By James Hamilton, J.D., LL.M.
In an opinion with broadly significant implications for secondary markets in distressed debt, including credit derivative swaps, a federal judge ruled that purchasers of distressed debt are protected from being subject to the personal disabilities of the sellers of that debt. This is an imperative principle in the distressed debt markets, said the court, where sellers are often anonymous and buyers of debt have no way of ascertaining if the seller has acted inequitably. No amount of due diligence will reveal that information, emphasized the court, and it is unclear how the market would price such unknowable risk. (Enron Corp. v. Springfield Associates, SD NY, Aug. 27, 2007, No. 01-16034).
The action arose during the Enron bankruptcy proceeding. Enron was a borrower under a credit agreement with a syndicate of banks, including Citibank. When Enron filed for bankruptcy, Citibank held a claim under the loan agreement. The banks transferred claims to other entities. One transferee acquired short-term debt from Citibank.
Enron sought equitable subordination of Citibank based on charges that the bank aided and abetted fraud and engaged in conspiracy with Enron insiders. Enron filed against the transferee-buyers for equitable subordination of their claims based on the misconduct of their transferor-sellers.
The Enron bankruptcy court accepted Enron’s argument, issuing a decision holding that improper conduct or receipt of an avoidable transfer by a prior holder of a claim taints the claim itself, rendering it worthless in the hands of a subsequent innocent purchaser
In an opinion with momentous implications for the functioning of the financial markets, the federal district judge vacated the bankruptcy’s court’s opinion. The court ruled that equitable subordination under the Bankruptcy Code could not be applied to claims held by transferees based on the alleged misconduct of the transferor. And here, said the court, there were no allegations of misconduct or inequitable actions by the transferees who purchased the distressed debt. Left standing, said the court, the bankruptcy court’s ruling threatened to wreak havoc on the markets for distressed debt.
Under the doctrine of equitable subordination, which the court called a drastic and unusual remedy, a bankruptcy court can subordinate a claim if it finds that the creditor’s claim resulted from the creditor’s inequitable behavior, such as fraud. The court held that equitable subordination is a personal disability of the claimant when a claim is sold and does not travel with the claim. It only travels with the claim if the claim is assigned.
Thus, the claim in the hands of transferee-buyers, be they hedge funds or other investors, is not subject to equitable subordination based on misconduct by the transferor. According to the court, this ruling should allay the concerns of the financial industry with the effects of the bankruptcy judge’s ruling on the markets for distressed debt. Equitable subordination arising out of the conduct of the transferee will not be applied to good faith open market purchasers of claims. This analysis, however, would not apply to bad faith purchasers or those with actual notice of the seller’s inequitable conduct.
According to an amicus brief filed by the financial industry, the bankruptcy court’s ruling would have inflicted significant damage on three segments of the financial markets: trading in loans, trading in physically settled credit derivatives; and trading in bonds. A credit derivative swap is essentially a risk transfer under which the holder of a bond, in exchange for a purchase price may obtain the right to be paid in full on the bond even if the obligor on the bond defaults.
The joint amicus brief was submitted by the Loan Syndications and Trading Association, the Securities Industry and Financial Markets Association, and the International Swaps and Derivatives Association, all leading financial industry trade associations.
Elliot Ganz, the General Counsel of the LSTA, noted that Judge Scheindlin’s opinion is a tremendous victory for the entire market. The decision lifts a horrible cloud that hung over every purchase and sale of debt in the secondary market, he emphasized, a cloud that threatened to choke off these otherwise vibrant markets.