S.D.N.Y. Bankruptcy Court Pivots from Enron; Holds “Disallowance Taint” Transfers With Purchased Claim in Firestar Diamond CaseSeptember 1, 2020
New York bankruptcy courts have long adhered to the 2007 ruling by the Bankruptcy Court for the Southern District of New York (the “Bankruptcy Court”) in In re Enron Corp., 379 B.R. 425 (S.D.N.Y. 2007) (“Enron”), which held that Section 502(d) “disallowance taint” – the possibility that a bankruptcy claim may be disallowed if the claimholder received an avoidable, yet unpaid transfer – would not follow a claim that was sold, rather than assigned. However, an April 22, 2020 ruling by Judge Sean H. Lane in the case In re Firestar Diamond, Inc., 615 B.R. 161 (“Firestar Diamond”) reverses course, holding that a debtor could assert defenses against buyers of claims to the same extent that it had claims or defenses against the original owner of the claim. Holding that disallowance taint travels with the claim, Judge Lane’s opinion effectively puts the onus on a would-be buyer to conduct diligence into the potential for a claim’s reduction, compensate for the risk in negotiating the purchase price for the claim, prepare for a future indemnity claim against the original seller, or otherwise protect its purchase.
Long-standing Enron Precedent:
Under Enron, disallowance taint under Section 502(d) was deemed a “personal disability” of the claimant, and whether it would travel with the claim would depend on “the nature of the transfer.” Where a claim is assigned, the assignee “takes with it whatever limitations it had in the hands of the assignor,” including disallowance taint. The Enron ruling distinguished transfers due to purchases, stating that where a claim is sold, it is effectively “washed” of disallowance taint, consistent with the judicial policy of protecting bona fide purchasers for value. The effect of this was that a claims buyer did not have to consider whether a debtor had claims or defenses to offset the validity of the claim; its purchase was protected.
Courts of other jurisdictions have declined to follow this holding by the Enron court, most notably the Third Circuit in In re KB Toys Inc., 736 F.3d 247 (2013) (“KB Toys”), which determined the risk of 502(d) disallowance to be an attribute of the claim that would travel with it upon transfer, regardless of nature. A number of other courts have come to the same conclusion as the Third Circuit, and now Judge Lane of the Bankruptcy Court for the Southern District of New York joins their ranks.
The Firestar Diamond Decision:
The pivotal decision Firestar Diamond arose from a bankruptcy case entrenched in fraud allegations. Towards the end of January 2018, Punjab National Bank (“PNB”) brought suit against Nirav Modi and several associated entities, alleging they had committed “the largest bank fraud in Indian history” against PNB and other banks. The following month, three U.S. indirect subsidiary corporations of Modi, Firestar Diamond, Inc., Fantasy, Inc., and A. Jaffe, Inc. (collectively, the “Debtors”), filed for Chapter 11 protection in the Southern District of New York. Concerns about a scheme of rampant bank fraud perpetrated by Modi and several non-debtor entity co-conspirators led the Bankruptcy Court to appoint an examiner, whose findings prompted the further appointment of a Chapter 11 Trustee to administer the Debtors’ estates.
The instant decision arose when the Chapter 11 Trustee challenged proofs of claim filed by four banks (the “Banks”), reflecting amounts owed by the Debtors to three non-debtor entities: Firestar Diamond International Pvt. Ltd., Firestar Diamond BVBA, and Firestar Diamond FZE (collectively, the “Non-Debtor Entities”). In all four of these claims, the Non-Debtor Entities had pledged receivables or sold invoices to the Banks for amounts owed by the Debtors. The Chapter 11 Trustee objected to all four claims, arguing they were barred under Section 502(d), since the Non-Debtor Entities had received millions in fraudulent transfers and preferences from the Debtors that had not been repaid.
The Banks encouraged the Bankruptcy Court to follow Enron, contending any disallowance taint had been washed of the claims through their sales by the Non-Debtor Entities. The Banks argued that they were innocent victims of the fraud committed by Modi, the Debtors, and the related entities, asking the Bankruptcy Court to weigh the equities in their favor and allow their claims.
The Chapter 11 Trustee invoked equity as well, pointing towards the millions of dollars the Non-Debtor Entities received in fraudulent transfers from the scheme. The Chapter 11 Trustee urged the Bankruptcy Court not to follow Enron, arguing that since the claims would be disallowed had they been filed by the Non-Debtor Entities (the original claimants), they should be disallowed even though they were filed by the Banks.
Judge Lane agreed with the Chapter 11 Trustee, emphasizing the persuasive analysis of courts of other jurisdictions and bankruptcy scholars in expressly declining to follow Enron, instead citing to the Third Circuit’s holding in KB Toys that deemed it improper to allow the original claimant to “wash” the claim of disabilities, as “[t]o allow the sale to wash the claim entirely of the cloud would deprive the trustee of one of the tools the Bankruptcy Code gives trustees to collect assets—asking the bankruptcy court to disallow problematic claims.” Judge Lane agreed with the Chapter 11 Trustee’s findings that “the claims are based on amounts owed to the entities that received fraudulent transfers from the Debtors in amounts exceeding the claims, and the claims would be subject to disallowance if those entities filed the claims,” and further found that “it would be inequitable to favor the banks over the Debtors’ other creditors.” The Bankruptcy Court granted the Chapter 11 Trustee’s objections, disallowing all four of the Banks’ claims.
Judge Lane also leaned on the KB Toys holding in addressing the Banks’ argument that disallowing the claims would “wreak havoc in the claims trading market or unfairly punish good faith transferees,” deciding that disallowance risk is properly borne by claim purchasers. Judge Lane offered two reasons for this: first, “claim purchasers ‘voluntarily choose to take part in the bankruptcy process’ and are aware of the risks associated therein;” and second, “claim purchasers can mitigate their risk through due diligence and indemnity clauses in the transfer agreement.” Creditors, in contrast, are involuntary participants with no means of protecting themselves against the risk that “claims with otherwise avoidable transfers will be washed clean by a sale or assignment.”
Judge Lane’s decision in Firestar Diamond that disallowance taint is an attribute of the claim, not the claimant, that cannot be “washed” through a sale by the original claimant presents a conflicting decision to the longstanding Enron precedent within the Southern District of New York. This conflict will effectively reduce the marketability of claims that have any possibility of being subject to a claim or defense of the debtor, particularly if additional judges of the Bankruptcy Court for the Southern District of New York follow Judge Lane’s decision to shift the burden to compensate for this risk to the sophisticated, voluntary participants in the claims marketplace. Savvy buyers will need to conduct adequate due diligence in order to negotiate appropriate risk mitigation, whether through a reduction in the purchase price or a contingency plan in the purchase agreement.
This shift towards a “buyer beware” market will undoubtedly reduce liquidity in the claims market itself. On the one hand, this will disadvantage those creditors who lack the time or resources to endure the bankruptcy process. On the other, this decision cleaves to the equitable core of the bankruptcy system, tightening a loophole that invited exploitation by unscrupulous parties, and restoring debtors’ ability to challenge claims in order to maximize the value of their estates.
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 In re Firestar Diamond, Inc., 615 B.R. 161 (Bankr. S.D.N.Y. 2020).
 In re Enron Corp., 379 B.R. 425, 439 (S.D.N.Y. 2007).
 Enron Corp., 379 B.R. at 435.
 Enron Corp., 379 B.R. at 435–36.
 Enron Corp., 379 B.R. at 448.
 In re KB Toys Inc., 736 F.3d at 254.
 Firestar Diamond, 615 B.R. at 167.
 Firestar Diamond Dkt. No. 294.
 Firestar Diamond, 615 B.R. 161, 163; Firestar Diamond Dkt. No. 394.
 The four banks are: Bank of India (Bharat Diamond Bourse Branch), Union Bank of India (UK) Ltd., Receivers on behalf of Bank of India (Antwerp Branch), and Bank of India (London Branch).
 Firestar Diamond, 615 B.R. at 164.
 Id., 615 B.R. at 169.
 Id., 615 B.R. at 164-5.
 Id., 615 B.R. at 167-8.
 Id., 615 B.R. at 167.
 Id., 615 B.R. at 169.
 Id. 615 B.R. at 171.
 Id., 615 B.R. at 169.
 Id., 615 B.R. at 169-70.