I am delighted to have the opportunity to comment on Adam Levitin’s fascinating paper on the negotiability of claims trading in bankruptcy cases following Enron. This is an extremely interesting paper that sheds light on a difficult and important question confronting bankruptcy courts.

For generalist readers of Conglomerate, "claims trading" describes the buying and selling by creditors of claims against a bankrupt corporate debtor. Although the issue has garnered little attention in law reviews and even courts, the business of bankruptcy claims trading has become a huge commercial market. The opportunity for claims trading arises because of the risks and delays inherent in a large Chapter 11 bankruptcy case. Large Chapter 11 cases may take years to confirmation and the expected payout in a case to any given creditor is quite speculative. An industry has arisen with specialized firms with expertise in valuing and diversifying the risk of bankrupt companies. Creditors seeking to escape the bankruptcy case with a certain payout can thus sell their claims against the debtor at a discount on the expected value of participating in the case and thereby walk away with a certain payout early in the case, transferring the risk to those with a comparative advantage in bearing the risk.

Levitin’s paper focuses on a new risk that has arisen in the wake of the Enron case—namely, the risk of equitable subordination of a creditor’s claim in bankruptcy. Equitable subordination is intended to punish creditors who have engaged in inequitable conduct and, in the judgment of the Court, should not be entitled to share on the same terms as innocent creditors in the case. As Levitin notes, however, a problem arises when a creditor that has engaged in inequitable conduct transfers its claim to an innocent third party. Should the bankruptcy trustee be permitted to subordinate the claim in the hands of the third party or should the transfer insulate the third party from the underlying subordination claim?

In Enron, Bankruptcy Judge Arthur Gonzalez concluded that the purchasers of the claims could be sued for equitable subordination of their claims, applying the common law principle of nemo dat quod non habet—you can only transfer what you have. In other words, the claim was transferred subject to the threat that it would later be attacked under the principle of equitable subordination.

Levitin argues that instead of applying the nemo dat principle, the Court should have applied the principle of "negotiability," that only limited defenses travel property, so that a good faith transferee can receive more or better title than the transferor had. In other words, the principle of negotiability effectively permits the "cleansing" of the claim through a good-faith transfer.

Levitin’s argument is comprehensive. His argument demonstrates a remarkable breadth and depth of research and analysis, weaving together property law analysis, the history of equity and common law, and myriad bankruptcy code sections. These arguments all seem sound and persuasive. In my available space here, I want to just pick up on one strand of Levitin’s argument that animates the underlying policy choice confronting a court in deciding whether to apply a presumption of nemo dat or negotiability to traded claims.

Levitin’s core argument is straightforward and powerful. His basic argument is that in any given situation, the decision whether to apply nemo dat or negotiability is grounded in identifying the legitimate expectations of the good-faith purchaser as to the property interest that is transferred. In most situations, purchasers accept that the seller can transfer only what he owns and that the mere fact of a transfer does not permit the transfer of more than the transferor holds. Levitin notes that "where the law varies from the nemo dat paradigm, it is only with clear notice that changes what constitutes justified reliance." He identified two such situations—negotiable instruments under Article 3 where the law defines them as such and property law systems (real estate and security interest) which both rest on notice-filing systems, permitting a purchaser to take full title to property over preexisting, nonrecorded rights.

The cornerstone of Levitin’s argument is that the negotiability in these scenarios arises from the ex ante nature of the notice given, which then defines the legitimate expectations of the transferee. If the cloud on the property is not evident at the time of the transfer then the cloud is extinguished. Levitin argues that claims-trading in bankruptcy fits this mold—the equitable subordination attack only comes ex post, after the transfer has already occurred. Equitable subordination is an exceptional remedy and at the time of the transfer it is not known that the claim may be subject to a subordination attack (assuming that the transferee takes in good faith and without notice of the underlying problems). As a result, Levitin concludes, the transferee’s legitimate expectation and property interest is that the claim is clean of equitable subordination vulnerability, and the law should treat it as such. Enron thus unduly interferes with claims trading by making it impossible to predict whether a claim will later be attacked or not. In fact, Levitin argues that this risk and unpredictability has actually led to a drying-up of the market, not merely a price discount on such claims, providing the case study of Refco, which arose post-Enron.

Levitin’s argument is quite ingenious and well-conceived. On the other hand, I’m not fully convinced that protection of legitimate expectations is the key policy goal that is in play here. Instead, it may be that the goal the law should be searching for here is that of identifying the least-cost avoider or bearer of the risk that the underlying claim is susceptible to subordination. In most situations it is likely that the policy goal of placing the risk on the LCA will dovetail with that of protecting legitimate expectations. But in transitioning from the context of property law to bankruptcy law it is not clear to me that this is in fact the case.

In the standard negotiability scenarios that Levitin describes, the LCA is either easily identified, or there is no obvious LCA of the risk. For property recording, the party that fails to record quite plainly is the least-cost avoider of the later misunderstanding, so it is wholly appropriate to place the risk on that person. It may be that the underlying maker of a note similarly is in the better position to protect against the risk of negotiability than is the transferee. I suspect that this concept of the least-cost avoider or bearer of the risk may provide the conceptual underpinning for the legitimate expectations doctrine that Levitin identifies.

In bankruptcy, however, it is not so clear. The bankruptcy scenario fundamentally pits two innocent parties against each other—other creditors of the debtor who have no notice of the defective claim versus the innocent third-party who takes the claim with no notice of the potential underlying defects. The question then is which of these innocent third parties should bear the risk. Levitin argues by analogy to other negotiability contexts that the other creditors should bear the risk. But it is not obvious to me that should be the case. Preference law seems somewhat analogous. There the law places some risk on innocent transferees (at least for ninety days).

So my most nagging question is whether changing the policy assumptions that underlie Levitin’s analysis would change his conclusions about the propriety of negotiability versus nemo dat.

One final possible concern might be that Levitin pays relatively summary attention to the possibility of "claims washing"—i.e., a knowingly guilty party selling claims to good-faith purchasers in order to nullify the subordination claim. I think that his short-shrift on this issue is actually appropriate, as if you buy his underlying model, this concern could be worked out on a case-by-case basis, just as in other contexts where BFP defenses are raised.

In the end, I think that I am convinced that his approach may be superior to that of Judge Gonzalez in Enron. The paper closes with a chilling discussion of the dampening of claims-trading in Refco, which if replicated in future cases could strangle the practice in the cradle. Given the possible indeterminacy in identifying either the BFP or the other creditors as the LCA in these cases, it may be that this general concern about the economic value of claims trading is sufficient to carry the day in favor of Levitin’s case.

This is a major contribution to the literature—a literate and sophisticated analysis of a difficult and pressing question.

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