A Conditional Interest in Property Creates a Transfer that may be Disallowed Under 502(b)

Mairead Cooney 

St. John's University School of Law 

American Bankruptcy Institute Law Review Staff 

In In re Firestar Diamond, Inc., et al, the Bankruptcy Court for the Southern District of New York held that Firestar Diamond Inc. (the “Debtor”) was not responsible for the debts owed to the Bank of India and Union Bank of India (the “Banks”), but rather the Affiliates of Firestar Diamond (Firestar Diamond International Private Limited, Firestar Diamond BVBA, and Firestar Diamond FZE) were responsible for those debts and because the pledges of accounts receivable under 502(b), the Banks had a conditional interest in the Affiliates’ property.[1] The Debtor operated a wholesale jewelry business in NY.[2] The Debtor is part of the international diamond business of Nirav Modi, which owned and controlled the Debtor and numerous other diamond businesses throughout the world.[3] The Debtor regularly purchased polished diamonds from the Affiliates, and the Banks provided commercial banking services to the Affiliates to finance the sales.[4] The Banks extended credit to the Affiliates or purchased the rights to payments on the Affiliates' invoices issued to the Debtors.[5] After each purchase, the Affiliates issued invoices to the Debtors directing that payments be made directly to the Banks, that the payments were for the ultimate benefit of the Affiliates, and that they were due between 120 and 152 days after the invoice date.[6] The Affiliates would then notify the Banks of every sale, and the Banks would draw on their credit funds.[7] As a security for the draw on credit, the Affiliates pledged the invoices and their account receivable to the Banks.[8] The Debtor filed a Chapter 11 bankruptcy proceeding on February 26, 2018.[9]

This case comes from a remand of the New York Southern District Court after an appeal from the Bankruptcy Court for the Southern District of New York where the Banks filed a complaint against Nirav Modi for “the largest bank fraud in Indian history.”[10] In the initial proceeding, the main issue was whether a disallowance under Section 502(d) is “a personal disability of the specific claimant or an attribute of the claim itself.”[11] The initial court found the Banks’ claims were disallowed because it does not matter who holds the claims.[12] On appeal, the District Court agreed that the “transferee of a claim is subject to the same burdens under Section 502(d) as the transferor,” but remanded the case to this Court to find specific factual findings regarding the characterization of the Banks’ claims, and how the claims are traced, or are not traced, to the Affiliates against the Debtors.[13] On remand, the Trustee filed a motion for summary judgment arguing that the claims the Banks made do not belong to the Banks, but rather the Affiliates, or in the alternative, the claims were subject to disallowance under 11 U.S.C. Section  502(d), given the Affiliates’ receipt of  fraudulent transfers and preference payments from the Debtors.[14]

First, the Bankruptcy Court looked to the textual language of the parties’ agreement to determine who was a party to the agreement with the Debtor.[15] The Bankruptcy Court found that the claims belong to the Affiliates, not the Banks.[16] The Affiliates remained liable for the debt and risk of non-payment by the Debtors, and the Banks’ risk was only that the Affiliates would not be able to satisfy the loan in the case of a non-payment.[17] The Banks argued that the documents are tripartite agreements, and thus there is an obligation from the Debtors to the Banks.[18] However, there was no evidence that there was a meeting of the minds between the Banks and the Debtors because the Banks only became aware of the Debtors after the invoices were sent.[19] There was no evidence that the 120 to 152 days the Affiliates gave the Debtor to pay was an offer extended by the Bank.[20] Lastly, the Banks’ “course of dealing” argument was not strong because extrinsic evidence cannot be used to contradict the express terms in the agreement.[21]

Second, the Bankruptcy Court considered whether the pledges of the accounts receivable are transfers under section 502(d) of the Bankruptcy Code.[22] Section 502(d) “requires a court to disallow an entity’s claim against the bankruptcy estate if the estate is entitled to recover property from that entity . . . but that entity has failed to first transfer this property back to the bankruptcy estate.”[23] Section 105 of the Bankruptcy Code defines transfer broadly as “disposing of or parting with property,” and obligation is presumed to mean a formal agreement to do a certain thing for a particular person or group.[24] The Court found the pledges of the account receivables are transfers under Section 502(d).[25] The Court cites Asia Global Crossing, where it was decided that since the guaranty of repayment did not create an interest in the property, there was no transfer.[26] Here, unlike in Asia, securing debt by using property as collateral created an interest in the property.[27] The pledges gave the Banks a conditional interest in the Affiliates’ property, and that is all it takes to establish a transfer.[28] If the Banks foreclose on the accounts before the transfer is complete, the claims are still disallowed because they would remain with the Affiliates and the Banks would have no claims at all.[29]

The Trustee’s motion for summary judgment was granted.[30] The Banks were unable to provide sufficient evidence to show they acquired the rights of payment and that the claims are obligations.[31] Therefore the Banks’ motion for summary judgment was denied.[32]