Claims Buyers Beware: Your Shiny New Claim May Face Avoidance Risk

The claims trading market provides a useful avenue for creditors who seek to quickly monetize their prepetition claims in bankruptcy cases. Rather than waiting out the bankruptcy process with the hope of obtaining a recovery from the bankruptcy estate, creditors may obtain an immediate recovery by selling their claims at a discount. Claims buyers are willing to purchase claims for less than the claims’ face value for a number of reasons. They may expect that the bankruptcy estate’s eventual distribution on account of the purchased claims will exceed the price they paid for the claims. Alternatively, they may believe there is an opportunity to receive equity in the reorganized debtor, or they may seek to influence a debtor’s reorganization by obtaining a significant portion of the debtor’s capital structure.

While a claims buyer purchases the right to receive whatever distribution is made on the purchased claim, the claims buyer also bears the risk that it will receive less than anticipated with respect to the purchased claim or that the purchased claim will be disallowed entirely. This risk has been exacerbated by a recent decision of the United States Bankruptcy Court for the Southern District of New York—a very active jurisdiction for claims trading—in the Chapter 11 cases of In re Firestar Diamond, Inc. In Firestar, the bankruptcy court rejected a prior decision by the United States District Court for the Southern District of New York and joined the growing majority of courts that have held that a purchased claim may be disallowed under Bankruptcy Code Section 502(d) where the claim seller had received, and had not returned, an avoidable transfer (such as a preference or fraudulent transfer).