The $500 billion distressed debt market in the U.S., which badly needs a break in the wake of the subprime mortgage credit crunch, caught one recently when U.S. District Judge Shira Scheindlin overturned a bankruptcy court decision in an Enron Chapter 11 case. The distressed market is one in which sophisticated investors, such as hedge funds, buy creditors' claims at a discount in return for the right to pursue the claims on their own behalf.
In her Aug. 31 decision, Scheindlin warned that U.S. Bankruptcy Judge Arthur Gonzalez's March 2006 decision "threatened to wreak havoc on the markets for distressed debt." Gonzalez's ruling suggested that innocent buyers of claims against a bankrupt company risked having courts wipe out their claims if they bought the claims from sellers that had engaged in misconduct.
As Scheindlin saw it, misconduct was a "personal disability" of the seller that didn't attach to the claim itself. If there was a "true sale" of the claim, the buyer did not take on that disability. But if the buyer acquired the claim by "assignment," it took over the position of the seller and was subject to the subordination or disallowance to the same degree as the seller.
This distinction, Scheindlin said, was "particularly imperative in the distressed debt market context, where sellers are often anonymous, and purchasers have no way of ascertaining whether the seller (or a prior transferee) has acted inequitably or received a preference."