Last year, then "Junior Scholar" — and now Associate Professor of Law at Georgetown — Adam Levitin (who is also a long-time reader of this blog!) wrote an excellent piece entitled Finding Nemo: Rediscovering the Virtues of Negotiability in the Wake of Enron, 2007 Colum. Bus. L. Rev. 83 (WL) / (pdf).  In it, he strongly criticized a decision by Bankruptcy Judge Arthur Gonzalez denying a good faith bankruptcy claim purchaser’s motion to dismiss the Enron estate’s cause of action for equitable subordination based not on the purchaser’s own misconduct, but on the conduct of previous owners of the claims purchased, regardless of whether the conduct related to the claims themselves.  Enron Corp. v. Springfield Assocs., L.L.C. (In re Enron), 2005 WL 3873893 (Bankr. S.D.N.Y.  11/28/05) (pdf).  Professor Levitin sums up his critique of Judge Gonzalez’s ruling as follows (at pp. 90-91):

The problems in Enron speak to a fundamental commercial law question about choice of property transfer rules.  Enron was based on the commercial law principle of nemo dat quod non habet — you can only transfer what you have.  Nemo dat means that defenses travel with property transfers, so if bankruptcy claims would be subject to equitable subordination in the hands of a transferor, they should remain so in the hands of a transferee.

Nemo dat is the default rule for property transfers, but there is a competing commercial law paradigm: negotiability [as in Articles 2, 3, 7, and 8 of the UCC], and the law of real estate mortgages and titles.  The essential characteristic of negotiability is that only limited defenses travel with property, and thus a transferee can receive more than the transferor had–a property right free of certain defenses against its enforcement.  This means that there is some level of negotiability in any area of law with a good faith purchaser defense…. 

Historically, the law has differentiated between whether it adopts a nemo dat regime or a negotiability regime based on whether transactions are commercial or consumer….  [T]his article argues in favor of applying a negotiability regime to bankruptcy claims trading and proposes a general reconsideration of the rules governing the defenses that travel with a property transfer in commercial contexts.

Last January, District Court Judge Shira A. Scheindlin (herself no stranger to high-stakes bankruptcy controversies) granted the disheartened claims purchasers’ request for leave to file an interlocutory appeal of Judge Gonzalez’s ruling.  She also concurrently granted the request filed in connection with an analogous interlocutory ruling by Judge Gonzalez in Enron Corp. v. Avenue Special Situations Fund II, LP (In re Enron), 340 B.R. 180 (Bankr. S.D.N.Y. 2006) (pdf), in which he disallowed under Code section 502(d) the claim of an entity that purchased its claim from a party who had received a potentially avoidable prepetition transfer.  Judge Scheindlin granted these interlocutory appeals, she said, so that she could consider the following question that "although fairly simply stated, is complex and of first impression in this Circuit, and will have serious ramifications well beyond the parties involved in this particular appeal":

Whether equitable subordination under 510(c) and disallowance under 502(d) can be applied, as a matter of law, to claims held by a transferee to the same extent they would be applied to the claims if they were still held by the transferor based on alleged acts or omissions on the part of the transferor.

Last week, Judge Scheindlin was again the toast of distressed debt industry based on her lengthy decision vacating Judge Gonzalez’s decisions.  See Springfield Assocs., L.L.C. v. Enron Corp. (In re Enron), 2007 WL 2446498 (S.D.N.Y. 8/27/07) (pdf).  Though Judge Scheindlin never cites to Professor Levitin’s article, she does note — as does Professor Levitin — that the central distinction to be made in analyzing the question presented is whether the "well-established doctrine of nemo dat qui non habet" applies.  (Op. at 20-22.) 

To Judge Scheindlin, if the claims are being asserted by good faith purchasers of bankruptcy debt, then the doctrine doesn’t apply and the claims cannot be equitably subordinated under Code section 510(c) or disallowed (pending receipt of the avoidable transfer) under Code section 502(d).  Conversely, Judge Scheindlin ruled, if the transferee obtained the claim by way of "assignment," then the nemo dat doctrine applies, the "personal disabilities" of the claimant "travel with the claim," and the assignee’s claim is subject to possible subordination and disallowance.  (Op. at 29-44.)

Notably, Judge Scheindlin emphasizes, her decision is not based on policy concerns, and in particular the impact that an affirmance would surely have on depressing values in an already depressed market for distressed debt.  See, e.g., Levitin Article at 161-164 ("Developments in the Refco bankruptcy provide an early look at … how seriously Enron has affected the claims trading market….  As soon as rumors surfaced of BAWAG’s alleged misdeeds, all claims that had ever passed through BAWAG’s hands became radioactive before the other Refco creditors filed suit against BAWAG.  No one would purchase them for any price because of the fear of subordination or disallowance.")  Still, she seemed relieved to be able to note not only that "[t]he unnecessary breadth of the Bankruptcy Court’s decisions threatened to wreak havoc on the markets for distressed debt," but also that, with this decision, "[t]hat result has now been avoided."  (Op. at 52.)

What then was the basis for Judge Scheindlin’s reversal? 

© Steve Jakubowski 2007

The issue is "a matter of statutory interpretation," she held.  (Op. at 30.)  And this is where things start to get interesting, for as everyone agreed, "there is no case directly on point."  Id.  Further, since Code section 510(c) only references vague "principles of equitable subordination," there is no "plain meaning" to guide us.  Judge Scheindlin, therefore, appropriately (see Judge Waldron’s outline referenced here) turned next to the legislative history "to determine whether the legislative intent was to create a characteristic of a claim or rather a personal disability of claimants."  (Op. at 30-31.)

Judge Scheindlin found no support in the legislative history or in pre-Code case law for extending the personal disability of a claimant to the good-faith purchaser of a claim, and here’s where Judge Scheindlin’s opinion begins to fray a bit at the edges.  The claims trading industry didn’t exist in the pre-Code days, so it’s not surprising that Congress didn’t consider the phenomenon.  Further, to focus–as Judge Scheindlin does–on a specific legislator’s or court’s use of the word "holder" or "claimant" versus the word "claim" in describing when equitable subordination is appropriate perhaps ascribes to legislators and previous courts a distinction they themselves may not have discerned when they imprecisely uttered those precise words.  (Op. at 31-36.) 

In my humble view, given the absence of legislative history or case law directly on point, principles of equitable subordination under Code section 510(c) and claims disallowance under Code section 502(d) are perhaps best analyzed first through the optics that the US Supreme Court has fashioned for us in cases like Howard Delivery Serv., Inc. v. Zurich Am. Ins. Co., 126 S. Ct. 2105 (2006) (pdf) (discussed at length here and again here), and Travelers Casualty v. Pacific Gas & Electric Co., 127 S. Ct. 1199 (2007) (pdf) (discussed at length here and again here). 

In Howard Delivery, the Court stated that "any doubt concerning the appropriate characterization [of a claim] … is best resolved in accord with the Bankruptcy Code’s equal distribution aim."  126 S. Ct. at 2116.  This policy approach would seemingly weigh against any approach that would enable a claimant to engage in "claims washing" because of the adverse effect such cleansing would have on other creditors.  (Compare Op. at 47-48.) 

On the other hand, we are reminded in Travelers of the bedrock principle from the 9-0 decision in Butner v. United States, 440 U.S. 48 (1979) that "[c]reditors’ entitlements in bankruptcy arise in the first instance from the underlying substantive law creating the debtor’s obligation, subject to any qualifying or contrary provisions of the Bankruptcy Code."  (Travelers at p.6.)  This principle, it would seem, favors recognition in bankruptcy of a purchaser’s state law rights to "negotiability" (to use Professor Levitin’s shorthand), subject to subordination and disallowance only in "drastic and unusual" circumstances (presumably absent here).  (Op. at 38.)

In the end, it seems impossible for a judge to avoid policy considerations when deciding whether to invoke "principles of equitable subordination," particularly where–as here–the tension between equality of distribution in bankruptcy and recognition of a good faith purchaser’s state law rights cannot be easily reconciled.  Judge Gonzalez’s rulings favored equality of distribution based on the presumption that any purchaser of a bankruptcy claim is necessarily on notice of the claim’s potential disability.  Conversely, Judge Scheindlin’s opinion favored the traditional enhanced rights of good faith purchasers for value, relying instead upon the trier of fact to determine whether the purchaser took in good faith without actual knowledge of the disability of–or the receipt of an avoidable transfer by–the original claimant.  (Op. at 37, 44.)

My sources (to whom I’m grateful for passing along this decision once it was issued) don’t yet know if an interlocutory appeal will be taken to the Second Circuit, but it’s hard to imagine given what’s at stake that such an appeal will not be attempted.  Given the central importance of this decision to the distressed debt industry (which Professor Levitin states at p. 86 "was estimated to be in the hundreds of billions of dollars about a decade ago and has seen a prodigious growth in recent years"), we can only hope that the case is taken up by the Second Circuit, and then by the US Supreme Court.  It’s hard to imagine a better pedigree than this case would offer the High Court on this issue. 

So while–for now–as Judge Scheindlin stated, no further havoc will be wreaked on the markets, it’s unclear whether the havoc already wreaked by Judge Gonzalez’s opinion has been avoided entirely.  As is often the case in litigation, time will tell.

Steve Jakubowski