainder of the creditor class. Under the court's rule, such 'claim washing' would be impossible because the claim would still remain subject to subordination no matter how many times it changed hands. This rule places the risk that a claim will be subordinated squarely on the transferee. Such a rule is desirable, the court concluded, because distressed claims traders are or should be aware of the risk of subordination, and can act accordingly to insulate themselves from that risk ' through entering into indemnity agreements and conducting due diligence.

Finally, the court determined that the 'good faith' defense under ' 550(b) of the Bankruptcy Code could not be asserted by the Defendants here (' 550(b) reads in relevant part that '[t]he trustee may not recover ' from: 1) a transferee that takes for value, including satisfaction or securing of a present or antecedent debt, in good faith, and without knowledge of the voidability of the transfer avoided; or 2) any immediate or mediate good faith transferee of such transferee.' The Defendants contended that here, they acted in good faith and paid fair value for the purchase of the Claim; they did not engage in any misconduct, nor did they have any knowledge that the Claims were subject to subordination. The court held the 'good faith' defense inapplicable here. The text of ' 550 does not refer to the transfer of claims equitably subordinated by ' 510(c), the court found. Further, even if the defense were applicable in principle in this situation, the Defendants would not qualify for it because 'a purchaser of a claim, by definition, knows that it is purchasing a claim against a debtor and is on notice that any defense or right of the debtor, including equitable subordination, may be asserted against the claim.' Equitable Subordination Decision, Slip Op. at 48. In other words, the Defendants had implied notice of the Claims' (presumably potential) taint, so they cannot be considered good faith purchasers.

In summary, the court concluded that: 1) equitable subordination was an appropriate remedy; 2) the remedy traveled with the claim itself; and 3) the Defendants were on notice and so could not exercise the 'good faith' defense.

Disallowance

Employing a substantially similar analysis to the one it used in dealing with the issue of equitable subordination, the court also concluded the Claims were subject to disallowance under ' 502(d), even though they had been transferred to third parties. The court found that the identity of the holder of the Claims was irrelevant when the estate takes action against the Claims under ' 502(d). Because the Claims would have been subject to disallowance in the hands of Fleet, due to the fact that Fleet allegedly received a preferential or fraudulent transfer, the Claims are still subject to disallowance in the hands of the Defendants unless or until the estate recoups the preferential or fraudulent transfer from Fleet.

Notably, the court found that the Claims were still subject to disallowance even though the underlying avoidance action had not yet been adjudicated. In other words, although it had yet to determine whether the alleged preferential or fraudulent payments made to Fleet should be recouped to the estate, the court still found that the Debtors' second cause of action should survive the motion to dismiss, because the Debtors' estate could potentially use ' 502(d) as a defense to the Defendants' Claims. However, the court did note that a final determination on the ' 502(d) disallowance cause of action would not be reached until there is a judicial determination as to the merits underlying the avoidance action.

Conclusions and Observations

These recent decisions serve as a stark reminder that claims traders and others who deal in the distressed debt market must be aware of the risks attendant to that occupation. The court here was particularly unsympathetic to arguments put forward by the Defendants with respect to their concern for the liquidity of the distressed debt market, and that as innocent third parties, the Defendants should not be penalized for the actions of the original claim holders ' actions they did not know about at the time they purchased the Claims. The court observed that, 'one should not lose sight of the fact that the claims trading market is not a fundamental part of the bankruptcy process, its policies, historical roots, or purpose. It is presumably a very active 'high risks' and 'rewards' market[. ]Even if the Defendants are correct that [this decision] will have a negative impact on the claim-transfer market, it is an issue for Congress.' Claims Disallowance Decision, Slip Op. at 41.

The court's decision, however, reflects a judicial policy that shifts the risk and burden of recovery onto the claims' purchaser. Someone needs to be responsible for suing and recovering against the initial creditor/transferee for its alleged wrongdoing against the estate. In lieu of having the estate bring the action (as the rightful aggrieved party), these decisions potentially shift the litigation outside of the bankruptcy court into a dispute as between the claims buyer and seller ' even though the underlying factual and legal dispute is one between the debtor and the initial creditor. These decisions also underscore that the recovery risk reaches conduct beyond the purchased 'claim.' A claims purchaser is subject to subordination or disallowance of an otherwise valid 'claim' because of the conduct of the 'claimant' 'which conduct may be wholly unrelated to the claim's validity. Until Congress takes up the issue, claims traders are advised to exercise extreme caution with respect to their activities in this market, and not to rely upon the courts for protections they can secure themselves through private agreements. These indemnities and representations required, in turn, must touch broadly upon all of the relationships and conduct between the selling creditor and the debtor, and not simply that the purchased 'claim' is valid and enforceable.

Adam C. Rogoff, a member of this newsletter's Board of Editors, is a Partner in the Bankruptcy & Restructuring Department of Kronish Lieb Weiner & Hellman LLP. His practice focuses on the representation of a wide variety of corporate debtors, creditors (including DIP lenders), and other parties in Chapter 11 restructurings and out-of-court workouts. Rogoff concentrates on complex transactional, litigation and restructuring advisory work. Noah Falk is an associate in the same department.

Here's the smell of the blood still: all the perfumes of Arabia will not sweeten this little hand. Oh, oh, oh!

William Shakespeare, Macbeth, Act V, Scene 1

There are those who believe that 'good faith' can cleanse all sins, even those of another. It is not unusual that, in certain areas of law, an interceding buyer in good faith can cut off legal rights by a third party. For example, it is well settled that a bona fide purchaser ' one who purchases in good faith, for value, without notice of any infirmity with respect to the purchase ' is shielded from a variety of adverse claims that might attach to his purchase. For example, in the area of securities law, the bona fide purchaser of a securities instrument takes that instrument without being subject to the defense that the instrument had been previously transferred to a third person. Similarly, if the instrument has been stolen and the bona fide purchaser acquires the instrument in good faith, for value, without notice of the instrument's purloined status, the purchaser acquires good title to the instrument even as against the true owner. See 15A Am Jur 2d Commercial Code ' 97 (2006).

However, like Lady Macbeth, whose washing was in vain, the ability to purchase a claim in good faith from the initial creditor does not protect the subsequent owner of the claim from attack based on the actions or wrongdoings of the initial creditor/transferee, whether or not related to the claim itself. Thus, two recent decisions by the Bankruptcy Court for the Southern District of New York ' Enron Corp. v. Avenue Special Situations Fund II, LP, Case No. 01-16034, Adv. Pro. No. 05-01029 (Bankr. S.D.N.Y. Nov. 17, 2005) (the Equitable Subordination Decision), and Enron Corp. v. Avenue Special Situations Fund II, LP, Case No. 01-16034, Adv. Pro. No. 05-01029 (Bankr. S.D.N.Y. Mar. 31, 2006) (the Claims Disallowance Decision) ' serve to reemphasize a maxim well known to those regularly involved in the distressed debt industry. Participants in the market for distressed claims must be aware of the inherent risks and uncertainties in dealing with post-petition debtors, and they must protect themselves accordingly. Those risks include the possibility that claims purchased by third parties may be either subordinated or disallowed by the bankruptcy court due to actions and omissions on the part of the original claimants prior to the transfer of the claims. These claims might still be subordinated or disallowed even if the third party transferee purchases the claims in good faith, for value, and without actual notice of any potential taint. As the court noted in the Equitable Subordination Decision, '[t]he purchase of a claim, itself, evidences the transferee's willingness to assume the risks attendant to a bankruptcy proceeding [and t]he risk that full recovery may not be available is a risk factor that must be assessed by a purchaser.' Slip Op. at 39. In short, and at the very least, third parties who purchase distressed claims for value would be wise to ensure that the sellers have warranted that the claims are free and clear of encumbrance, and have indemnified the purchaser against subordination, disallowance, reduction or expungement of the claims.

Case Study

Both of the decisions discussed in this article, the Claims Disallowance Decision and the Equitable Subor-dination Decision, deal with the same set of underlying facts and arise out of the same adversary proceeding associated with the Enron Chapter 11 cases, currently pending in the Southern District of New York.

Facts

Prior to filing for Chapter 11 relief in December of 2001, Enron Corporation and certain of its affiliated entities (together, Enron or the Debtors) entered into a $1.75 billion short term revolving credit facility, as well as a $1.25 billion long term revolving credit facility with certain banks. As one of the banks participating in the short-term facility, Fleet National Bank (Fleet) loaned Enron approximately $54 million. Subsequently, and during the pendency of the bankruptcy, Fleet filed claims for this debt against the Debtors' estate (the Claims). Fleet ultimately sold the Claims to a group of six banks (together, the Defendants).

On Sept. 23, 2003, after Fleet had sold the Claims to the Defendants, Enron commenced an adversary proceeding against Fleet, alleging that Fleet had received partial repayments in the form of two prepaid forward transactions, and that these repayments constituted preference or fraudulent payments.

Subsequently, on Jan. 12, 2005, Enron commenced an adversary proceeding against the Defendants, seeking to disallow the Claims originally held by Fleet but subsequently transferred to the Defendants. Enron sought relief based on two causes of action. The first cause of action was based on equitable subordination under ' 510(c) of the Bankruptcy Code, which reads in relevant part, that a court may, after notice and a hearing, 'under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim ' '

The second cause of action was based on the disallowance of claims under ' 502(d) of the Bankruptcy Code, which reads in relevant part, that a court 'shall disallow any claim of any entity from which property is recoverable under ' 542, 543, 550, or 553 of this title or that is a transferee of a transfer avoidable under ' 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 ' ' The Defendants filed a motion to dismiss the causes of action for failure to state a claim. In two separate opinions, each addressing one of Enron's causes of action, the court denied the Defendants' motion.

Central to the court's holdings with respect to both causes of action is the premise that '[t]he purchase of the claims in a bankruptcy proceeding should not grant a transferee any greater rights than the transferor had. The risks inherent in bankruptcy proceedings are merely shifted to another who stands in the shoes of the original or previous claimant.' Equitable Subordination Decision, Slip Op. at 31.

Equitable Subordination

In its decision addressing Enron's cause of action grounded in the principles of equitable subordination, the court actually decided three issues. First, the court determined that it had authority to subordinate the Claims based on ' 510(c) of the Bankruptcy Code, even though the Claims themselves did not arise from any misconduct. Equitable subordination would be warranted, the court found, if a fact-finder concluded that the original claimants had engaged in inequitable conduct that disadvantaged other members of their creditor class, regardless of whether that conduct gave rise to the Claims themselves. The court reasoned that limiting subordination only to those claims directly related to injurious conduct would limit the remedy available through ' 510(c), would be inconsistent with the principles of equitable subordination, and would confer an unfair advantage on claimants who had engaged in misconduct at the expense of other members of the creditor class.

The court then determined that claims subject to subordination in the hands of the original claimant would also be subject to subordination ' to the same extent ' in the hands of a transferee. The court concluded that because the plain language of ' 510(c) deals with 'claims' and not 'claimants,' the equitable relief available under that section follows the claims themselves. Not only does this reading of ' 510(c) comport with the text of the statute, the court reasoned, but it also advances the policy rationales underlying the statute and the Bankruptcy Code as a whole, although it penalizes innocent third parties who have not engaged in any misconduct.

In arriving at this rule, the court examined the potential harm to other members of the injured creditor class an opposite rule would allow for. If a tainted claim subject to equitable subordination could be 'washed' free of the taint simply by transferring it to a third party, it would reward those creditors who engaged in inequitable behavior at the expense of the remainder of the creditor class. Under the court's rule, such 'claim washing' would be impossible because the claim would still remain subject to subordination no matter how many times it changed hands. This rule places the risk that a claim will be subordinated squarely on the transferee. Such a rule is desirable, the court concluded, because distressed claims traders are or should be aware of the risk of subordination, and can act accordingly to insulate themselves from that risk ' through entering into indemnity agreements and conducting due diligence.

Finally, the court determined that the 'good faith' defense under ' 550(b) of the Bankruptcy Code could not be asserted by the Defendants here (' 550(b) reads in relevant part that '[t]he trustee may not recover ' from: 1) a transferee that takes for value, including satisfaction or securing of a present or antecedent debt, in good faith, and without knowledge of the voidability of the transfer avoided; or 2) any immediate or mediate good faith transferee of such transferee.' The Defendants contended that here, they acted in good faith and paid fair value for the purchase of the Claim; they did not engage in any misconduct, nor did they have any knowledge that the Claims were subject to subordination. The court held the 'good faith' defense inapplicable here. The text of ' 550 does not refer to the transfer of claims equitably subordinated by ' 510(c), the court found. Further, even if the defense were applicable in principle in this situation, the Defendants would not qualify for it because 'a purchaser of a claim, by definition, knows that it is purchasing a claim against a debtor and is on notice that any defense or right of the debtor, including equitable subordination, may be asserted against the claim.' Equitable Subordination Decision, Slip Op. at 48. In other words, the Defendants had implied notice of the Claims' (presumably potential) taint, so they cannot be considered good faith purchasers.

In summary, the court concluded that: 1) equitable subordination was an appropriate remedy; 2) the remedy traveled with the claim itself; and 3) the Defendants were on notice and so could not exercise the 'good faith' defense.

Disallowance

Employing a substantially similar analysis to the one it used in dealing with the issue of equitable subordination, the court also concluded the Claims were subject to disallowance under ' 502(d), even though they had been transferred to third parties. The court found that the identity of the holder of the Claims was irrelevant when the estate takes action against the Claims under ' 502(d). Because the Claims would have been subject to disallowance in the hands of Fleet, due to the fact that Fleet allegedly received a preferential or fraudulent transfer, the Claims are still subject to disallowance in the hands of the Defendants unless or until the estate recoups the preferential or fraudulent transfer from Fleet.

Notably, the court found that the Claims were still subject to disallowance even though the underlying avoidance action had not yet been adjudicated. In other words, although it had yet to determine whether the alleged preferential or fraudulent payments made to Fleet should be recouped to the estate, the court still found that the Debtors' second cause of action should survive the motion to dismiss, because the Debtors' estate could potentially use ' 502(d) as a defense to the Defendants' Claims. However, the court did note that a final determination on the ' 502(d) disallowance cause of action would not be reached until there is a judicial determination as to the merits underlying the avoidance action.

Conclusions and Observations

These recent decisions serve as a stark reminder that claims traders and others who deal in the distressed debt market must be aware of the risks attendant to that occupation. The court here was particularly unsympathetic to arguments put forward by the Defendants with respect to their concern for the liquidity of the distressed debt market, and that as innocent third parties, the Defendants should not be penalized for the actions of the original claim holders ' actions they did not know about at the time they purchased the Claims. The court observed that, 'one should not lose sight of the fact that the claims trading market is not a fundamental part of the bankruptcy process, its policies, historical roots, or purpose. It is presumably a very active 'high risks' and 'rewards' market[. ]Even if the Defendants are correct that [this decision] will have a negative impact on the claim-transfer market, it is an issue for Congress.' Claims Disallowance Decision, Slip Op. at 41.

The court's decision, however, reflects a judicial policy that shifts the risk and burden of recovery onto the claims' purchaser. Someone needs to be responsible for suing and recovering against the initial creditor/transferee for its alleged wrongdoing against the estate. In lieu of having the estate bring the action (as the rightful aggrieved party), these decisions potentially shift the litigation outside of the bankruptcy court into a dispute as between the claims buyer and seller ' even though the underlying factual and legal dispute is one between the debtor and the initial creditor. These decisions also underscore that the recovery risk reaches conduct beyond the purchased 'claim.' A claims purchaser is subject to subordination or disallowance of an otherwise valid 'claim' because of the conduct of the 'claimant' 'which conduct may be wholly unrelated to the claim's validity. Until Congress takes up the issue, claims traders are advised to exercise extreme caution with respect to their activities in this market, and not to rely upon the courts for protections they can secure themselves through private agreements. These indemnities and representations required, in turn, must touch broadly upon all of the relationships and conduct between the selling creditor and the debtor, and not simply that the purchased 'claim' is valid and enforceable.

Adam C. Rogoff, a member of this newsletter's Board of Editors, is a Partner in the Bankruptcy & Restructuring Department of Kronish Lieb Weiner & Hellman LLP. His practice focuses on the representation of a wide variety of corporate debtors, creditors (including DIP lenders), and other parties in Chapter 11 restructurings and out-of-court workouts. Rogoff concentrates on complex transactional, litigation and restructuring advisory work. Noah Falk is an associate in the same department.