The claims trading industry has only grown in the nine years since the publication of this quote. Indeed, it is common in "mega" Chapter 11 cases to see on the docket hundreds, if not thousands, of "claims transfer notices" filed pursuant to Federal Rule of Bankruptcy Procedure 3001(e), and that is only a small set of the claims trading activity.
Why do buyers seek to acquire claims against bankrupt persons and companies? There are various reasons, including seeking profit, making strategic investments and attempting to control plan voting.
Likely, the most typical reason that an investor purchases a claim in bankruptcy is because the claims purchaser believes that the distribution on the claim will ultimately, on a present-value basis, be greater than the price that the claims purchaser is paying. A garden-variety conversation with a claims trader may read as follows:
"Why do you want to buy a claim?"
"Because I am paying 10 cents on the dollar, and I think the debtor will pay 25 cents on the dollar in a year."
Numerous funds invest and become involved in claims trading based on variants of this simple conversation. But this universe of claims traders can be further divided into passive investors and activist investors.
Passive Investors — The simple form of claims trading is by the passive investor. This investor researches the expected value of a claim when payments are projected to be made, conducts a present value analysis, and determines whether the present value of the claim's payments over time exceeds a seller's purchase price; if the answer is yes, the passive investor likely is willing to make the trade and purchase the claim. Certain basic due diligence includes:
-the timing of distributions and estimated recoveries;
-significant estate assets and how the estate proposes to use and maximize the value of those assets;
-whether the case has been, is, or is likely to be litigious, such that "administrative expenses" (including costs incurred by the professionals employed by the bankruptcy estate) would devour any recoveries to creditors; and
-any significant litigation claims held by the estate, including avoidance actions and turnover actions that could bring cash into the estate.
This form of passive investing may be more common in Chapter 7 and Chapter 13 cases involving consumers because the likelihood of unforeseen events altering the purchaser's analysis is lower than in Chapter 11 cases. Typically, traders purchase claims in a Chapter 7 case when there are large contingent claims, such as pending lawsuits, that may result in significant distributions to creditors.
Additionally, claims traders may purchase secured claims in a Chapter 7 case in order to credit bid for assets of a debtor’s estate. In such cases, the cost of actively monitoring the investment — by participating in the bankruptcy case — lowers the expected return of the claim.
The passive investor is less common in Chapter 11 cases. The expected return on claims against a Chapter 11 debtor typically involves numerous factors that are beyond the direct control of the creditor.
For example, whether the debtor has access to capital (such as use of cash collateral or debtor-in-possession financing) to finance operations, whether the debtor's existing equity and/or management desires to have a continuing stake in the company, and the competing interests of secured and unsecured creditors are all factors that can greatly impact the value of claims and yet have nothing to do with the claim directly. This creates significant drawbacks to passive investors purchasing claims in Chapter 11 cases.
If a passive investor does seek to purchase claims in Chapter 11 cases (or more complex cases generally), the investor may want to examine, in addition to the bullet points identified above, any information in court filings or court hearings relating to the timing of distributions and estimated recoveries, including analyzing any proposed plan of reorganization and whether debtor-in-possession financing has been provided, and what the rights of the debtor-in-possession lender are.
The costs associated with this sort of diligence is higher and often makes claims trading in Chapter 11 cases less desirable for passive investors. Indeed, while, unlike activist investors, a passive investor will likely not want to insert itself into the proceedings, the passive investor may still need to hire counsel to review key contracts (e.g., indentures, credit agreements, etc.) related to important constituents in Chapter 11 cases, as well as key filings, court hearings, and litigation related to the bankruptcy case.
Activist Investors — In Chapter 11 cases, the activist investor is a far more common breed of claims purchaser. This investor seeks to maximize return by attempting to influence the course of the bankruptcy case — by appearing and filing pleadings; by interfacing with the debtor-in-possession, the bankruptcy trustee, or the creditors' committee; and by trying to negotiate with other creditor constituencies. Activist investors may, and often do, engage in the following activities:
-Filing motions or oppositions to motions to advance certain positions with respect to the debtor's operations, assets or liabilities;
-Seeking to form ad hoc groups with similarly situated creditors to have a greater "voice" in the course of the case;
-Seeking to become a member of an official committee of unsecured creditors — although it is important to note that if a transferor or transferee of a claim does indeed become a member of the creditors’ committee, the transferor or transferee will then have certain fiduciary obligations, which will most likely result in trading restrictions and “walls” being established. As noted in “Potential Restrictions on Trades,” committees often seek “trading orders” in cases to address trading restrictions and the fiduciary nature of committee membership, and activist traders should have ethical wall procedures in place regardless of whether a trading order is entered;
-Proposing a plan of reorganization for the debtor if the debtor's exclusive right to propose a plan of reorganization has terminated; and
-In cases where creditors' recoveries consist of equity interests in the reorganized debtor, offering positions on valuation of the debtor's enterprise value.
Claims traders often acquire claims for strategic purposes. In these circumstances, the claims purchaser is less interested in acquiring the claim for purposes of maximizing the return on the claim but is more interested in using the claim as a springboard for other goals.
Some of the more common reasons are described below. All of these reasons stem from the bankruptcy principle that a person holding a claim against a debtor has standing to appear and be heard in the debtor's bankruptcy case. See 11 U.S.C. § 1109(b) ("A party in interest, including the debtor, the trustee, a creditors' committee, an equity security holders' committee, a creditor, an equity security holder, or any indenture trustee, may raise and appear and be heard on any issue in a case under this chapter.").
Conversely, entities that may have an economic stake in the outcome of a debtor's case but that hold no claims directly against a debtor have no standing. See, e.g., Sentinel Trust Co. v. Newcare Health Corp. (In re Newcare Health Corp.), 244 B.R. 167 (B.A.P. 1st Cir. 2000) (a secured creditor of a debtor's affiliates is not a party with standing to file a motion seeking the appointment of an examiner); Masonic Hall & Asylum Fund v. Official Comm. of Unsecured Creditors (In re Refco, Inc.), 2006 U.S. Dist. LEXIS 85691 (S.D.N.Y. Nov. 26, 2006) (investors in a fund that is a party to an adversary proceeding do not have standing to oppose a settlement or to take discovery).
Debt to Equity Conversion
A common goal of a strategic purchaser such as private equity shops and hedge funds, at least in Chapter 11 cases, is to gain ownership of the debtor and to acquire debt in order to convert such debt into equity of the debtor. Acquiring sufficient claims in a particular class of claims against a debtor can lead this form of strategic purchaser to propose or advocate for a plan of reorganization that results in their owning equity in the reorganized debtor.
These "loan-to-own" claims purchasers are less concerned about the recovery on account of the claims because the purchasers anticipate greater returns through owning the reorganized debtor upon its emergence from bankruptcy. "Loan to own" can be quite lucrative in comparison to more traditional lending strategies.
The "loan-to-own" strategy creates an interesting dynamic. Holding a significant amount of debt gives the creditor standing to participate in the bankruptcy case and leverage to negotiate with the debtor and other constituencies from a position of strength. Moreover, the creditor normally wants to be able to convert its investment in the debt into equity of the reorganized company.
However, since the "loan-to-own" creditor is more interested in acquiring the business, it will likely have to engage in the same type of due diligence as any purchaser of a company would have to engage in — analyzing the historical and projected financial performance of the company, as well as understanding the company's customer base, vendor relationships, material contracts, labor and employment issues, and retention of key management.
There is no doubt that such a creditor must be prepared to execute a confidentiality agreement and, once it has obtained confidential information, avoid the temptation to use (or be accused of using) confidential information to acquire additional claims against the debtor. Thus, the "loan-to-own" creditor may have to first acquire debt knowing that it lacks access to critical information, and then refrain from purchasing additional debt in hopes that the creditor can execute on its strategy.
Another common goal of a strategic purchaser is to acquire specific assets of the debtor. Similar to the claims purchaser seeking to hold claims in order to convert debt to equity, this form of claims trader purchases the claims to have standing to object to the sale of assets, or procedures with respect to the sale of assets, to other parties so that the claims purchaser can present its own proposal to acquire the assets.
Furthermore, for purchasers acquiring secured claims, Section 363(k) of the Bankruptcy Code generally permits the secured creditor to "credit bid" the claim secured by collateral in any proposed sale of such collateral. Thus, a claims purchaser who acquired a secured claim at a discount usually is entitled to "credit bid" the full amount of the claim.
If the value of the collateral exceeds what the claims purchaser paid but is equal to or less than the face amount of the claim, the claims purchaser may well have earned a tidy profit. A creditor seeking to use "credit bid" rights to acquire an asset will likely consider the following issues:
Is the claim subject to disallowance or subordination? Only holders of "allowed" secured claims may use Section 363(k)'s credit bidding rights. This includes the validity of the lien securing the claim. Courts sometimes require secured creditors to post collateral as security in the event that the secured claim is later disallowed (in whole or in part) or subordinated.
Section 363(k) permits a court to refuse to permit credit bidding "for cause." The Bankruptcy Code does not define "cause," and a court may decide cause exists if permitting credit bidding would have a materially adverse impact on the course of the case.
Has the collateral been valued or appraised at or below the amount of the secured debt, and will the debtor or other players in the case fight that valuation? The creditor should understand valuation before determining the appropriate amount to credit bid.
If a plan is proposed that transfers the collateral and the secured creditor objects to the treatment of its secured claim, some courts have refused to enforce the "credit bidding" rights provided for under 11 U.S.C. § 1129(b)(2)(A)(ii) if the plan otherwise provides for the "indubitable equivalent" of the secured creditor's claim. But the United States Supreme Court recently affirmed the Seventh Circuit's decision in In re River Road Hotel Partners LLC, which held that a debtor’s plan that sells collateral free and clear of a creditor’s lien is not confirmable if it strips away credit bidding rights. See RadLAX Gateway Hotel LLC v. Amalgamated Bank, 132 S. Ct. 2065 (U.S. May 29, 2012).
Another type of strategic purchaser of claims is the competitor of the debtor. This type of claims purchaser seeks to acquire claims because of the debtor's status as a competitor. This type of strategic purchaser is less common, arguably because it is fraught with risk to the claims purchaser.
Any competitor buying claims will likely be subject to heightened scrutiny if it gains access to confidential information, and any vote that it submits on a plan of reorganization may be analyzed more closely to determine whether the competitor is using the claim to advance ulterior motives. See 11 U.S.C. § 1126(e) (votes of claims on a Chapter 11 plan may be designated if not made or solicited in good faith).
What constitutes "bad faith" is not defined by the Bankruptcy Code, but a recent Second Circuit decision, In re DBSD North America Inc., 627 F.3d 496 (2d Cir. 2010), sheds light on the subject. In DBSD, the debtors were developing a services network that can deliver wireless satellite communications services to mass-market consumers.
One company that was not a prepetition creditor of the debtors purchased all of the debtors' first lien secured debt two weeks after the debtors filed a plan of reorganization. The company was a provider of satellite television and was also a significant investor in a competitor of the debtors.
Because the first lien debt was separately classified under the debtors’ plan, the purchase meant that the competitor was the sole creditor voting in that class. The competitor also purchased portions of the second lien debt, but only from those creditors who were not bound by a plan support agreement with the debtors. Throughout this period, the company was also pursuing a strategic transaction with the debtors.
The competitor voted against the plan, and the debtors moved to designate the vote as being made in bad faith. The bankruptcy court sided with the debtors, and the Second Circuit subsequently affirmed.
In reviewing the bankruptcy court’s decision to designate the competitor’s vote against the plan, the Second Circuit noted that “merely purchasing the claims in bankruptcy for the purpose of securing the approval of rejection of a plan does not itself amount to ‘bad faith’” and that “selfishness alone [does not] defeat a creditor’s good faith; the code presumes that parties will act in their own self interest and allows them to do so.”
Instead, as the Second Circuit noted, designation aims to punish a very specific wrong: attempting to obtain some benefit to which a creditor is not entitled, which is also referred to as voting with an “ulterior motive” or with “an interest other than an interest as a creditor.”
Even though not every ulterior motive is an improper one that requires designation, in DBSD, the competitor apparently went too far; for example, the court cited to internal communications and documents stating that the competitor saw a “strategic opportunity to obtain a blocking position ... and control the bankruptcy process for this potentially strategic asset."
A common method by which activist claims purchasers or strategic claims purchasers attempt to maximize their greatest influence in Chapter 11 cases is through voting on a plan of reorganization.
Assuming certain requirements are met as set forth in section 1129(a) of the Bankruptcy Code, a Chapter 11 plan of reorganization may be confirmed in one of two ways. First, a plan may be confirmed if every impaired class of claims accepts the plan. See 11 U.S.C. § 1129(a)(8).
Second, a plan may be confirmed if there are classes of claims that have voted to reject the plan, as long as at least one impaired class has accepted the plan, which is determined "without including the acceptance of the plan by any insider." See 11 U.S.C. § 1129(a)(10). This second confirmation method is routinely referred to as "cramdown."
A class accepts a plan if two requirements are met. The first such requirement is met if two-thirds in dollar amount of allowed claims in a class that actually vote accept the plan. The second requirement is satisfied if more than one-half in number of the claims in a class that actually vote accept the plan. See 11 U.S.C. § 1126(c).
Whether a blocking position strategy is likely to be publicly revealed; not surprisingly, if market participants anticipate that a particular creditor is seeking a blocking position, the price is likely to rise as the creditor closes in on the blocking percentage;
While obtaining a blocking position is generally viewed as not constituting “bad faith” that could lead to vote designation under Section 1126(e) of the Bankruptcy Code, see Figter Ltd. v. Teachers Insurance & Annuity Association of America (In re Figter Ltd.), 118 F.3d 635, 638–39 (9th Cir. 1997), acquiring a blocking position in order to advance an alternative plan or obtain control of property may lead to a bad finding under DBSD, 627 F.3d 496 (2d Cir. 2010).