When Is It Appropriate To Disallow An Allowed Claim? By Geraldine E. Ponto and David N. Crapo

When Is It Appropriate To Disallow An Allowed Claim? By Geraldine E. Ponto and David N. Crapo Time-honored principles concerning the allowance of claims are breached when the strictures of Section 502(d) of the Bankruptcy Code are applied prematurely. Section 502(d) of the Bankruptcy Code does not provide prophylactic relief to a trustee (or debtor in possession) and prevent a distribution on a deemed allowed claim before a determination has been made by the court that property is recoverable from the claimant or that the claimant is liable on an avoidance claim. 11 U.S.C. 502(d). [T]he purpose of section 502(d) is to ensure compliance with judicial orders. In In re Odom Antennas, Inc., 340 F.3d 705, 708 (8 th Cir. 2003), citing In re Davis, 889 F.2d 658, 661 (5 th Cir. 1989), cert denied, 495 U.S. 933 (1990). The language of Section 502(d) expressly provides for the disallowance of a claim held by an entity that retains an avoidable transfer such as a preference. Odom Antennas, id., citing 11 U.S.C. 502(d). Consequently, a court-ordered determination that an entity has received an avoidable transfer must be made before Section 502(d) can be invoked to disallow a claim. In re Lids Corp., 260 B.R. 680, 684 (Bankr. D. Del. 2001), citing Davis, 889 F.2d at 658. See also In re Atl. Computer Sys., 173 B.R. 858, 862 (S.D.N.Y. 1994) (Section 502(d) envisions some sort of determination of the claimant s liability [under the avoidance provisions of the Bankruptcy Code] before its claims are disallowed... ). As with any other statute, an analysis of Section 502(d) must begin with the plain language of the statute itself. 1 The interpretation of Section 502(d) should be guided by the premise that what Congress says in a statute it means and means in a statute what it says there. Hartford Underwriters Ins. Co. v. Union Planters Bank, N.A., 530 U.S. 1, 6 (2000) 1 Section 502(d) provides: (d) Notwithstanding subsections (a) and (b) of this section, the court shall disallow any claim of any entity from which property is recoverable under section 542, 543, 550, or 553 of this title or that is a transferee if a transfer avoidable under section 522(f), 522(h), 544, 545, 547, 548, 549, or 724(a) of this title, unless such entity or transferee has paid the amount, or turned over any such property, for which such entity or transferee is liable under section 522(i), 542, 543, 550, or 553 of this title. 11 U.S.C. 502(d). #1258128 v1

(quoting Connecticut Nat. Bank v. Germain, 503 U.S. 249, 254 (1992)). When the statute s language is plain, the sole function of the courts--at least where the disposition required by the text is not absurd--is to enforce it according to its terms. Hartford Underwriters, id. (quoting U.S. v. Ron Pair Enterprises, Inc., 489 U.S. 235, 241 (1989) (citations omitted)). The plain language of Section 502(d) affords relief after the liability of a transferee of an avoidable transfer has been determined. In re LaRoche Indus., Inc., 284 B.R. 406, 408 (Bankr. D. Del. 2002). The determination of liability must come first, or else, as the court determined in the Odom Antennas case, it is impossible to determine whether Section 502(d) applies. See Odom Antennas, 340 F.3d at 708. Despite the plain language of Section 502(d) and the courts that have found that it requires a court-ordered determination of liability before such relief comes into play, Section 502(d) has been invoked as authority to defer distribution on claims that have been deemed allowed under Section 502(a), before a trustee has (i) analyzed whether the claimants potentially received an avoidable transfer, (ii) initiated an avoidance action against the claimants (iii) proven the case and obtained a determination of liability. That type of wholesale, premature application of the statute is improper. It works this way: a trustee identifies all, or almost all, vendors to a debtor as potentially having received an avoidable transfer and moves to temporarily disallow those vendors claims until the trustee reviews and analyzes whether he has grounds to seek to avoid any avoidable transfers to those vendors. The trustee may predicate the relief sought on the fact that he has not yet had time to analyze avoidance claims but believes that once he does, he will be asserting avoidance claims against vendors whose claims have been deemed allowed. No time limit is imposed on the trustee for completing his analysis of avoidance claims under Section 502(d), and, therefore, the only time limit on that process would be the statute of limitations under Section 546(a) of the Bankruptcy Code. 2 Absent an objection by vendors 2 Section 546(a) provides: (a) An action or proceeding under section 544, 545, 547, 548, or 553 of this title may not be commenced after the earlier of - 2 - #1258128 v1

affected by such a motion, even though no avoidance action against the vendors has been initiated by the trustee, much less any determination by a court of the vendors liability, the trustee may succeed in disallowing the vendors deemed allowed claims using Section 502(d) as the ground for relief. In effect, the trustee obtains an indefinite injunction precluding a distribution on such claims, without the necessity of satisfying the requirements under Rules 7001(7) and 7065 of the Federal Rules of Bankruptcy Procedure. That result also supplants the relief provided in Section 502(a) of the Bankruptcy Code, which deems a claim allowed when a proof of claim has been filed unless a party in interest has objected to the claim. 11 U.S.C. 502(a). 3 Worse yet, Section 502(d) has been applied to claims previously allowed by court order following the trustee's objection to the claim on other grounds. To accomplish that, the trustee merely reserves his right to contest the claims at a later time in the case. It is commonplace for claimants to face the prospect of multiple challenges to a single claim raised at different times during a case. May A Preference Action Be Initiated After A Creditor s Claim Has Been Allowed By Court Order? Beginning with Katchen v. Landy, 382 U.S. 323 (1966), and continuing with Langenkamp v. Culp, 498 U.S. 42 (1990), the Supreme Court has pronounced that the resolution of preference claims is an integral part of the general claims resolution process. Katchen v. (1) the later of (A) 2 years after the entry of the order for relief; or (B) 1 year after the appointment or election of the first trustee under section 702, 1104, 1163, 1202, or 1302 of this title if such appointment or such election occurs before the expiration of the period specified in subparagraph (A); or (2) the time the case is closed or dismissed. 11 U.S.C. 546(a). 3 Section 502(a) provides:.objects. A claim or interest, proof of which is filed under section 501 of this title, is deemed allowed, unless a party in interest.. 11 U.S.C. 502(a). - 3 - #1258128 v1

Landy was decided under the Bankruptcy Act of 1898 ( Bankruptcy Act ). In that case, the trustee had interposed an objection pursuant to section 57(g) 4 of the Bankruptcy Act to a creditor s claim on the basis that the claimant had received a voidable transfer that had not been returned to the trustee. The claimant had challenged the bankruptcy court s exercise of summary jurisdiction over the section 57(g) objection. The Supreme Court rejected that challenge and held that the bankruptcy court s summary jurisdiction extended even to that portion of the bankruptcy trustee s claim objection that arose under section 57(g). 382 U.S. at 330-31. The Court reached that conclusion because [t]he objection under [ 57(g)] is, like other objections, part and parcel of the allowance process and, therefore, was subject to the bankruptcy court s summary jurisdiction. 5 Id. at 330. Accord LaRoche Indus., Inc., 284 B.R. at 409. (Bankr. D. Del. 2002) ( [a] preference action is part and parcel of the claims allowance process), citing In re Asousa P ship, 276 B.R. 55, 73 (Bankr. E.D. Pa. 2002) (applying the Katchen rationale to the effect that a ruling on a proof of claim and a preference action would be deciding the same issues). Following the enactment of the Bankruptcy Reform Act of 1978, the Supreme Court in Langenkamp v. Culp reinforced its earlier teaching in Katchen v. Landy concerning the relationship between the resolution of preference claims to the general claims resolution process. In Langenkamp, the Supreme Court held that, by filing a proof of claim in the bankruptcy case, a 4 When repealed by the Bankruptcy Reform Act of 1978, section 57(g) of the former Bankruptcy Act provided: The claims of creditors who have received or acquired preferences, liens, conveyances, transfers, assignments or encumbrances, void or voidable under this title, shall not be allowed unless such creditors shall surrender such preferences, liens, conveyances, transfers, assignments or encumbrances. 5 It bears noting that under the Bankruptcy Reform Act of 1978, as amended by the Bankruptcy Amendments and Federal Judges Act of 1984, the question of the summary or plenary jurisdiction has given way to questions of core or non-core jurisdiction. See 28 U.S.C. 157(b) and (c). The Supreme Court s teaching in Katchen v. Landy concerning the relationship as between the resolution of preference actions and the claims resolution process, however, has not been overruled and remains good law. See In re Cambridge Indus. Holdings, Inc., 2003 WL 21697190 (noting that Katchen v. Landy offers useful insight into the importance of not separating the resolution of a creditor s claim from proceedings to recover avoidable transfers received by the same creditor). Cases such as the district court opinion in In re Cambridge Indus. Holdings, Inc., 2006 WL 516764, * 2 (D. Del. 2006), and In re Bridge Info. Sys., Inc., 293 B.R. 479, 488 (Bankr. E.D. Mo. 2003), thus appear to read Katchen v. Landy too narrowly. - 4 - #1258128 v1

creditor/preference defendant had waived the right to a jury trial in a preference action brought against him. 498 U.S. at 45. In reaching its decision, the court reasoned that, by filing a proof of claim, the creditor/preference defendant triggers the process of allowance and disallowance of claims, thereby subjecting himself to the bankruptcy court s equitable powers. Id. (citations omitted). If the trustee then files a preference action, that action becomes part of the claimsallowance process. Id. (citations omitted). In other words, the creditor s claim and the ensuing preference action by the trustee become integral to the restructuring of the debtor-creditor relationship. 6 Id. That being the case, the reasoning in Langenkamp compels the conclusion that any objection to the allowance of a claim in a bankruptcy case should include at that time any objection to the claim based on a preference or other avoidance theory. The Bankruptcy Reform Act of 1978 replaced section 57(g) of the former Bankruptcy Act with current Section 502(d). See LaRoche Indus., 284 B.R. at 498 (the legislative history of 502(d) shows that it was derived from then existing law), quoting H.R. Re. no. 595, 95 th Cong., 1 st Sess. 354 (1977), reprinted in App. Pt. 4(d)(i); S.Rep. No. 989, 95 th Cong., 2d Sess. 65 (1977), reprinted in App. Pt. 4(e)(i), U.S. Code Cont. & Admin. News 1978, pp. 5963, 6310, 5787). The provisions of Section 502(d) do not differ substantively from the provisions of repealed section 57(g). See n.5 above. Like repealed section 57(g) of the former Bankruptcy Act, and consistent with the teaching of Katchen v. Landy, the plain language of Section 502(d) of the Bankruptcy Code provides for the disallowance of a claim held by a transferee of an avoidable transfer, unless the amount for which the transferee is liable has been turned over to the estate. See 11 U.S.C. 502(d). The Supreme Court in Katchen v. Landy emphasized that very point with respect to section 57(g) of the former Bankruptcy Act when it stated that the statute contemplates that allowance of a claim may be conditioned on surrender of a preference 6 It does not appear from the Supreme Court s opinion in Langenkamp that the trustee had objected to the preference defendant s proof of claim. - 5 - #1258128 v1

received with respect to transactions unrelated to the claims. Katchen v. Landy, 382 U.S. at 331(emphasis added). In other words, like the plain language of repealed section 57(g), the plain language of Section 502(d) contemplates the prior determination by the Court that a creditor has received an avoidable transfer as a condition to the disallowance of a claim. What the plain language of section 57(g) and Section 502(d) has never done is to authorize either (i) bringing an avoidance action against a creditor whose claim has been previously allowed, or (ii) withholding a distribution on a previously allowed claim pending the resolution of such an avoidance action against the holder of the claim. 7 The requisite finding that a creditor has received an avoidable transfer must be determined as part of the claims process and not at a later time, especially if that time occurs after a distribution under a plan. LaRoche Indus., id., at 408-09. As the Supreme Court in Katchen v. Landy instructs, preference actions should be brought either before or at the same time as other claims objections. LaRoche Indus., id. at 409. Failure to do so precludes bringing a subsequent preference action. Id. The bankruptcy court in LaRoche Indus. also considered issues of fairness when interpreting Section 502(d). 284 B.R. at 410. Fairness dictates that [a]ll matters concerning a creditor s claim should be resolved at one time. Id. See also In re Cambridge Indus. Holdings, Inc., 2003 WL 21697190 * 4 (noting that the joinder of all disputes concerning a creditor s claim 7 For this reason, the opinion of the district court in In re Cambridge Indus. Holdings, Inc., 2006 WL 516764 is unpersuasive. It correctly acknowledges that Section 502(d) is a shield the trustee may raise during the claimsallowance process to deflect the claims of any preference defendant, but despite the plain language of Section 502(d), the court actually treats the statute as authorizing preference actions long after the claims-allowance process has been completed and the withholding of a distribution to a creditor s previously allowed claim until the preference action is resolved. Id. * 2. That analysis flies in the face of the rule that all matters related to a creditor s claim should be resolved at one time (see LaRoche Indus., 284 B.R. at 410) and reflects an undue emphasis on policy and practice at the expense of a careful analysis of the plain language of Section 502(d). Other cases holding that the allowance of a claim does not preclude a subsequent preference suit against the creditor ignore the plain language of Section 502(d) and overemphasize their perception of policy and practice considerations, which do not trump the statutory scheme. See e.g. In re TWA Inc., Post Confirmation Estate, 305 B.R. 221, 226-27 (Bankr. D. Del. 2004); In re Dornier Aviation (North America), Inc., 320 B.R. 831 (E.D. Va. 2005); In re Rhythms NetConnections Inc., 300 B.R. 404 (Bankr. S.D.N.Y. 2003); In re Bridge Info. Sys., Inc., 293 B.R. 479, 488 (Bankr. E.D. Mo. 2003) (trustee may refrain from asserting the Section 502(d) defense when objecting to a claim). - 6 - #1258128 v1

in a single proceeding should expedite, not delay, the administration of bankruptcy cases). In LaRoche Industries, the court noted that it had become the custom in the District of Delaware to object to claims first and bring preference actions later. LaRoche Indus., id. The court also correctly noted, however, that [l]ocal customs are no basis to ignore the mandates of the Bankruptcy Code and Rules nor are local customs a basis for allowing debtors to take unfair advantage of their creditors. Id. The LaRoche Indus. court concluded that, in addition to the plain language of Section 502(d), issues of fairness precluded debtors from bringing preference actions against creditors whose claims previously had been allowed. Moreover, if an uncontested claim allowed under Section 502(a) of the Bankruptcy Code constitutes a final judgment for purposes of res judicata, then it may be argued that an order of the court allowing a creditor s claim also is final and must be accorded res judicata effect. Under the doctrine of res judicata, or claim preclusion, [a] final judgment on the merits of an action precludes the parties or their privies from relitigating issues that were or could have been raised in that action. EDP Med. Computer Sys., Inc. v. United States, No. 06-0106-cv, 2007 U.S. App. LEXIS 5544, *1 (2d Cir. March 9, 2007)(quoting St. Pierre v. Dyer, 208 F.3d 394, 399 (2d Cir. 2000))(internal citations omitted). Res judicata serves many desirable purposes. It puts an end to, and prevents unnecessary costs resulting from, multiple litigation; it conserves judicial resources, prevents inconsistent decisions and fosters reliance on adjudication. EDP Med. Computer Sys., at *7. The Second and Ninth Circuits have both held that a bankruptcy court order allowing an uncontested proof of claim constitutes a final judgment and is thus a predicate for res judicata. Id. at *9. Claims that could have been adjudicated as part of an action, where the party against the whom the doctrine is used enjoyed a full and fair opportunity to litigate the matter, would be barred under the doctrine of res judicata. Federated Dep t Stores, Inc. v. Moitie, 452 U.S. 394, 398 (1981); Allen v. McCurry, 449 U.S. 90, 94 (1980). Courts are divided as to whether principles of res judicata bar an objection to a previously allowed claim. Compare, Cambridge Indus. Holdings, Inc., 2003 WL 1818177, * 2 (Bankr. D. - 7 - #1258128 v1

Del. 2003) (principles of claim preclusion bar a trustee from contesting a previously allowed claim), with Bridge, 293 B.R. at 484 (principles of claim preclusion do not bar an objection to a previously allowed claim); In re Ampace Corp., 279 B.R. 145, 155-56 (Bankr. D. Del. 2002) (same). The plain language of Section 502(d) makes the resolution of any preference claim against a debtor a condition to disallowing the claim on the basis of a retained preference. Resolution of the preference claim must occur prior to or contemporaneously with the resolution of other objections, if any, against a creditor s claim. See, e.g., Odom Antennas, 340 F.3d at 661; Atl. Computer Sys., 173 B.R. at 862; In re Enron Corp., 340 B.R. 180, 190-103 (Bankr. S.D.N.Y. 2006); LaRoche Industries, 284 B.R. at 408-09. If a trustee elects not to resolve an avoidance claim as part of the claims resolution process, under the foregoing authorities, the trustee would be precluded from prosecuting that avoidance claim. - 8 - #1258128 v1