The purchase and sale of claims held by creditors against debtors in a bankruptcy proceeding has become a big business. The motivations for the buyer are varied. They include making a profit on any distributions in the debtor's case above the price paid to the seller, obtaining the right to vote on the debtor's plan of reorganization, and participating more generally in the debtor's case. The seller gets a guaranteed return without having to wait for the bankruptcy to run its course.

In a recent bankruptcy case, In re Woodbridge Group of Companies, Case No. 17-12560 (KJC), 2018 Bankr. LEXIS 1904 (Bankr. D. Del. June 20, 2018), Bankruptcy Judge Kevin J. Carey considered three issues in connection with the sale of a bankruptcy claim: whether an anti-assignment clause in a promissory note was a valid restriction on assignment rights under Delaware law; whether a nonbreaching party to a promissory note in payment default was still bound by an anti-assignment clause while also seeking to enforce the note in bankruptcy through a proof of claim; and whether the Uniform Commercial Code (UCC) overrode and nullified an anti-assignment clause in a promissory note. Carey held that the anti-assignment clause in the note was enforceable under Delaware law, the tenets of contract law, and the UCC, and sustained the debtors' objection to the assignee's claim.

In December 2017, the debtors filed for bankruptcy under Chapter 11. Prior to the bankruptcy, one of the debtors issued to its lenders three promissory notes in the principal amount of $25,000 each. The promissory notes contained an anti-assignment clause which provided that the notes could not be assigned without the borrower's written consent, and any such assignment without consent would be “null and void.” After the bankruptcy filing, the holders of the notes sold them to a hedge fund, which then filed a proof of claim asserting a secured claim against the issuer debtor in the amount of $75,000. The debtors objected to the claim on the grounds that the assignment of the notes to the hedge fund was null and void.

The hedge fund first argued that sustaining the claim objection would cause disruption in the claims trading market, and that neither the Debtors nor the court should attempt to police it. Carey rejected this argument, noting that he was not aware of any provision in the Bankruptcy Code, or any overarching bankruptcy policy, which would prevent the court from determining and enforcing applicable nonbankruptcy law concerning contract provisions which might restrict transfers of claims.

Carey found that the Delaware courts, while recognizing the validity of anti-assignment clauses, generally construed such provisions narrowly because of the importance of free assignability. Delaware, consistent with the modern approach, distinguishes between the power to assign and the right to assign. In order for a court to find that a contract clause prohibits the power to assign, there must be express language that any subsequent assignment will be void or invalid. Otherwise, the contract merely restricts the right to assign, and the assignment is valid and enforceable but results in a breach of contract by the party assigning its interest.

Carey found that the anti-assignment clause in the promissory notes manifested a clear intention to forbid the power to assign the promissory notes and any rights thereunder. Any assignment of the notes without the issuer debtor's written consent was null and void. Since the anti-assignment language provided a clear intent to restrict the power to assign the notes as opposed to restricting only the right to assign, the transfer of the notes to the hedge fund assignee was void.

Carey also held that the issuer debtor's prior breach of the promissory notes did not render the anti-assignment clause unenforceable. He noted that a nonbreaching party may not emerge after the breach with more rights than it had prior to the breach. Neither the original holders nor the assignee could end up after the breach with more rights than they had before the breach. A claim purchaser holds the claim subject to the same rights and disabilities under the Bankruptcy Code as did the original claimant. The original holders' violation of the anti-assignment clause was a “disability” that traveled with the transferred claim into the hands of the hedge fund assignee, and therefore the assignee did not have the right to file the proof of claim.

The last argument considered by Carey was whether the UCC invalidated the anti-assignment clause. The hedge fund assignee argued that Section 9-408 of the UCC (Restrictions on assignment of promissory notes, health care insurance receivables, and certain general intangibles ineffective) nullified any provision of the promissory notes that restricted the assignment of the notes or required the consent of the maker before the notes could be transferred. The debtors argued that this section prohibits only restrictions on the assignment of a security interest in a promissory note, not the promissory note itself. Carey found little decisional law on the issue, so he looked to the statute and the associated comments for guidance. He concluded that Section 9-408 is applicable only to grants of security interests, and not to the sale or assignability of promissory notes. Based on this analysis, Section 9-408 was inapplicable.

As Carey explained, quoting from an earlier decision of his, “buyers of debt, in the court's experience, are highly sophisticated entities fully capable of performing due diligence before any acquisition.” Carey is no doubt correct that his decision will not cause disruption in the claims trading market. Instead, the decision is a cautionary tale for buyers of debt to be more vigilant in their due diligence to avoid the potential applicability of anti-assignment clauses in the underlying instruments they seek to purchase.

Barry M. Klayman is a member in the commercial litigation group and the bankruptcy, insolvency and restructuring practice group at Cozen O'Connor. He regularly appears in Chancery Court.

Mark E. Felger is co-chair of the bankruptcy, insolvency and restructuring practice group at the firm.