The term "bankruptcy" is often misunderstood and interpreted to mean "bad business" or "bad investments." However, what is less known is that bankruptcy can be laden with profitable investment opportunities and the opportunity to reduce risk. Investment banks and venture capitalists have long taken advantage of the bargain deals that bankruptcies give rise to in a phenomenon called "claims trading."
As exemplified by the recent downturn in the Asian economy, many companies are attempting to restructure their finances both in and out of bankruptcy. As a result, investors are frequently purchasing the "claims" of creditors against these companies in order to profit from the pending restructure.
Before discussing the advantages and limitations of claims trading in the United States, this article will present a general overview of bankruptcy law in the United States and discuss some of the issues which may arise when dealing with companies in bankruptcy. Finally, we will discuss some of the risks and concerns which can arise when companies trade claims improperly.
UNITED STATES BANKRUPTCY LAW IN GENERAL
This article describes federal bankruptcy law and practice in the United States. Bankruptcy law in the United States is governed primarily by federal statute, Title 11 of the United States Code. Congress enacted the Bankruptcy Code as a type of organized debt collection system whereby the federal bankruptcy courts provide a collective forum for sorting out the rights of various creditors against the assets of a debtor, typically where there are not enough assets to pay all claims in full. At the same time, the Bankruptcy Code can provide relief to the debtor by discharging pre-petition debts and allowing the debtor to reorganize and/or begin with a "fresh start."
TWO FORMS OF BANKRUPTCY: LIQUIDATION AND REORGANIZATION
In general, there are two forms of bankruptcy: liquidation and reorganization. Chapter 7 of the Bankruptcy Code governs liquidation of an individual or corporate debtor’s assets. Chapter 13 of the Bankruptcy Code governs individual or "wage-earner" reorganizations, which allow the debtor to retain his or her assets while making payments to creditors pursuant to a court-approved plan. Typically, there are not enough assets in a Chapter 7 or Chapter 13 case to warrant trading claims, though it is plausible that claims trading may arise in these cases as well. Further, Chapter 7 debtor companies are usually liquidated too quickly for creditors to contemplate trading claims. Accordingly, this article will primarily focus on Chapter 11 bankruptcy cases which principally concern reorganizations of corporations, partnerships and individuals, with no debt limit.
CREDITORS’ CLAIMS AND FILING A PROOF OF CLAIM
Creditors’ claims are important in bankruptcy law since only "claims" can be discharged, and only "claimants" with "claims" can vote on a plan of reorganization in a Chapter 11 case. Also, the particular type of the claim often determines whether the creditor will receive a distribution and the amount of that distribution.
Section 101(5) of the Bankruptcy Code defines a "claim" as a right to payment, or right to equitable remedy for breach of performance if such breach gives rise to a right of payment. Bankruptcy laws have steadily expanded the scope of "claims" over the years and the United States Congressional report makes clear that "the [Code] contemplates that all legal obligations of the debtor, no matter how remote or contingent, will be able to be dealt with in the bankruptcy case." Thus, a "claim" can be a defined amount of money, such as an account receivable or note installment, or a contingent unliquidated liability such as an asserted claim for damages which has yet to be determined by a court or jury. It is these rights to payment or "claims" which are routinely bought and sold based upon the buyer’s and seller’s expectation of the ultimate recovery in the case.
In a typical Chapter 11 case, claims are divided into secured and unsecured claims,and the unsecured claims are often divided further based on the type of claim. Secured claims generally receive priority in payment over unsecured claims in any distribution plan, while the unsecured claims are again prioritized so that administrative expense claims (including certain professional fees and expenses, certain employee wage and benefit claims, certain tax claims and claims of creditors providing post-petition credit to the debtor) usually take priority over pre-petition general unsecured creditors. Accordingly, creditors who are considering selling their claims, as well as buyers who are considering buying claims, must be aware of the relative priorities among secured and unsecured claims.
A debtor is usually responsible for identifying the name, amount and designation of a Creditor’s claim on the debtor’s Schedule of Assets and Liabilities, which is filed as part of the initial bankruptcy proceeding. However, a proof of claim should also be filed by all creditors to dispute or supplement what the debtor has filed. A creditor’s proof of claim is normally filed by the creditor on an official bankruptcy form and sets out the amount due and the proper name and address of the creditor. Filing a proof of claim is required in a Chapter 7 case in order to receive distributions. Filing a proof of claim is not required in Chapter 11 cases if the claim is properly listed on the debtor’s schedules. Nevertheless, if the claim is listed incorrectly, or as disputed, contingent or unliquidated, the creditor must file a proof of claim or run the risk of the court accepting the debtor’s designation, which in some cases may result in loss of voting and distribution rights. The time to file a proof of claim is determined by the court in Chapter 9 and 11 cases, and is required to be filed within 90 days after the first scheduled meeting of creditors in a Chapter 7 case.
TRADING CLAIMS IN BANKRUPTCY
SELLERS OF CLAIMS AND THE MOTIVATIONS BEHIND SELLING CLAIMS
The sellers of bankruptcy claims can be either: (i) creditors that have extended unsecured credit to the debtor company (most commonly trade suppliers of materials or services); or (ii) secured creditors (most commonly financial institutions) that have obtained collateral to secure an advance of credit to the debtor. Though unsecured claims are generally not as large as the secured claims of institutional creditors, the impact of a delinquent payment to an individual unsecured creditor normally has a much greater impact than on an institutional secured creditor.
For example, if Company X is a supplier of semiconductor chips and its largest customer, Company Y, files for bankruptcy and suspends payment of its invoices, the impact on Company X can be immediate and severe. It is possible that Company Y’s debt represents a large portion of Company X’s total outstanding accounts receivable. Under these conditions, Company X may not have the time to wait for Company Y to reorganize. Even if Company X is fairly certain that it will eventually recover a large portion of the debt owed it, it simply may not be able to afford the wait.
Creditors which find themselves in these situations may choose to sell their claims at a discount. Simply put, for many of these creditors, it is better to recover thirty ($.30) to sixty($.60) cents on the dollar today (for example), rather than risk entering bankruptcy themselves by holding out for a better return in the future. Thus, selling bankruptcy claims offers the seller an opportunity to turn a claim that otherwise might not be satisfied for many years, into liquid assets.
Another common motivation for an unsecured creditor to sell its bankruptcy claim is the intimidation surrounding the bankruptcy itself. When a creditor becomes aware that a debtor has filed a Chapter 11 bankruptcy petition, many panic and sell their claim to the first willing buyer. These sellers fail to research the potential recovery value of the debt they are selling. They enter the claims market with a willingness to take far less than their claim may ultimately be worth.
On the other hand, other claim sellers enter the market after careful research and thorough reflection. These sellers have weighed the risks and potential benefits, and have simply decided that they would be better off by selling the debt, obtaining cash immediately, and learning from the experience.
BUYERS OF CLAIMS AND THE MOTIVATIONS BEHIND BUYING CLAIMS
Although companies and individuals sometimes purchase bankruptcy claims directly from creditors, more commonly brokers and traders act as middlemen in the transaction. Generally, these middlemen maintain a network of potential investors, and search bankruptcy court dockets for potential sellers. Their usual commission is .5% to 1% of the total value of the transaction. Brokers and traders sometimes package claims into units ranging in value from as low as U.S. $30,000 to as high as millions of dollars. These packaged claims can be comprised of a single claim or a mixture of claims from several different bankruptcy filings. By mixing claims, high and low risk claims can be blended and packaged in a proportion that is attractive to potential investors. As set forth below, claims investors can be sorted into two (2) principal groups; passive investors and active investors.
In its simplest form, purchasing bankruptcy claims can be a fairly straightforward endeavor. Using this approach, an investor researches the expected value of the claim at the end of the Chapter 11 bankruptcy and the expected duration of the bankruptcy process—thereby leading to a discounted present value analysis. The investor then compares the seller’s offering price against the claim’s projected final value at the end of the bankruptcy process. If the return is large enough, and the duration of the bankruptcy is not too long, then the investor purchases the claim and waits for the debtor to work its way out of the bankruptcy.
This passive approach, however, is not commonly used by most investors because the return on their investment is dependent upon too many variables beyond the investor's control. Though bankruptcy can be a smooth process, unforeseeable time delays can destroy an investor’s return. In addition, the potential for proactive maneuvering on the part of other creditors makes it extremely difficult to determine at the outset what the final value of the claim will be. Therefore, most investors who choose to enter the bankruptcy claims market prefer to take an active role in shaping the bankruptcy process.
One way investors can increase the return on their investment is to attempt to take an active role in the reorganization process and support a reorganization plan that maximizes the value of their claim. Though the incumbent management of a bankrupt company initially maintains control through the "exclusivity periods," ultimately the right to file a reorganization plan (and, thus, control the timing and amount of payments to creditors) may be made available to any claim-holder who proposes an alternate plan.The reorganization plan specifies what payments (and the time period for said payments) proposed to holders of secured and unsecured claims, and contains a road map, including projections, of the debtor's future operations. Often sophisticated claims investors buy groups of claims in a single bankruptcy case. This consolidation of claims increases the buyer's leverage in negotiations regarding the debtor’s plan of reorganization.
Another factor that motivates active investors is the expectation that in cases where unsecured claims will not be paid in full, these unsecured claims will be converted into stock in the reorganized debtor. Therefore, by purchasing a large block of the outstanding claims, an investor may have the opportunity to position itself to become a controlling or influential shareholder once the reorganization plan is approved.
CLAIMS TRADING PROCEDURE
It is important to note that the trading of bankruptcy claims is not explicitly regulated by the Bankruptcy Code. Although there are some general provisions in the Bankruptcy Code that apply to claims trading, the process is largely governed through more general legal principles. Accordingly, its is essential for both buyers and sellers to retain competent professionals who understand the process and procedure of trading bankruptcy claims.
Bankruptcy Rule 3001(e) governs the mechanics of claims trading. If those procedures are followed, the rights held by the original claim-holder are transferred to the investor who purchases the claim. These rights transfer as if the investor had paid the full face value for the claim, even if the actual purchase price was substantially discounted from the face value. Because the claim assigned is subject to any defenses/set-offs available to the debtor against the transferor, claims trading must be undertaken with detailed knowledge of the debtor’s potential rights and defenses against the selling creditor.
PITFALLS OF TRADING CLAIMS
The Bankruptcy Code contains flexibility to assist a reorganizing debtor to confirm a reorganization plan that will create long-term stability. This flexibility in the Bankruptcy Code means that the bankruptcy judge has considerable influence in shaping the outcome. As a threshold matter, the bankruptcy judge has the power to determine whether a proposed reorganization plan will be confirmed, and what terms will be included in the plan. Accordingly, all buyers and sellers of claims must understand the risks of bankruptcy and respect the fact that the ultimate resolution of all claims is, to some degree, out of their control.
The investor who buys a bankruptcy claim must also take steps to ensure that there will be no difficulties in establishing title to its recently purchased claim. Though uncommon, there is a chance that the seller’s claim could be fraudulent. This type of fraud includes, but is not limited to: Multiple sales of a single claim; misrepresentation of the size of the claim; and misrepresentation of the claim’s seniority. An investor must be knowledgeable in bankruptcy procedures or obtain the assistance of knowledgeable legal counsel to help insure that the newly-acquired claim is valid and will be recognized by the bankruptcy court.
Claims-holders must also be concerned about breaching any fiduciary relationships that might exist. Claims-holders who sit on an Official Creditors Committee (generally consisting of the seven largest unsecured creditors) will have access to sensitive and confidential information regarding the debtor and, therefore, be considered a "fiduciary" to other creditors. Although the Bankruptcy Code does not expressly address the issue of insider trading, bankruptcy judges will generally sanction a buyer or seller of claims who trades on inside information obtained while acting as a fiduciary. In fact, recently a bankruptcy court flirted with the application of a per se rule prohibiting insiders from purchasing a claim without adequate disclosures of the insider’s identity and relationship to the debtor. See, In re Papercraft Corp., 187 B.R. 486 (W.D. Pa. 1995). The court in Papercraft limited the insider’s recovery for his claim to the price he paid to the original creditor. This holding turned an investment that had netted U.S.$50,000,000.00 in profits into a break-even venture.
This per se rule was short lived. Noting that the bankruptcy court’s per se rule was a"new rule" not supported by statutory or common law, the Appellate Court reversed the Bankruptcy Court’s adoption of the per se rule. In re Papercraft Corp., 211 B.R. 813 (Papercraft II) (W.D.Pa. 1997). Though the court noted that in almost every statutory scheme there may be the need for judicial interpretation of ambiguous or incomplete provisions, the court found that the Bankruptcy Code contained no provision giving the Bankruptcy Court the power to fashion new federal common law.
Though the court overruled the per se rule, the court required a further review of the extent that the insider’s claims should be "equitably subordinated" under Bankruptcy Code Section 510(c). Equitable subordination is a remedy given to the Bankruptcy Court which, among other things, permits him or her to reverse the statutory priority scheme and actually re-position a secured or unsecured creditors claim to an inferior position of payment priority based upon "inequitable conduct."
The Papercraft II court adopted three (3) criteria that must be satisfied to equitably subordinate a claim which has been traded:
- The claimant must have engaged in some type of inequitable conduct;
- the misconduct must have resulted in injury to the creditors of the debtor or conferred an unfair advantage on the claimant; and
- equitable subordination of the claim must not be inconsistent with other provisions of the Bankruptcy Code.
In determining whether these three conditions have been met in the context of a creditor who purchases or sells a claim, three (3) general principles must be considered.
- First, inequitable conduct directed against the bankrupt company or its creditors may be sufficient to subordinate a claim irrespective of whether it was related to the acquisition or assertion of a claim.
- Second, a claim should only be subordinated to the extent necessary to offset the harm which the bankrupt company or its creditors suffered on account of the inequitable conduct.
- Finally the party seeking equitable subordination usually has the burden of proof, but when the allegations of inequitable conduct involve an insider transaction, the burden is on the insider to prove not only the good faith of the transaction, but also the inherent fairness from the viewpoint of the bankrupt company and other creditors.
The reversal of the per se rule in Papercraft removed a major point of concern for insider investors. At the same time, the Appellate Court’s interpretation of Bankruptcy Code Section 510(c) raises new concerns. Inside investors who purchase claims in a debtor’s bankruptcy case must carefully scrutinize the inherent risks in purchasing claims in a bankruptcy case, particularly when they are insiders. Any inside investor who decides to purchase claims of a debtor should, at a minimum:
- Make full disclosure of the insider's identity;
- fully disclose his/her relationship to the debtor;
- disclose the nature of the insider’s actions; and
- ensure that the insider did not take or usurp a corporate opportunity of the debtor.
These cautionary measures may avoid years of protracted litigation and may avoid jeopardizing an investor’s hard earned returns.
The foregoing is by no means an exhaustive list of the legal concerns that a claims trader in bankruptcy may encounter. However, the legal concerns are surmountable. As a result, a careful, well-advised investor can trade in bankruptcy claims safely and profitably.
TRADING CLAIMS IN NON-BANKRUPTCY SITUATIONS
Although the main thrust of this article focused upon a discussion of the ways in which bankruptcy can create significant investment opportunities and reduce risk, purchasing and selling claims outside of bankruptcy may be a more preferable method of asset management. Of course, not all companies that are experiencing financial distress seek formal bankruptcy protection. The vast majority of companies first try to restructure their debt and business affairs out of court. Out-of-court restructuring allows troubled companies to avoid the high costs and stigma that filing a bankruptcy can involve. In fact, nearly fifty percent (50%) of U.S. public firms that experienced financial distress in the 1980s managed to overcome their difficulties by restructuring their debt out of court.
In addition to avoiding the stigma of a bankruptcy proceeding, restructuring a company's debts out of court saves a great deal of administrative and legal expense. Moreover, a bankruptcy proceeding may also be time-consuming. By avoiding the Bankruptcy Court, management can focus on recovery and the debtor’s long-term financial rehabilitation. Although less formalized, claims trading is quite common in non-bankruptcy situations.
Trading in bankruptcy claims can be a profitable venture for both the buyer and seller of the claim. The pitfalls that do exist can generally be circumvented by knowledgeable business people and professionals. As a result, by understanding the bankruptcy process, what has traditionally been seen as a business "disaster" can be converted to a business "opportunity" for the intelligent buyer, seller or investor.