Five Steps Hedge Fund Managers Should Take to Mitigate Avoidance and Disallowance Risks After Delaware Court Finds That Avoidance and Disallowance Risks Travel with Trade Claims

Distressed investors, such as hedge fund managers, purchasing trade claims against a debtor in the secondary market must now face the fact that certain disabilities may attach to and travel with claims following a May 4, 2012 decision by Judge Kevin J. Carey of the United States Bankruptcy Court for the District of Delaware (Court) in the KB Toys bankruptcy proceeding.  The Court held that a purchaser of a trade claim against a debtor takes such claim subject to the risk of disallowance of the claim under Bankruptcy Code Section 502(d) based on the original claimholder’s receipt of (and failure to pay) an avoidable transfer.  While Judge Carey specified that the decision was limited solely to trade claims purchased from the original holders of such claims, the Court’s reasoning could be extended to other circumstances, such as bank loans traded in the secondary market.  Therefore, it is essential that distressed investors perform the necessary diligence and negotiate sufficient protections in agreements to purchase distressed debt.  In a guest article, Steven F. Wasserman and Howard S. Steel, both Partners at Brown Rudnick, and Laura F. Weiss, an Associate at Brown Rudnick, provide an overview of the KB Toys decision and recommend five best practices to minimize risks to recoveries in light of this important decision.

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