Jenner & Block

"Third Circuit Holds Creditor’s Claim Disallowable Even When Held By Subsequent Transferee," Jenner & Block Spotlight Newsletter

By: Andrew J. Olejnik and Abraham M. Salander

In In re KB Toys Inc., 736 F.3d 247 (3d Cir. 2013) (No. 13-1197), the Third Circuit held that when a creditor sells or assigns a claim against a debtor, the claim still can be disallowed as if the original creditor continued to hold the claim.  The result of this holding is that purchasers of bankruptcy claims may end up losing their investments or requesting that the original creditor indemnify them for such losses.  In KB Toys, the bankruptcy trustee moved under Section 502(d) of the Bankruptcy Code to disallow claims held by a claims purchaser, not because the purchaser had received a preference or fraudulent transfer, but because the original creditor had.  The Third Circuit affirmed the lower courts’ decisions to disallow the claims, explaining that to hold otherwise would contravene a purpose of the relevant bankruptcy provisions – to ensure equality of distribution.  The court emphasized that the original claimant should not be permitted to sell an otherwise disallowable claim for value––essentially “washing” it of its disability––to a buyer who could then receive a distribution from the estate that the original claimant never could have received.  Although many agreements governing the sale and transfer of claims contain indemnification by the seller to protect against this outcome, as a result of this decision, creditors selling bankruptcy claims may notice purchasers placing increased importance on such indemnification provisions or reducing their offered amount to account for this disallowance risk.