Chapter VI Section 502 and Claim Disallowance

• Jurisdiction: United States

Chapter VI Section 502 and Claim Disallowance

Section 502 of the Bankruptcy Code governs the allowance and disallowance of claims and interests in bankruptcy. In the context of avoidable transfers, § 502(d) and (h) are of particular importance. Section 502(d) provides that the court shall disallow the claims of a creditor that has received an avoidable transfer, unless the creditor either pays an amount equal to the transfer or returns the property that was the subject of the transfer.⁶³³ Section 502(h) provides that a party that returns an avoidable transfer may receive a claim on account of the returned transfer if the party provided consideration for the original transfer.⁶³⁴ This section provides an overview of the significant distribution-related issues that can arise when claims of, payments to, or liens of a creditor are avoided as fraudulent transfers.

A. Section 502(d)

Pursuant to § 502(d) of the Bankruptcy Code, the court shall disallow the claims of a creditor that has received an avoidable transfer, unless the creditor either pays an amount equal to the transfer or returns the property that was the subject of the transfer. Section 502(d), therefore, precludes entities that have received avoidable transfers from sharing in the distribution of the estate's assets unless that entity has returned the avoidable transfer or otherwise made the estate whole.⁶³⁵ This is intended to promote two goals: (1) equal distribution of a debtor's assets; and (2) compliance with judicial orders regarding the return of assets that are the subject of an avoidable transfer.⁶³⁶

A party-in-interest can raise a § 502(d) objection either by claim objection or through an adversary proceeding.⁶³⁷ Case law suggests that § 502(d) requires a court to determine whether a transfer is avoidable before disallowing a transferee's claims.⁶³⁸ However, this does not mean that a transferee's claims are allowed during the pendency of a § 502(d) claim objection; rather, such transferee's claims are deemed neither allowed nor disallowed.⁶³⁹

Although § 502(d) appears fairly straightforward on its face, there are a handful of related topics that merit further discussion — namely, whether (or to what extent) § 502(d) applies in the context of avoided liens, avoided obligations and transferred claims.⁶⁴⁰

1. Section 502(d) and the Creation of a Lien or Security Interest

Section 502(d), by its terms, applies to the claims of a transferee of an avoidable "transfer." The Bankruptcy Code defines "transfer" to include the creation of a lien or the retention of title as a security interest.⁶⁴¹ Therefore, if the granting of either a lien or security interest is an avoidable transfer, § 502(d) may operate to disallow the claims of the transferee of that lien or security interest.⁶⁴²

2. Section 502(d) and the Incurrence of an Obligation

Section 502(d) applies explicitly to the claims of transferees of avoidable transfers, but does not address the claims of obligees of avoidable obligations. This has led some courts to conclude that § 502(d) does not apply to the claims of an obligee of an avoidable obligation.⁶⁴³ Therefore, in a § 502(d) context, the distinction between a transfer and the incurrence of an obligation becomes important.⁶⁴⁴ Although the Bankruptcy Code does not define "incurrence of an obligation," case law provides some guidance.

One court has defined the incurrence of an obligation to be "a formal binding agreement or acknowledgement of a liability to pay a certain amount or to do a certain thing for a particular person or set of persons; esp., a duty arising by contract."⁶⁴⁵ More specifically, courts have determined that certain guarantees or loan agreements are examples of obligations rather than transfers.⁶⁴⁶ When analyzing § 502(d), then, it is necessary to analyze the nature of the underlying transaction to determine whether it falls under the category of a "transfer" or the "incurrence of an obligation."

3. Section 502(d) and Transferred Claims

The case law addressing the applicability of § 502(d) to transferred claims is unsettled. The uncertainty centers on whether § 502(d) applies to bar the claims of a transferee of a claim if the transferred claim's original holder was subject to avoidable transfer liability.⁶⁴⁷ Put another way, does avoidable transfer liability travel with a claim?

Two decisions from Enron Corp.'s bankruptcy illustrate the lack of clarity surrounding this question. In the first Enron decision, Enron I, the U.S. Bankruptcy Court for the Southern District of New York concluded that avoidable transfer liability traveled with the transferred claim.⁶⁴⁸ As a result, the court held that § 502(d) applied to the claims of a transferee because the claim's original holder was subject to avoidable transfer liability.⁶⁴⁹ The court reasoned that the original holder of a claim could not provide a transferee with greater rights than the original holder had with respect to the claim.⁶⁵⁰

On appeal, the U.S. District Court for the Southern District of New York in Enron II vacated Enron I, holding instead that avoidable transfer liability does not travel with a claim that is sold in bankruptcy.⁶⁵¹ The court reasoned that avoidable transfer liability — such as a claim's susceptibility to disallowance under § 502(d) — is a personal disability of an individual claimant rather than an attribute of the underlying claim.⁶⁵² Although personal disabilities may travel with claims when they are assigned, they do not travel with claims when they are sold.⁶⁵³ Therefore, when a claim-holder sells a claim to a transferee, rather than assigns it — as in the Enron cases — the original holder's personal liability (i.e., avoidable transfer liability) does not travel with the claim.⁶⁵⁴

Adding to the debate, the U.S. Bankruptcy Court for the District of Delaware addressed the issue several years after Enron II and, following the bankruptcy court's reasoning in Enron I, held that avoidable transfer liability traveled with a claim.⁶⁵⁵As with Enron I, the court reasoned that a claim in the hands of a subsequent transferee has the same rights and disabilities as the claim in the hands of the original holder.⁶⁵⁶ With respect to...