When the Exclusive Remedy for Disallowance is a Rebate

The disallowance provision is probably the most distinguishing feature1 of the typical bankruptcy claim2 assignment. This provision obligates the seller of the claim to rebate buyer’s purchase price to the extent the enforceability of the claim has been impaired3, subject to certain conditions.4 The assignment also typically contains seller representations and warranties that the claim is not subject to “impairment” of any kind.5

It has become somewhat commonplace for buyer to limit its recovery for impairment of a bankruptcy claim to a rebate of its purchase price6 under the assignment’s disallowance provision. Proponents of this approach argue that the “automatic” nature of the disallowance provision eliminates the need for “non-impairment” and similar seller representations and warranties. Are they right?

Probably not, for two reasons. First, a disallowance provision isn’t always as “automatic” as it appears, and the buyer that agrees to make such a provision its exclusive remedy may be one procedural misstep away from being remediless.7 Second, surrendering the right to pursue indemnification for seller’s breach of its “non-impairment” representation may leave buyer unable to realize any appreciation in the market value of the claim during the often lengthy period between closing and claim disallowance.

Damages for breach of contract under New York law8 are generally measured at the time of the breach, construed to be the time at which all elements of the cause of action for breach have occurred.9 In the case of a breach of a representation and warranty, this is ordinarily at the time the contract is executed.10

But the typical “non-impairment” representation—a statement that the claim is not subject to defenses, counterclaims, subordination, setoff and the like—is essentially a promise that nothing will happen in the future to cause such a result. If one accepts the premise that you can’t determine whether a claim is subject to disallowance until you know whether the claim actually has been disallowed, then seller’s cause of action for breach of this representation would not even appear to arise until the impairment had been judicially determined or at least stipulated to. This would in turn potentially yield buyer an opportunity to capture the benefit that had accrued to its original bargain as a result of an increase in the market value of the claim since the closing date.

The claim buyer that scales the contractual hurdle of an exclusive remedy provision may also encounter stricter judicial scrutiny if its efforts to capture post-closing date claim value appreciation are construed as a claim for lost profits.11 Steps that might be considered to furnish evidence of the specific party intent required in these circumstances include specifying the methodology by which buyer’s damages for breach of the non-impairment representation will be calculated, and reciting the intent of the parties for such damages to be available.

  1. Disallowance provisions also routinely appeared in agreements for the purchase and sale of distressed domestic bank loans until the Loan Syndications and Trading Association (“LSTA”) standardized this form in the mid-1990’s.
  2. The term “bankruptcy claims”, as are used in this post, refers to claims not arising from bank loans, notes, bonds, debentures and similar instruments.
  3. Bankruptcy claims are deemed allowed if not objected to, 11 U.S.C. § 502(a)(2011), but because there is no time limitation for objections, In re McLean Indus., Inc., 184 Bankr. 10 (Bankr. S.D.N.Y. 1995), corrected (June 20, 1995) and aff’d 196 B.R. 670 (S.D.N.Y.1996), claims frequently have not yet been allowed at the time they are assigned. Full or partial disallowance of a bankruptcy claim may result from causes ranging from a failure to credit debtor advertising allowances or delivery of non-conforming goods in the case of a vendor claim, to an unfavorable valuation, in the case of a credit-default swap termination claim. Challenges to the enforceability of distressed bank loans, by contrast, rarely involve a debate over the actual amount of the loans.
  4. These may range from the mere filing of an objection to the claim to the requirement of a final, non-appealable order disallowing it; the assignment may also obligate buyer to provide seller with written notice of a filed objection to the claim and an opportunity to resolve it.
  5. The typical “disallowance” provision likewise generally addresses not only claim disallowance per se but also subordination, setoff, recoupment and any other potential “impairments” of the subject claim.
  6. Many disallowance provisions also require buyer to pay seller a negotiated rate of interest on the portion of the purchase price being rebated, for the period from the time of assignment to the time of the rebate, together with attorneys’ fees and expenses incurred in connection with enforcing the provision.
  7. See ALJ Capital I, L.P. v. David Joseph Co., 15 Misc.3d 1127(A), 2007 WL 1218355 (N.Y.Sup. 2007), aff’d, 48 A.D.3d 208, 851 N.Y.S.2d 154 (1st Dep’t 2008) (purchaser of bankruptcy claim who failed to provide timely written notice of, and opportunity to cure, claim objection as required by claim assignment not entitled to reimbursement of purchase price).
  8. Where New York law does not govern the assignment—a not uncommon occurrence where seller is a large company residing outside New York State—the “damages at the time of the breach” rule may not apply.
  9. See Simon v. Electrospace Corp., 28 N.Y.2d 136, 145, 269 N.E.2d 21, 320 N.Y.S.2d 225 (1971); Oscar Gruss & Son, Inc. v. Hollander, 337 F.3d 186, 197 (2d Cir. 2003).
  10. 10  See Lana & Edward’s Realty Corp. v. Katz/Weinstein P’ship, 26 Misc.3d 1238(A), 2010 WL 963564 (N.Y.Sup. 2010).
  11. 11  See Ashland Mgmt. Inc. v. Janien, 82 N.Y.2d 395, 403, 624 N.E.2d 1007, N.Y.S.2d 912 (1993); cf. Sharma v. Skaarup Ship Mgmt. Corp., 916 F.2d 820, 826 (2d. Cir. 1990).
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