In re KB Toys Inc, et al.

No. 13-1197, November 15, 2013, United States Court of Appeals for the Third Circuit
A trade claim that is subject to disallowance under § 502(d) of the Bankruptcy Code in the hands of the original claimant is similarly disallowable in the hands of a subsequent transferee (such as a claims buyer). The language of § 502(d) states that “any claim of any entity” who received an avoidable transfer shall be disallowed. Thus, the statute operates to render a category of claims disallowable—those that belonged to an entity who had received an avoidable transfer. Because the statute focuses on claims—and not claimants—claims that are disallowable under § 502(d) must be disallowed no matter who holds them. If the original claimant could transfer the claim for value to a transferee, the original claimant would receive value for a claim that would otherwise be disallowed and the transferee, who would receive the claim “washed” of its disability, could then share in the distribution of estate assets. In short, the original claimant would have an incentive to sell its claim—so it could receive some value for an otherwise valueless claim—and the transferee would have an incentive to buy the claim—because once the claim is in its hands, the claim is eligible to receive a distribution. Allowing such a result would negatively impact the other creditors in two ways. First, because the original claimant has not returned the avoidable transfer, the estate has less money and the other creditors would receive smaller amounts from the estate because it would not include the unreturned preference payment or conveyance. Second, the estate would pay on a claim that would have been otherwise disallowed. Interpreting § 502(d) to permit this type of “claim washing” would undermine the aim of § 502(d). Because claims traders are sophisticated and they choose to voluntarily take part in the risky bankruptcy claims trading process, it is only fair to require them to bear the risk that the original claimant will not return an avoidable transfer. In addition, claim purchasers are in a position to mitigate risk particular to bankruptcy, as demonstrated in their agreements, and it is evident that ASM was aware that disallowance could potentially attach to, and travel with, the claims. Thus, ASM’s conduct when negotiating and entering into the agreements with the original claimants is consistent with the Court of Appeals' interpretation of § 502(d). Finally, the Court of Appeals rejected ASM's argument that the claims should not be disallowed because it purchased its claims in “good faith” and is therefore entitled to the protections of a good faith purchaser under 11 U.S.C. § 550(b). In short, because § 502(d) permits the disallowance of a claim that was originally owned by a person or entity who received a voidable preference that remains unreturned, 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.
Procedural context:
Decision of the Bankruptcy Court for the District of Delaware, appealed to the District of Delaware, then appealed to the Third Circuit Court of Appeals.
On July 31, 2009, the Residual Trustee of the KBTI Trust (the "Trustee") filed an objection (the "Objection") with the Bankruptcy Court pursuant to § 502(d) of the Bankruptcy Code seeking the disallowance of certain claims that had been assigned to ASM Capital, L.P. and and ASM Capital II, LLP (collectively, “ASM”), a claims traders. The Trustee did not allege that ASM itself received avoidable transfers. Instead, the Trustee contended that the claims are disallowable under § 502(d) because each original claimant received a preference before transferring its claim to ASM.
Argued before Judges Chagares, Vanaskie and Shwartz. Opinion by Judge Shwartz

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