Judge overturns Enron distressed debt ruling

Distressed debt market escapes potential devastating impact of Enron's court ruling

A federal judge has overturned a ruling concerning Enron’s bankruptcy proceedings that concluded good faith purchasers of claims against a bankrupt company could have those claims wiped out if they were obtained from sellers that were themselves guilty of misconduct. The ruling had the potential to severely impact the $500 billion a year distressed debt market. The new ruling from US district judge Shira Scheindlin earlier this week has been welcomed by investment banks and trade associations.

The previous findings emerged from a case in May 2002 concerning a $1.75 billion credit agreement involving Springfield Associates, Citigroup and Enron. Springfield bought $5 million of Enron bank debt originally held by Citibank. Enron brought an adversary proceeding against Springfield seeking to equitably subordinate its claim based solely on Citibank’s alleged inequitable conduct and receipt of avoidable transfers. There is no allegation that Springfield itself engaged in any improper conduct or received any avoidable transfer. During the 2002 case, the Enron bankruptcy court accepted Enron’s argument, issuing a decision holding that improper conduct or receipt of an avoidable transfer by a prior holder of a claim taints the claim itself, rendering it worthless in the hands of a subsequent – and a wholly innocent – purchaser.

The negative effects of the ruling were brought to Scheindlin’s attention by a joint amicus submission by trade associations the Loan Syndications and Trading Association (LSTA), the Securities Industry and Financial Markets Association (Sifma) and the International Swaps and Derivatives Association (Isda).

Scheindlin described the bankruptcy court’s opinion as “overreaching”, and noted that it “resulted in [an] outcry from commentators and amici curiae, who have expressed great concern that [the decision] will wreak havoc in the markets for distressed debt”. Her opinion clarified that equitable subordination and disallowance are “personal disabilities” that do not transfer with claims when they are sold. She therefore held that purchasers of claims “are protected from being subject to the personal disabilities of their sellers.”

Elliot Ganz, the general counsel of the LSTA, said: “Judge Scheindlin’s careful opinion is a tremendous victory for the entire market. The decision lifts a horrible cloud that hung over every purchase and sale of debt in the secondary market – a cloud that threatened to choke off these otherwise vibrant markets...”