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Enron Appeal - Equitable Subordination and Disallowance Do Not Inhere in a Claim but are Personal Disabilities of Individual Claimants that May Be Transferred
Judge Shira A. Scheindlin of the US District Court for the Southern District of New York issued an opinion in the In re Enron case which has significant consequences for the distressed debt market. On August 27, 2007, Judge Scheindlin ruled that equitable subordination under section 510(c) and disallowance under section 502(d) are personal disabilities of individual claimants that do not, without more, travel with the claim when the claim is transferred by way of a sale. However, equitable subordination and disallowance can be applied to claims held by a transferee when such claim is transferred by way of assignment. Judge Scheindlin remanded the case to the Bankruptcy Court to determine whether the transfers, documented by purchase and sale agreements and assignment agreements, constitute sales or assignments and thus, whether the conduct of a prior transferor, Citibank, can be imputed to a subsequent transferee, Springfield, so that equitable subordination and disallowance could be applied to the claim. A brief description of the factual background and the issues involved follows.
On December 2, 2001, Enron filed for protection under Chapter 11 of the Bankruptcy Code (the “Petition Date”). Citibank and certain other syndicate banks held claims as of the Petition Date for loans extended to Enron under a short-term credit agreement. At various times after the Petition Date, Citibank and certain other syndicate banks transferred, directly or indirectly, some portion of their claims to other entities. Citibank transferred $5 million of Enron bank debt to Deutsche Bank pursuant to a purchase and sale agreement and an assignment and acceptance agreement and Deutsche Bank transferred that interest to Springfield Associates, LLC on May 15, 2002 on similar documents.
The Transferor Actions
Enron filed an action on September 24, 2003 in the Bankruptcy Court against Citibank and other transferors seeking, among other things, (1) equitable subordination of the transferors’ claims pursuant to section 510(c) of the Bankruptcy Code based on allegations that the transferors engaged in inequitable conduct; (2) disallowance of the transferors’ claims under section 502(d) of the Bankruptcy Code based on allegations that the transferors received and failed to repay certain avoidable transfers.
The Transferee Actions
On January 10, 2005, Enron filed a series of adversary proceedings against each of the transferees, including Springfield, in which Enron sought: (1) equitable subordination of the transferee’s claims under section 510(c) based solely on the alleged misconduct of the transferor of the claims; and (2) disallowance of the transferee’s claims under section 502(d) based solely on the allegation that a transferor received and failed to repay an avoidable transfer. Judge Scheindlin noted that “[t]he complaints against the transferees contain no allegations for misconduct or receipt of and failure to return an avoidable transfer on the part of the transferees.”
On April 1, 2005, Springfield and certain of the other transferees moved to dismiss the transferee actions on the grounds that neither section 510(c) nor section 502(d) may be applied as a matter of law to the claims held by the transferees based solely on the alleged conduct of the transferors of those claims. The Bankruptcy Court denied the motions to dismiss both actions.
Judge Scheindlin’s Ruling
Judge Scheindlin defined the issue at hand as whether “equitable subordination and disallowance could be applied to a claim in the hands of a transferee based solely on conduct of the transferor.” She based her rulings on the statutes, the legislative intent and further considered the effect that the court’s interpretation would have on the markets.
The court began with a discussion of Bankruptcy Code 510(c) and 502(d) and concluded that both 510(c) and 502(d) claims are personal disabilities of particular claimants and therefore do not automatically travel with the claim. Judge Scheindlin pointed to the application of equitable subordination to unrelated claims based solely on the fact that they are held by a bad actor as evidence that the proper focus is on the claimant personally and not the claim. Judge Scheindlin distinguished between transfers where a transferee has acquired its claim pursuant to a sale as opposed to acquiring it by pure assignment. “A personal disability that has attached to a creditor who transfers its claim will travel to the transferee if the claim is assigned, but will not travel to the transferee if the claim is sold.” Transferees in a sale are protected from being subject to the personal disabilities of their sellers since such transferees do not stand in the shoes of their sellers. Judge Scheindlin pointed to this distinction as being “particularly imperative in the distressed debt market context, where sellers are often anonymous and purchasers have no way of ascertaining whether the seller (or a prior transferee) has acted inequitably or received a preference. No amount of due diligence on their part will reveal that information, and it is unclear how the market would price such unknowable risk. Parties to pure assignments, by contrast, can easily contract around the risk of equitable subordination or disallowance by entering into indemnity agreements to protect the assignee.”
Judge Scheindlin stated that “it is undisputed that Springfield is not alleged to have itself acted inequitably or received any preference that would subject its claims to equitable subordination or disallowance.” However, Springfield may be subject to equitable subordination and disallowance based solely on the conduct of the transferor if the claims were transferred to Springfield by way of an assignment. Judge Scheindlin remanded the case to the Bankruptcy Court to decide whether the transfer was an assignment or a sale and thus whether Citibank’s conduct may be imputed to Springfield. It is important to note that the decision does not attempt to answer the question of how a court should distinguish between an assignment and a sale. Judge Scheindlin, in a footnote of the opinion, provided an example of a sale (purchase on the open market) and an assignment (acquisition by operation of law, such as subrogation), but no characteristics are identified which would guide the bankruptcy court. While the court did imply that the labels which the parties give to the transaction would not be controlling, no further guidance is provided. The Bankruptcy Court should provide some insight into this issue on remand.
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