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September 26, 2022

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How Claims Buyers Can Protect Themselves – The Firestar Decision

In the world of bankruptcy claims trading there has long remained an open question as to whether a debtors’ defenses against proofs of claim in a bankruptcy can be enforced against third party claims purchasers. This was particularly true in New York where until recently the Southern District of New York (SDNY) had taken a different approach from many other Courts on this issue.

The SDNY followed Enron II, where the Southern District Court held that an impairment of a claim is personal to the claimant rather than to the claim, and that liabilities will only travel with the assignment of a claim but not with the sale of a claim.1 This difference between “assignment” and “sale” was never well articulated; definitions of such terms do not appear in the Bankruptcy Code, and the two words are often used interchangeably among claims traders. As such it should be no surprise that most other courts, including the Third Circuit in KB Toys, have held that a disallowance travels with the claim, regardless of whether it is transferred via a sale or an assignment.2

On April 22, 2020, Judge Sean H. Lane of the SDNY Bankruptcy Court issued a ruling in In re Firestar Diamond, Inc. which came to the same conclusion as the Third Circuit: that claim disabilities follow the claim, irrespective of whether the transfer is documented as a sale or an assignment. Although this ruling does not bind other New York bankruptcy courts, it comes as no surprise and reflects current market practice. Although some questions remain open, the Firestar ruling provides some clarity on defects traveling with a claim and serves as a reminder that claims buyers need to protect themselves through documentation and diligence.

Firestar Diamond

Firestar Diamond, Inc. (“Firestar”), and affiliated companies including Fantasy, Inc., and A. Jaffe, Inc. (collectively, the “Debtors”), filed for Chapter 11 protection in the SDNY Bankruptcy Court on February 26, 2018. About one month prior to the bankruptcy filing, Indian authorities announced criminal charges against Mr. Nirav Modi, the founder of Firestar, accusing him of perpetrating the largest bank fraud in Indian history. A bankruptcy examiner was appointed in the Chapter 11 case to investigate the fraud and determined there was substantial evidence that senior officers and directors of the Debtors knew of, or were involved in, criminal conduct. As alleged by the Indian authorities, Mr. Modi and co-conspirators used various entities posing as independent third parties for sham transactions to import jewelry, gemstones, and related goods, valued at billions of dollars, and obtained bank financing in the form of Letters of Understanding (“LOUs”) based on these fraudulent transactions. The Indian Central Bureau of Investigation alleges that the parties involved in the bank fraud obtained approximately $4 billion from Punjab National Bank through the fraudulently issued LOUs, of which approximately $1 billion remains unpaid.

As such, the SDNY Bankruptcy Court appointed a Trustee over the Debtors’ estates in the proceedings. Four Indian banks (the “Banks”) filed proofs of claim in the Chapter 11 proceedings claiming to be owed millions of dollars. These claims were on “pledge” agreements with certain non-debtor affiliates of the Debtor, pursuant to which the Banks extended credit to these non-debtor affiliates secured by the rights the affiliates had under specific invoices allegedly owed by the Debtors to the non-debtor affiliates. To complicate matters further, the non-debtor affiliates had received millions of dollars in fraudulent transfers and preferences from the Debtors that remained outstanding. As such, the Banks’ claims against the Debtors were on account of the funds that the Debtors owed to the non-debtor affiliates, which in turn were due to the Banks on account of the Pledge by Firestar to the non-affiliates.

The Trustee objected to the Banks’ claims, arguing that they are disallowed under Bankruptcy Code Section 502(d) as voidable preference transfers between insiders. The Trustee’s reasoning was that the claims filed by the Banks, based on the Debtors’ dealings with non-debtor affiliates, would be disallowed if the claims had been filed by the non-debtor affiliates instead of by the Banks. The Trustee argued that the claims should not be treated better by having been filed by the Banks instead of by the non-debtor affiliates. The Trustee was essentially arguing that the essential features of a claim don’t change, regardless of who holds it. The Banks responded that the claims should be allowed because under Enron II, the claims were acquired through a “sale” and not an “assignment,” thus the disallowance did not follow the transfer.3

Firestar found the reasoning in Enron II unpersuasive, and adopted the reasoning of the Third Circuit in KB Toys ruling that, for purposes of a disallowance of a claim, a distinction between a sale and an assignment is immaterial.4 Like a number of other Courts, Firestar found the Enron II decision problematic because it created a distinction between a sale and an assignment of claims where the Bankruptcy Code does not provide for one.5 Arguably, the definition of “transfer” under the Bankruptcy Code includes both a sale and an assignment; 11 U.S.C. § 101(54)(D) defines the term broadly to mean “each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with (i) property; or (ii) an interest in property.”

The Firestar Court rejected Enron II despite the fact there were many other ways to differentiate the claims of the Banks from that of a true third party purchaser of a claim. The claims of the Banks in Firestar fundamentally different than a fund or other investor buying an interest in a claim. Among the differences is that the Banks were not a true third party purchaser as they were engaged in a business relationship with affiliates of the Debtor. There is also good cause to question whether the pledge amounts are as large as the Banks were claiming them to be.

We expect the Firestar decision to replace Enron II as the new legal precedent, and claims buyers should be on notice as the Courts will not rely on how a transfer of a claim is made when evaluating whether the claim should be disallowed. As Firestar confirms, the disallowance is based on the claim, not the claimant.

Additionally, parties seeking to purchase bankruptcy claims bear the risk because they (1) are voluntarily choosing to participate in the process, and (2) can mitigate potential risk through due diligence and indemnity clauses in transfer agreements.

Claims Purchase Documentation and Diligence

Even prior to the Firestar decision, the vast majority of claims trading transactions were negotiated under the assumption that any impairment to a claim would travel to the buyer with the buyer looking to protect itself with representations and indemnities from the seller. The three key ways for a buyer to protect themselves are through documentation, diligence, and purchase price holdback. Each of these will be discussed below.

1. Transfer Documentation:

Standard claims trading documentation protects the buyer of a claim from any impairment that would cause the claim to be treated worse than other similarly situated claims.

  • Representations and Indemnities: A claims trading document should provide certain representations, generally backed by an indemnity, including that the claim is valid, that the seller did not impair the claim, and that the seller neither owes any funds to the debtor nor possesses any insider knowledge. If the Banks in the Firestar had tried to sell their claims to a third party they would likely have been in breach of almost every representation in the standard claims trading assignment agreement.

  • Disallowance Protection: As an alternative to litigating breaches of representations and warranties, most claims trading documents contain additional disallowance provisions which provide that if an impairment is discovered after the settlement date, the seller will be required to immediately repurchase the claim from the buyer, often at a high rate of interest. What counts as a “disallowance” and how interest is treated are two points that vary wildly by document, and are often a point of negotiation in claims trades.

  • Seller Recourse to Original Claim Holder: Many trade claims buyers purchase claims through a broker, such as a major banks or specialty claims broker, and documents vary as to whether buyer’s recourse is directly to the broker/seller or to the original claim holder. It is not uncommon for a buyer’s right to disallowance to be subject to the seller/broker receiving payment from the prior holder.

  • Are All Claims Being Transferred? Claims transfer agreements should make sure to include the rights being sold against any entity that may have a claim that is being sold, including guaranty obligations. This could be done by having more than one selling entity sign a single assignment agreement or by executing multiple assignment agreements.

  • Responsibility to Fight an Impairment: Sellers should consider whether they prefer to have the direct ability to challenge an impairment or it is a responsibility of the original claim holder.

2. Diligence:

The level of diligence appropriate for a claim often depends on whether a claim is allowed by a final court order, stipulated by the debtor, and/or has already been partially paid by the debtor. If a claim is allowed by a final order or if the estate has scheduled a claim for payment, the chance of the claim being challenged is extremely low.

  • Invoices: If claims are not yet allowed, a seller will generally want to see all underlying invoices that support the claim. Buyers should review the invoices to ensure that the correct account was billed and the invoices appear to have been properly submitted. Large debtors often use an online vendor payment system which may list the status of an invoice, through which buyers can request copies or screen shots of invoices.

  • Contracts Supporting the Claim: Buyers should also review whether the obligations of the seller are guaranteed by a third party and whether proofs of claims have been filed against all debtor obligors and guarantors. If there is a chance that the debtors may pay post-petition interest, it is important to see if there is a default interest rate listed in the contract.

  • Guaranty: Who is the debtor under the claim and can the claim benefit from a parent or other guaranty?

  • Timeliness of Proof of Claim: Was the proof of claim filed prior to the bar date? Has the claim been filed against the entity that the contact or obligation is against. In the event that the claim can benefit from a guaranty of another debtor entity a separate proof of claim should be filed against the entity providing the guaranty.

  • Correspondence: Buyer should review any correspondence related to the claim from the debtor or other entities, including any emails or letters wherein the debtor challenged the claim or accused the seller of any misconduct.

  • Record of Payment: Were any payments made on the claims being sold either pre- or post-bankruptcy filing?

  • Payment history: In cases where distributions have already been made on the claims being sold, one of the most important parts of the diligence is making sure that all expected payments have been received and that the amounts of such payments match the amounts expected to be paid under the plan of reorganization.

  • Current Business Relationship: Is the debtor still doing business with the seller and have they paid for work done post- petition? This is important since if the parties are still doing business with each other it diminishes the risk that there will be a dispute about the validity of the claim or the quality of the goods or services provided to the debtor.

  • Financial Diligence: Sellers may want to ask for audited financials or similar information. Particularly for non-stipulated claims, if the buyer remains concerned about the financial status of seller they may want to request a holdback or other payment provision outlined below.

  • Litigation Search: Is the seller being sued by the debtor or by other third parties in a way that could be material to the financial stability of the seller.

  • Trustee: Has a trustee been appointed in the proceeding or is a motion being considered? As seen in Firestar it is often a court-appointed trustee that is more likely to challenge a claim than a debtor who has a business relationship with the seller.

  • Business Area of Seller: Could the seller be accused of being liable to the debtor for conduct that may have contributed to the debtor’s financial distress. For example in the Enron bankruptcy a number of banks, had their claims against Enron disallowed after they were accused of lending to Enron at a time that allowed Enron to continue to fraudulent activity ? Another more theoretical example is if a debtor has a mass tort obligation (i.e. an oil well explosion) the claims of certain of its suppliers may be disallowed on the grounds that they contributed to the accident.

    Purchase Price Protection/Holdback:

    Even with diligence and a purchase agreement protecting against impairments, a claims buyer may still be concerned whether the seller will have the financial wherewithal to pay in the event of disallowance or indemnity. This protection can be obtain in a number of ways.

  • Holdback of Purchase Price: A claims buyer can request that all or a portion of the claim’s purchase price be held back until such claim is resolved or fully paid. A seller may prioritize locking in the claim value over the need for liquidity, but since most sellers are looking for cash up front, holdbacks are not commonly used other than for small portions of a claim or short term if a stipulation is expected shortly.

  • Escrow: Similar to a holdback, a seller may ask the buyer to put all or a portion of the purchase price in escrow, until a claim is stipulated or allowed by the debtor. From a buyer’s perspective an escrow can be risky as their funds unavailable and subject to litigation to get the unds released.

  • Guaranty: A buyer may also request that a seller obtain a guaranty for a seller’s indemnity or disallowance risk under a claim purchase agreement from a parent entity or even an individual owner when there are concerns about the seller’s liquidity.


We have long advised our clients not to rely on their status as a “good faith purchaser” to “wash” a claim free of a disability. Moving forward, when evaluating whether to participate in a claims transfer, a purchaser should engage in exhaustive due diligence to mitigate risk and take into account potential claim defenses.

© Polsinelli PC, Polsinelli LLP in CaliforniaNational Law Review, Volume X, Number 160

About this Author

Stephen A. Rutenberg Shareholder Polsinelli New York Bankruptcy and Financial Restructuring Bankruptcy Litigation Capital Markets ,Commercial Lending ,Debt and Claims Trading, Financial Services, Insolvency, Financial Technology FinTech and Regulation

Stephen Rutenberg’s practice focuses on the intersection of special situations investing and FinTech including cryptocurrency and blockchain technology. 

A significant component of Stephen’s practice relates to his work in the distressed debt market, representing clients in the purchase and sale of loans and securities of distressed and bankrupt companies. Recent representations include advising on the purchase, sale and financing of bankruptcy trade claims in several major chapter 11 cases, including Lehman Brothers, and the MF Global and Icelandic bank liquidations. He works with...


Morgan Fiander represents and provides valuable legal counsel to clients in the financial services industry. Morgan advises lenders involved in participated, co-lending, and syndicated loan transactions in enforcing their rights and protecting their interests. Morgan also represents financial services clients in matters arising out of consumer protection laws related to loan servicing, debt collection, and lending.

Morgan is experienced in handling all aspects of litigation in state and federal court from inception to trial, as well as appeals. She represents clients of all sizes,...