GT Alert

Enron Court Holds That Transferred Claims Are Subject To Equitable Subordination in Hands Of Good Faith Purchaser

December 2005

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In a matter of first impression, Judge Arthur Gonzalez, a Southern District of New York bankruptcy judge, issued an opinion in the Enron case that has potentially huge ramifications for purchasers of distressed credits, including loans, publicly traded debt and trade claims. The bankruptcy court held that where a bank which sold its interest in a loan allegedly engaged in “inequitable conduct” wholly unrelated to the transferred loan interest, that interest remains subject to equitable subordination in the hands of good faith purchasers based on the bad acts of the transferor. In its decision, the bankruptcy court also noted that the same result would likely be reached if the transferred claims were notes or bonds rather than an interest in a loan. This case is important as much for its content as because it was issued by a bankruptcy court in the Southern District of New York in connection with a participation in a $1.7 billion loan assigned by a major financial institution to a group of funds that are not alleged to have participated or known of the transferor’s wrongdoing.

Section 510(c) and the Doctrine of Equitable Subordination

Section 510(c) of the Bankruptcy Code provides that, after notice and a hearing, a court may

under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or part of another allowed interest...

Bankruptcy courts have great discretion in determining whether equitable subordination is warranted. The doctrine of equitable subordination is typically applied where a creditor did a “bad act” with the affect of injuring other creditors of their common debtor.

Factual Background

Approximately seven months before filing its bankruptcy petition, Enron Corporation (“Enron”) borrowed approximately $1.7 billion from a group of banks pursuant to a short term credit agreement (the “Credit Agreement”). Fleet National Bank (“Fleet”) loaned Enron approximately $53 million (the “Fleet Credit Agreement Claims”) as one of the participants in the Credit Agreement.

In a separate and unrelated transaction, Fleet participated in two prepaid forward transactions (the “Forward Transactions”) with Enron approximately one year before the bankruptcy filing. Enron alleged that in connection with the Forward Transactions, Fleet received partial repayments that were voidable as preferences or fraudulent conveyances. Enron further alleged that “Fleet benefited from its inequitable conduct, including aiding and abetting Enron in engaging in accounting fraud, that resulted in injury to Enron’s creditors and conferred an unfair advantage on Fleet.” Enron did not allege that there was fraudulent or inequitable conduct under the Credit Agreement or that payments made under the Credit Agreement were voidable as preferences or fraudulent conveyances.

After the filing of Enron’s bankruptcy case, Fleet sold portions of the Fleet Credit Agreement Claims to multiple debt funds. Some of the purchasing funds re-sold portions of the Fleet Credit Agreement Claims to other funds. Enron did not allege that any of the purchasing funds engaged in any inequitable conduct or had actual knowledge of Fleet’s allegedly inequitable conduct.

Approximately four years after the filing of Enron’s bankruptcy case, Enron filed a complaint in which it sought (i) equitable subordination of the claims of Fleet, including the transferred Fleet Credit Agreement Claims, and (ii) disallowance of the Fleet Credit Agreement Claims pursuant to Section 502(d) of the Bankruptcy Code.1

Addressing the equitable subordination issue, the court first concluded that a bankruptcy court has authority to “subordinate claims that did not arise from any misconduct, but were held by a creditor who is found to have engaged in inequitable conduct regarding the debtor.” The second and more novel issue addressed by the court was “to what extent, if any, a claim subject to equitable subordination in the hands of a transferor remains subject to equitable subordination in the hands of a transferee.”

Relying most heavily on a 1906 decision of the United States Supreme Court and a 1942 8th Circuit decision, the court concluded that a transferee of a claim should be in no better position than the transferor and, therefore, equitable subordination based on conduct of the transferor can be asserted against the claim in the hands of the transferee. The court also noted that the same analysis would apply to notes and bonds that trade after the filing of the debtor’s bankruptcy case:

The Defendants also argue that not all categories of debt, such as bonds, are traded in the claims-transfer marketplace where the trading parties are free to negotiate representations, warranties, indemnities and other protection devices. The purchase of bonds and notes are not at issue before the Court in the instant proceeding. However, the Court notes that the post-petition purchaser of such debt instruments either knows or should know that the issuer of these securities is a debtor, so the prices of these transfers would reflect the attendant risks that the claims might be subordinated. Under those circumstances, the purchaser may well not have any available indemnity remedy against the seller, as is the case with the claims trading. But it is the market place that should address such risks in pricing. Apprehending higher risks associated with these securities, the purchaser may demand further discounts on the prices. And based on the Court’s previous policy analysis, no legal and policy basis supports the premise that transferees of bonds or notes should be treated differently than those holding the transferred loan claims. All post-petition transferees assume the risk that their claims may be subject to subordination.

The Impact of the Enron Decision

It remains to be seen whether this decision withstands the inevitable appeal, whether other courts will follow this decision and, if so, whether the holding is expanded to include pre-petition claim transfers as well as post-petition claim transfers. This decision underscores the need for purchasers of distressed claims to diligence the prior holders’ conduct vis-à-vis the debtor, as well as to get a “good conduct representation” from the seller. Standard LSTA (Loan Syndications and Trading Association) documentation addresses this issue in the form of an “acts and omissions” representation, but this is often the subject of negotiation in a distressed situation and is completely unavailable in most bond trades. Until this and other issues are resolved, the Enron decision will not only create real transactional risk for purchasers of distressed claims, but will also increase the leverage of debtors and committees in negotiating with purchasers of distressed claims. Purchasers of distressed debt should consult with their attorneys about ways of reducing or transferring the equitable subordination risk in certain types of transactions.

Footnotes

1 Section 502(d) of the Bankruptcy Code provides for disallowance of “any claim of any entity” from which property is recoverable under certain provisions of the Bankruptcy Code or that is a transferee of a voidable transfer, until such property has been turned over or voidable transfer repaid. The court did not address the 502(d) issues in its opinion.

This Alert was written by James P.S. Leshaw in the Miami office. Please contact Mr. Leshaw (305) 579-0500 or your Greenberg Traurig liaison if you have any questions regarding the subject matter of this Alert.

© 2005 Greenberg Traurig

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