In a recent case related to the liquidation of KB Toys Inc. and affiliated entities, the U.S. Court of Appeals for the Third Circuit (Third Circuit) held that a trade claim disallowable under Section 502(d) of the U.S. Bankruptcy Code (Bankruptcy Code) in the hands of the original claimant is similarly disallowable in the hands of a subsequent transferee. In other words, the Third Circuit affirmed the decision of the U.S. District Court, District of Delaware holding that disallowance risk attaches to and travels with claims. The U.S. District Court for the Southern District of New York recently reached the opposite conclusion, holding that disallowance is a personal disability of the claimant, and not an attribute of the claim itself, unless the transferee took the claim by assignment rather than by sale. This article summarizes the legal and factual background of the case and the Third Circuit’s analysis. The article also highlights six implications arising out of the Third Circuit’s decision for prospective claims purchasers, including hedge funds. For further discussion of the risks faced by hedge funds participating in claims trading, see “Two Key Levels of Risk Facing Hedge Funds That Buy or Sell Bankruptcy Claims
,” Hedge Fund Law Report, Vol. 4, No. 27 (Aug. 12, 2011). For coverage of similar best practices helpful in managing the risk of claims disallowance under Bankruptcy Code Section 502(d) based on a seller’s avoidance liability, see “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
,” Hedge Fund Law Report, Vol. 5, No. 24 (Jun. 14, 2012).