Claims Trading in Bankruptcy Cases

October 15, 2008

By: Caroline C. Fuller

I. Introduction

“[C]laims trading remains a gray area in bankruptcy law that the court and Congress have left the parties to negotiate.”  ReGen I, Inc. v. UAl Corp., et al. (In re UAL Corp.), 635 F.3d 312, 323 (7th Cir. 2011).  Neither the Bankruptcy Code nor the Bankruptcy Rules regulates claims trading.  While Bankruptcy Rule 3001(e) defines procedures for claims trading, it is not intended to regulate the trading of claims.  Rule 3001(e) was amended in 1991 “to limit the court’s role to the adjudication of disputes regarding transfers of claims. . . .  This rule is not intended either to encourage or discourage postpetition transfers of claims or to affect any remedies otherwise available under nonbankruptcy law to a transferor or transferee such as for misrepresentation in connection with the transfer of a claim.”  Advisory Committee Note to 1991 Amendment to Rule 3001(e).  As a result, when improprieties in claims trading have been alleged, courts have looked to their equitable powers, and rights under applicable nonbankruptcy law, to determine the relative rights and responsibilities of the parties.   
II. Terms of Agreement
A. Terms of Assignment
1. Identification of Claims to be Assigned

Claims trading occurs with administrative claims (including 503(b)(9) claims), secured claims, priority claims, and unsecured claims.  The claims assignment documents should identify with particularity the claims to be assigned.

2. Consideration

Typically, if there is a known dispute as to the allowed amount of a claim – such as the assignor has filed a proof of claim in an amount different than the amount reflected in the Debtor’s schedules – the buyer will purchase the claim based on the scheduled amount, with a true-up provision obligating the buyer to pay the same percentage purchase price to the extent the claim is ultimately allowed in an amount in excess of the scheduled amount.  Sometimes, the purchase obligation is optional, and if not exercised by the buyer, the assignor and buyer may each own a percentage interest in the ultimately allowed claim, with an obligation to account to the other for any excess payments received.

B. Representation and Warranties

The standard form of assignment may include one or more of the following representations and warranties: 

i. the assignor holds a liquidated, undisputed, non-contingent and enforceable claim against the debtor, with no known defenses or offsets thereto;
ii. All statements in any filed proof of claim are true and correct;
iii. No objections to allowance of the claim have been filed as of the date of the assignment;
iv. The assignment agreement has been duly authorized and executed by assignor;
v. The assignor has not previously assigned the claim (either outright or as security for a loan) and is the sole owner thereof with good title; 
vi. The assignor has not received any distribution from the debtor’s bankruptcy case as of the date of assignment;
vii. The assignor has not received a preferential transfer;
viii. The assignor is not insolvent or in bankruptcy;
ix. The assignor is not an insider of the debtor or a member of a creditors committee in the debtor’s bankruptcy case. 
b. Impact of Claims Dispute

The assignment forms typically grant the buyer the right to put the claim (or that portion of the claim that is subject to dispute)  back to the assignor if the claim is disputed, and the assignor must repurchase the claim (or portion thereof) at the purchase price paid, plus an agreed interest rate from the date of purchase.  These provisions vary from agreement to agreement, and may require a repurchase upon filing of a claims objection, upon resolution of the claims objection, or if the claims objection has not been satisfactorily resolved within a defined period of time.  The buyer can always choose not to elect to put the claim back, and defend the claims objection instead, with, perhaps, assignor being liable for the costs of defense incurred by buyer. 

Some assignment forms may obligate the assignor to immediately repay any preferential payment received, upon receipt of a demand from the debtor or trustee, under Sec. 547 of the Code, in order to avoid the disallowance of the claim assigned under Sec. 502(d). 
c. Right to Vote
The assignment typically provides that the buyer is entitled to vote the claim in connection with confirmation of any plan, and obligates the assignor to provide copies of all pleadings received,
d. Miscellaneous

The assignment will require the assignor to promptly turn over to the buyer any distributions received on account of the claim. 

The assignment may include indemnification obligations related to any breach of a representation or warranty, including fees and costs incurred by the buyer in defending against any claims objection. 

The assignment may include an acknowledgement that the buyer may have current access to, or may subsequently acquire, information that might be material to the assignor in connection with whether to make the decision to assign, and buyer has no liability to assignor in connection with any such information.

Attached to this Article are several samples of Claims Assignments used by parties that are in the business of purchasing claims in bankruptcy cases.

II. Rules and Procedures

Rule 3001(e) governs claims assignments.  If the claim is assigned before a proof of claim is filed, the assignee may simply file the proof of claim, with appropriate evidence of its ownership of claim.  If the claim is assigned after a proof of claim is filed, then the transferee files a notice of claim assignment, and the bankruptcy court clerk sends written notice to the transferor that a notice of assignment has been filed.  The transferor has 21 days to object to the assignment, failing which the assignee is substituted for the transferor as owner of the claim.   Rule 3001(e)(3) and (4) contain additional procedures if a claim has been transferred as security.  Attached are samples of notices of assignment. 

If only a portion of a claim is assigned, or only certain types of claims held by the assignor are to be transferred, the assignment documents filed with the Court should make it clear to all parties what claims, or portions of claims, are being assigned, and what portions are retained by the assignor. 

III. Issues in Interpretation of Claims Transfers

a. Is transfer an assignment or sale, and significance of difference

In what appears to be a unique decision in the Enron bankruptcy case, the bankruptcy court considered whether a claim assignee takes the claim free of, or subject to, the defenses against the claim in the hands of the assignor, including claims of equitable subordination or disallowance.  The bankruptcy court found that the claims transferee took the claims subject to all defenses that the debtor had to the claims in the hands of the transferor, including equitable subordination and disallowance under Sec. 502(d) of the Bankruptcy Code.  On appeal, the district court reversed.   In re Enron Corp., 379 B.R. 425 (S.D.N.Y. 2007). 

The district court conducted an extensive analysis of the types of defenses that might be raised to a particular claim, and whether those defenses were personal to the claims holder, or whether they should apply to the claim in the hands of any party.  In particular, the court held that a claim of equitable subordination, which is premised on the bad acts of the individual creditor, is personal, and does not follow the claim if it is sold to a third party without knowledge of the defense.  Similarly, the court held that disallowance under Section 502(d), which is premised on the receipt of an avoidable transfer, is also personal to the claim holder, and would not follow the claim if it were sold to a holder in due course.  The court noted that the defenses of equitable subordination and disallowance under Section 502(d) may not be fixed as of the petition date, at least in part because post-petition acts may give rise to these defenses.  Thus, these personal disabilities do not necessarily follow the claims as it changes hands, as the remedies are intended to be directed specifically to the creditor guilty of the bad acts. 

The court then analyzed the distinctions between the assignment of a claim, and the sale of a claim.  The court found that an assignee of a claim stands in the shows of the assignor and is subject to all equities against the assignor, because an assignee cannot take anything more, in assignment, than the assignor is capable of assigning.  In contrast, a claims purchaser who qualifies as a holder in due course, without notice or knowledge of the disabilities, does not stand in the shoes of the claims seller, and thus may in fact acquire a better claim than the seller had. 

The court justified this distinction by suggesting that claims purchases are frequently anonymous, and done without due diligence, while claims assignments are frequently heavily negotiated, including contractual provisions for indemnification against potential liability.  The court noted that the following factors may be considered in deciding whether a claim is an assignment or a sale:  (a) whether there is a fully negotiated contract containing representations, warranties, and other indemnities; (b) whether there is an anonymous seller and a purchaser who has no opportunity to conduct due diligence, or instead whether there are face-to-face negotiations and lots of due diligence; and (c) whether there is a potentially insolvent or financially troubled assignor.  The district court remanded to the bankruptcy court for consideration of these factors and determination of whether the transaction in question was an assignment or sale.  The dispute settled without issuance of any further decisions. 

In the litigation, Enron argued strenuously that the interests of the creditors of its estate would be significantly and adversely affected by loss of the ability to seek equitable subordination in the hands of a claim purchaser based on the bad acts of the seller.  It further argued that a claims seller, knowing that its claim was subject to equitable subordination, could cleanse the claim by selling it to an innocent purchaser, thereby profiting by its bad acts.  Amicus parties filed briefs, arguing equally strenuously that the market for claims would be adversely affected if claims in the hands of bona fide purchasers were subject to personal defenses such as equitable subordination, and disallowance premised on receipt of an avoidable transfer.  Ultimately, the court sided on preservation of a claims trading market.

At the end of the day, however, there can be no dispute that in limited circumstances, a bad faith transferor may be able to sell its claim to a bona fide purchaser for value, effectively ‘wash’ its claim in the hands of the purchaser, take the proceeds and run, to the detriment of other creditors.  However, 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.  Enron focuses on the harm that will come to the creditors as a result, but the law protects bona fide purchasers for value, and this context is no different.  This is a question of allocating the burden and risk of pursing the bad actor transferor between two groups of innocents:  the creditors as a whole or the transferee.  The Court finds that the balance struck by the foregoing legal analysis is fair:  the burden and risk is better carried by creditors as a whole in favor of the bona fide purchaser in the context of a sale, but better carried by the assignee in favor of the creditors in the context of an assignment, particularly given the ability of parties to an assignment to obtain indemnities and warranties. 

379 B.R. at 448.

Interestingly, the Enron decision suggests that claims purchasers may serve better in situations where they purchase claims with no representations and warranties, and without any due diligence, than they might if they negotiate for typical indemnifications, representations, and warranties, and conduct due diligence into potential defenses to the claims. 

The Enron analysis was followed by another district judge in New York in Longacre Master Fund, Ltd. V. ATS Automation Tooling Systems, Inc., 2011 WL 3423821 (S.D.N.Y. 2011).  There, Longacre, the claims purchaser, sued ATS, the claims seller, claiming impairment of the claims triggering a repurchase obligation on the part of ATS under the terms of their agreement, when Delphi, the debtor, objected to the claims assigned by ATS under Section 502(d), and sued ATS to recover preferential transfers, even though the claims objection was subsequently withdrawn.  On cross-motions to dismiss, the court dismissed all of Longacre’s claims, finding that, because the transaction was a sale, not an assignment, Longacre took the claims free of any defenses under Section 502(d), and thus the claims had not been impaired under the terms of the parties’ agreement.

In contrast, in unpublished decisions entered in the In re Ames Department Stores, Inc. bankruptcy case, the bankruptcy and district courts, without referencing the Enron decision, that a claims transferee took the claims subject to disallowance under Section 502(d).  In re Ames Department Stores, Inc., Case No. 0-42271 (Bankr. S.D. N.Y. Dec. 1, 2006); ASM Capital, L.P. v. Ames Department Stores, Inc., No. 1:07-cv-00219 (S.D. N.Y. Mar. 2, 2007).  There, the debtor sued and obtained a default judgment on account of preferential transfers received by the transferor, and then objected to the claim filed by the transferee.  The claim transferred was an administrative claim for goods sold post-petition, but the court found that Section 502(d) is broad enough to apply even to administrative claims.  Finding that it was highly unlikely that the debtor would ever collect on its default judgment, the court disallowed the transferred claim, unless the transferee satisfied the judgment against the transferor.  Neither court made any distinction between assignments and sales in its analysis.  On appeal to the Second Circuit, the court reversed the lower courts on whether Section 502(d) was applicable to administrative claims.  In re Ames Department Stores, Inc., 582 F.3d 422 (2d Cir. 2009).   Finding that administrative claims were not subject to disallowance based on the claimant’s receipt of an avoidable transfer, the circuit court was not required to address the issue of whether disallowance under Section 502(d) followed the claim upon assignment. 

The Enron court’s distinction between a sale and assignment may be appropriate for debt instruments that may be traded on public markets.  The distinction is far less likely to be meaningful in private markets, where whether a claim transfer is considered an assignment or a sale may depend on the language the claims purchaser has chosen to use in its conveyance documents.  It does not appear that the regular claims traders have modified their standard forms, which typically contain an amalgam of sale and assignment language, and contain standard representations and warranties, in response to the decision. 
b. Assignee’s entitlement to cure payments

If a claim assignment involves a claim arising under an unexpired lease or executory contract, and that lease or contract has not been assumed or rejected as of the date of the assignment, the parties should address which party is entitled to the cure payment upon assumption.  See UAL Corp., 635 F.3d 312, holding that a claims purchase agreement was sufficiently broad to include any cure payments.    The same claims purchaser also litigated the issue of whether it was entitled to payment on account of an allowed unsecured claim, even though the executory contract had been assumed and cured prior to the assignment of the claim.  ReGen I, Inc. v. Halperin (In re Wireless Data, Inc.), 547 F.3d 484 (2d Cir. 2006).  Not surprisingly, the circuit court refused to allow the general unsecured claim. 

Finally, in In re Delphi Corp., No. 05-44481 (Bankr. S.D.N.Y., Sept. 25, 2008), the bankruptcy court rejected a request by an ad hoc trade committee composed strictly of claims purchasers, who sought to impose procedures requiring that the debtor send cure notices and cure payments to claims purchasers, rather than the selling creditors. 

c. Contingent reimbursement rights

In In re M. Frabrikant & Sons, Inc., 385 B.R. 87 (Bankr. S.D.N.Y. 2008), the secured lenders sold their claims during the case, after entry of a final cash collateral order.  After the claims were sold, the creditors’ committee filed suit against the original lenders to avoid their liens.  Based on provisions of the cash collateral orders, the original lenders asserted administrative claims for their legal fees and costs in defending against the action.  The court found that the assignment of the secured lenders’ claims was broad enough to include rights of reimbursement, and thus denied the lenders’ requests.
IV. Designation of Votes

Section 1126(e) provides that, on request of a party in interest, and on notice and a hearing, the court may designate the vote of any entity whose acceptance or rejection of a plan was not in good faith, or was not solicited or procured in good faith.  A number of bankruptcy courts have considered whether the purchaser of claims against the debtor voted in good faith on the plan of reorganization, and whether its votes should be counted under the circumstances.

The duty of good faith does not impose a duty to vote in “selfless disinterest.”  Insinger Machine Co. v. Federal Support Co. (In re Federal Support Co.), 859 F.2d 17, 19 (4th Cir. 1988).  Instead, it is assumed that parties will act in their own self interest in a bankruptcy case.  Thus, the purchase of claims for the purpose of securing acceptance or rejection of a plan of reorganization is not per se bad faith.  In re Allegheny International, Inc., 118 B.R. 282, 289 (Bankr. W.D. Pa. 1990) ;  In re 255 Park Plaza Assocs. Ltd. P’ship, 100 F.3d 1214, 1219 (6th Cir. 1996).  Rather, votes should be designated when the creditor has cast its vote with the ‘ulterior purpose’ of gaining some advantage to which it would not otherwise be entitled in its position.  In re Gilbert, 104 B.R. 206, 216 (Bankr. W.D. Mo. 1989).  Where a vote is cast for an ulterior purpose, such as coercing payment to the creditor of more than it would otherwise be entitled, the creditor has not voted in good faith.  Insinger Machine, 859 F.2d at 19.  Impermissible ulterior motives may include pure malice, strikes, blackmail, and the purpose of destroying an enterprise in order to advance the interests of a competing business.  Id.  A split of authority exists as to whether or not good faith may be determined peremptorily, or only after the vote has actually been tendered.  In re Kovalchik, 175 B.R. 863, 875 (Bankr. E.D. Pa. 1994). 

The origin of vote designation is generally considered to date back to Texas Hotel Securities Corp. v. Waco Development Co., 87 F.2d 395 (5th Cir. 1936).  There, Conrad Hilton purchased claims against a debtor in order to block confirmation of a plan that would have resulted in the transfer of a leasehold interest in hotel property, previously owned by Hilton, to a third party.  By obtaining a blocking position, Hilton hoped to force confirmation of a competing plan that would reestablish his interest in the property.  While the district court disregarded Hilton’s vote, the Fifth Circuit reversed, finding that the district court lacked authority to scrutinize a creditor’s motives in voting on the plan.

The predecessor to Section 1126(e) was enacted in response to the Texas Hotel Securities case.  The Supreme Court, in Young v. Higbee, 324 U.S. 204, 211 (1945) held that the predecessor statute enabled the bankruptcy court to designate a creditor’s vote if the creditor voted “in the hope that someone would pay [the creditor] more than the ratable equivalent of [its] proportionate part of the bankrupt assets.”  Id. 

The most recent significant decision on this topic is DISH Network Corp. v. DBSD North America, Inc. (In re DBSD North America, Inc.), 634 F.3d 79 (2d. Cir. 2011).  There, the Second Circuit affirmed lower court rulings that the votes of a creditor which purchased claims in order to obtain a blocking position on the debtor’s plan should be designated and not counted.  DBSD was attempting to develop a mobile communications network.  DISH Network owned a significant stake in another entity that was in direct competition with DBSD.  After DBSD filed its plan and disclosure statement, DISH Network purchased all of the claims in a senior class of secured creditors at full face value, and then voted to reject the plan.  DISH Network simultaneously tried to negotiate a strategic transaction with DBSD in order to gain control of its operations.

The court engaged in a lengthy analysis of section 1126(e), noting that it should be employed sparingly, and that the party seeking to designate another’s vote has the burden of proving that the vote was not cast in good faith.  Based on the facts presented, the court found that the bankruptcy court had properly designated DISH Network’s votes. 

DISH, as an indirect competitor of DBSD and part-owner of a direct competitor, bought a blocking position in (and in fact the entirety of) a class of claims, after the plan had been proposed, with the intention not to maximize its return on the debt but to enter a strategic transaction with DBSD and ‘to use its status as a creditor to provide advantages over proposing a plan as an outsider, or making a traditional bid for the company or its assets. . . .’   In effect, DISH  purchased the claims as votes it could use as levers to bend the bankruptcy process toward its own strategic objective of acquiring DBSD’s spectrum rights, not toward protecting its claim.  . . .   DISH’s motive . . . is evidenced by DISH’s own admissions in court, by its position as a competitor to DBSD, by its willingness to overpay for the claims it bought, by its attempt to propose its own plan, and especially by its internal communications, which . . . showed a desire to ‘obtain a blocking position’ and ‘control the bankruptcy process for this potentially strategic asset.’

634 F.3d at 104-05. 

The other most frequently cited decision on designation of votes of a claims purchaser is Allegheny International, supra.  There, Japonica purchased sufficient claims in several classes to obtain blocking positions in those classes.  It sought to use its blocking power to defeat the debtor’s plan, and to obtain confirmation of its own competing plan, which would give it control of the debtor’s business.  The court found that Japonica paid disproportionately high prices for the claims of certain creditors, the claims were purchased “at the eleventh hour,” and Japonica’s competing plan was filed only after voting on the debtor’s plan had commenced.  Because the court found that Japonica acted with the ulterior motive of obtaining control over the debtor’s business, as opposed to furthering the legitimate interests of a creditor seeking fair treatment under a plan of reorganization, Japonica’s votes should not be counted. 

V. Equitable Subordination

Section 510(c) provides that a claim may be subordinated “under principles of equitable subordination.”  Generally, a claim may be subordinated if three tests are met:

i. the claimant engaged in some type of inequitable conduct, such as fraud, illegality or breach of fiduciary duties, undercapitalization, or use of the debtor as a mere instrumentality or alter ego;

ii. the misconduct must have resulted in injury to the creditors of the debtor or conferred an unfair advantage on the claimant;

iii. equitable subordination is not inconsistent with provisions of the Bankruptcy Code.

Benjamin v. Diamond (In re Mobile Steel), 563 F.2d 692, 700 (5th Cir. 1977).  In determining whether these conditions have been satisfied, courts should keep three principles in mind:  (a)  inequitable conduct may be sufficient to warrant subordination irrespective of whether it was related to the acquisition or assertion of the claim; (b) the claim should be subordinated only to the extent necessary to offset the harm which the debtor and its creditors suffered on account of the inequitable conduct; and (c) the dealings of fiduciaries with their corporation are subjected to rigorous scrutiny, and where any of their contracts or engagements is challenged, the burden is on the director or stockholder not only to prove the good faith of the transaction, but also to show its inherent fairness from the viewpoint of the corporation and its creditors.  Id.
The Seventh Circuit recently considered whether a secured claim purchased by an entity formed post-petition by two individual Chapter 7 debtors, should be equitably subordinated based on the alleged inequitable conduct of the individual debtors.   In re Kreisler, 546 F.3d 863 (7th Cir. 2008).   The bankruptcy court subordinated the claim, finding that the purchase of the secured debt was part of an “elaborate scheme” for the debtors to receive proceeds from the sale of the secured creditor’s collateral to the exclusion of unsecured creditors.  The Court of Appeals reversed, finding that unsecured creditors were not harmed by the transaction.
In  In re Papercraft Corp., 187 B.R. 486 (Bankr. W.D. Pa. 1995) rev’d 211 B.R. 813 (W.D. Pa. 1997), the court considered whether claims purchased by an insider should be equitably subordinated.  The bankruptcy court adopted a per se rule that a claim purchased by an insider without full disclosure was a breach of fiduciary duty resulting in harm to the debtor and its creditors, and reduced the claim to the amount paid by the insider for it.  The district court rejected adoption of a per se rule requiring automatic subordination of any claim purchased by an insider without adequate disclosure, and remanded to the bankruptcy court for consideration of the appropriate remedies, including the extent of subordination.  The Third Circuit affirmed.  Citicorp Venture Capital, Ltd. V. Committee of Creditors Holding Unsecured Claims (In re Papercraft Corp., 160 F.3d 982 (3d Cir. 1998).  It held that, at a minimum, the insider should be deprived of the profit it made on the purchase of the claims.  Further subordination might be appropriate, but only if supported by “findings that justify the remedy chosen by reference to equitable principles.”  160 F.3d at 991.
On remand, the bankruptcy court found three kinds of economic harm caused by the insider’s secret claims trading:  (i) its breach of fiduciary duty caused a delay in plan confirmation resulting in quantifiable monetary harm to creditors; (ii) its breach created uncertainty over the amount of its claim distribution; and (iii) its breach increased professional fees in the case, to the detriment of creditors. As a result, the bankruptcy court ordered that the claim be subordinated so that its profit was eliminated, and so that nonselling creditors were compensated for lost interest, the reduction in amounts available to creditors by the increased administrative and professional fees, and by additional post-confirmation US Trustee fees the debtor was required to pay.   In re Papercraft Corp., 247 B.R. 625 (Bankr. W.D. Pa. 2000).  The bankruptcy court quantified the damages and the extent of subordination in a subsequent decision.  In re Papercraft Corp., 253 B.R. 385 (Bankr. W.D. Pa. 2000).  The appellate courts affirmed these findings.  In re Papercraft Corp., 323 F.3d 228 (3d Cir. 2003). 
In In re Olson, 191 B.R. 991 (Bankr. D. Minn. 1996), the estate owned a partnership interest in a shopping center; the debtors’ children were also partners.  The children also owned the management company which managed the shopping center.  After negotiations to buy the estate’s partnership interest failed, the management company purchased all of the unsecured claims against the debtors’ estate, with a face amount of approximately $525,000 for $67,000, and then moved to dismiss the bankruptcy case.  The court refused to dismiss the case, and ordered the clerk not to substitute the management company for the names of the original unsecured creditors on the claims register.    Subsequently, the trustee sold the estate’s remaining assets for approximately $455,000, resulting in funds available for distribution to unsecured creditors totaling $225,000.  The bankruptcy court found that the management company had special knowledge of the value of the assets, and that it had provided false, misleading, or incomplete information to the claims sellers.  The bankruptcy court approved the claims assignments only to the amount actually paid by the insider, leaving the selling creditors with the balance of the claims, and then subordinated the insider’s claim to the sellers’ retained claims, resulting in the insider receiving nothing.  The district court affirmed, but the Eight Circuit reversed, holding that, since no creditor objected to the claims assignment under Bankruptcy Rule 3001(e), the court was obligated, under Rule 3001(e)(2) to issue an order substituting the management company for the original claim owners.  Thus, there was no injury for the court to redress, and the Chapter 7 trustee had no standing to object on behalf of the creditors who had sold their claims.  In re Olson, 120 F.3d 98 (8th Cir. 1997). 

VI. Tax Considerations

Frequently, a valuable asset of a bankruptcy estate is its tax attributes, including net operating losses (“NOLs”).  Those losses may be carried back to offset prior income on which income taxes have been paid, generating income tax refunds, and may be carried forward to offset future income that might otherwise be taxable. 

Provisions of the Internal Revenue Code significantly limit the ability of a debtor to preserve its NOLs upon a change in ownership.  26 USC Sec. 382.  If, under a plan of reorganization, a debtor intends to issue its stock to creditors in full or partial satisfaction of their claims, that stock issuance may trigger a change in ownership resulting in the diminution, or complete loss, of NOLs. 

The Internal Revenue Code contains a narrow exception for changes in control that occur during a bankruptcy case.  In order to qualify for this exception, (i) shareholders and creditors of the company must end up owning at least 50% of the reorganized debtor’s stock (by vote and value); (ii) shareholders and creditors must receive their stock interest in discharge of their interest in and claims against the debtor; and (iii) stock received by creditors under a plan is counted toward the 50% test only if it is received in satisfaction of debt that (a) had been held by the creditor for at least 18 months prior to the bankruptcy filing; or (b) arose in the ordinary course of the debtor’s business and the same creditor has at all times held the beneficial interest in the claim.  26 USC Sec. 382(l)(5).  In addition, after confirmation of the plan, the debtor’s business must continue for at least two years, and, there must be no additional change of ownership in the same two-year period, or the reorganized debtor forfeits the benefits realized under Sec. 382(l)(5).

Where a debtor anticipates that its reorganization plan may result in the issuance of stock in the reorganized debtor in satisfaction of creditors’ claims, the debtor will want to closely monitor claims trading, so that the ability to preserve NOLs is not inadvertently lost.  Courts have held that NOLs are property of the estate; thus an act that would intentionally or inadvertently destroy the value of the NOLs would be in violation of the automatic stay.  In re Prudential Lines, Inc., 928 F.2d 565, 574 (2d Cir. 1991).  Following this reasoning, a number of bankruptcy courts have been willing to issue orders enjoining claims trading, or requiring that claims assignments require prior court approval, so that the debtor can insure that the NOLs are preserved.  In re Ames Dept. Stores, No. 90 B 11233 (Bankr. S.D.N.Y. July 31, 1991); In re Pan Am Corp., No. 91 B 10080 (Bankr. S.D.N.Y. 1991); In re Phar-Mor, Inc. 152 B.R. 924 (Bankr. N.D. Ohio 1993);   In re Southeast Banking Corp., 1994 Westlaw 1893513 (Bankr. S.D. Fla. 1994);  In re First Merchants Acceptance Corp., 1998 Bankruptcy LEXIS 1816 (Bank. D. Del. Jan. 20, 1998); In re Service Merchandise Co., Inc., 2000 Bankruptcy LEXIS 1523 (M.D. Tenn. Dec. 2000). 
VII. Rule 2019

Prior to December 1, 2011, Bankruptcy Rule 2019 required that an entity or committee, other than an official committee appointed under Sections 1102 or 1114 of the Code, that represents more than one creditor or security holder must file a verified statement with the court making certain disclosures.  These disclosures include information that may be considered confidential by claims traders, including the date each committee member acquired its claims (unless more than a year prior to the petition date), the amount paid for the claims, and any subsequent sales or dispositions of the claims. 

Courts have disagreed as to whether, if a claims trader is a member of an ad hoc committee or other informal group of creditors that act on a consolidated basis in the bankruptcy case, Rule 2019 applies to require disclosure.  See In re Washington Mut. Inc., 419 B.R. 271, 290 (Bankr. D. Del. 2009) and In re Northwest Airlines Corp., 363 B.R. 701 (Bankr. S.D. N.Y. 2007) (ad hoc committee is a committee for purposes of Rule 2019 disclosure); contra In re Phila. Newspapers, LLC, 422 B.R. 553, 568 (Bankr. E.D. Pa. 2010); In re Premier Int’l Holdings, Inc., 423 B.R. 58 (Bankr. D. Del. 2010). 

A rule amendment, scheduled to become effective on December 1, 2011, clarifies that Rule 2019 applies to groups that “consist of or represent” multiple creditors acting in concert, whether or not as a formal committee.  Thus, Rule 2019 is being expanded to apply to members of official committees, as well as informal groups.

Rule 2019 is narrowed to provide that the committee or group must “represent” the interests of the group.  “Represent” is defined as taking a position before the court, or soliciting votes regarding confirmation of a plan on behalf of another.  The notes indicate that an attorney retained by a group only to monitor the case, but not advocate before the court, is not subject to the provisions of Rule 2019.  Also excluded from the scope of new Rule 2019 are groups comprised entirely of affiliates, indenture trustees, agents under loan agreements, class action representatives, and governmental entities.

New Rule 2019 requires disclosure of “disclosable economic interests,” which is defined to include claims, interests, pledges, liens, options, participations, derivative instruments, and similar rights.  New Rule 2019 eliminates the requirement of disclosure of the amount paid for the “disclosable economic interest,” and the date it was acquired, except in certain limited circumstances.  New Rule 2019 requires that the disclosures be made on a member-by-member basis, not in the aggregate. 
VIII. Additional Resources

Levitin, Finding Nemo:  Rediscovering the Virtues of Negotiability in the Wake of Enron, 2007 Colum. Bus. L. Rev. 83 (2007)

Smith, The Shifting of Risk from Buyer to seller in the Trading of Bankruptcy Claims, ABI Committee News, Vol. 5, No. 1 (Feb. 2008)

Wiener and Malito, On the Nature of the Transferred Bankruptcy Claim, U. of Penn. J. of Bus. Law, Vol. 12:1, p. 35 (2009). 

Giddens, Distressed-Debt Trading in Bankruptcy, presented as the International Bar Association Conference on “Insolvency is Changing Globally – How and Why”  in Seville, Spain, April 17-20, 2004. 

Levitin, Bankruptcy Markets:  Making Sense of Claims Trading, 4 Brook. J. Corp. Fin. & Com. L. 64 (2010). 

Corbi, Hildbold, Petts, New Rule 2019:  Distressed Investors, What Are You Holding?, Vo. XXX ABI Journal 14 (June 2011). 

Fortgang and Mayer, Trading Claims and Taking Control of Corporations in Chapter 11, 12 Cardozo L. Rev. 1 (1990).

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Comments or inquiries may be directed to:
Caroline C Fuller.