Savvy Claims Purchasers Must Avoid Pitfalls

Journal Issue

Jun 2006

Column Name

Claims Chat

Citation

ABI Journal, Vol. XXV, No. 5, p. 26, June 2006

Topic Tags

Investment Banking

Journal HTML Content

Editor's Note:

Claims Chat is a new periodic column addressing topics of interest
relating primarily to chapter 11 bankruptcy claims.
</blockquote>An increasing amount of
distressed investment capital in the market has led to the
participation in bankruptcy cases by third-party purchasers of claims
and interests. Claims-trading in chapter 11 is nothing new. Holders of
claims who are not in the business of investing and speculating on the
outcome of chapter 11 cases are usually willing to sell their claims
at a discount. But increased claims-purchasing activity at all levels
of the capital structure has introduced some new players into the
process and paved the way for the development of new guidelines. This
article focuses on the types of claims being purchased, identifies
procedural and substantive pitfalls associated with the process, and
proposes guidelines for managing some of the pitfalls. Types of
Investors Investors buy different types or classes of claims and
interests within a company's capital structure to facilitate their
goal of maximizing profits or owning an asset or equity stake in the
reorganized company. Type 1 investors (typically hedge funds or
private investors looking to avoid the risks associated with the
equity market) purchase claims or debt securities with an eye toward
owning an equity stake in the reorganized entity. Type 2 investors buy
unsecured trade or bank debt at a discount, hoping for a recovery that
exceeds the purchase price. Type 3 investors include other types of
investors who buy claims to facilitate standing as a party-in-interest
in particular proceedings, such as asset sales. Pitfalls for Type
1 Investors The goal of a Type 1 investor is to own a substantial
equity stake in the reorganized entity. There is significant
competition within the Type 1 investing arena. These parties purchase
subordinated debt securities at a substantial discount. Type 1
investors are active participants in cases, working aggressively toward
a plan structure that includes a debt-for-equity swap. Type 1 investors
who want a piece of the reorganized company may try to avoid the risk
of reinstatement or nonequity plan currency by taking an active role
in the case as a secured creditor or serving on the committee of
unsecured creditors. There are some pitfalls associated with this
kind of activity. First, it is hard for Type 1 investors to obtain
positions on committees (even though investments can be made
post-petition) unless the debt is purchased pre-petition because
committees are typically established at the beginning of the chapter 11
case. While the Office of the U.S. Trustee (UST) may substitute
committee members throughout the case, there are no guarantees that
the UST would add a Type 1 investor to a committee mid-case,
particularly if a Type 1 investor is already currently serving on the
committee. (Type 1 investors often try to overcome this challenge by
establishing ad hoc committees during the plan formulation
process). While the composition of the committee has been left to the
discretion of the UST, some courts have cautioned that the interests
of the estate are not always served when committee members transition
in and out as the debt trades hands. Second, committee members owe
fiduciary duties to their constituencies. The most common possible
breach of fiduciary duty by a Type 1 investor committee member is
trading in the debtor's securities. Committee members are entitled to
confidential information throughout the chapter 11 cases, which is why
courts often issue "blocking" or "screening"
orders directing that committee members may not share confidential
information with members of the organization who are trading in the
debtor's securities. Type 1 investors should consider some important
issues before purchasing debt securities and becoming involved in a
chapter 11 case. Not all bond issuances are alike. Depending on the
secured or unsecured nature of the bond, a debtor may reinstate the
debt or include a plan provision to pay back the issuance with the
proceeds of exit financing. While this would provide the investors
with a recovery, it would be limited to the face amount of the issuance
plus accrued and unpaid interest at best, and would likely not result
in the investor receiving a significant equity stake in the
reorganized company. In addition, debtors frequently request trading
limitations on large debtholders to preserve potential net operating
losses (NOLs) to offset against future tax liabilities of the
reorganized company. Courts have helped debtors safeguard NOLs by
establishing procedures to monitor ownership changes through claims
trading. Some courts are willing to issue claims-trading injunctions (to
the extent trading exceeds a given dollar amount) to protect the
debtor's ability to rely on Internal Revenue Code §382 as a way
to protect NOL carry-forwards. Pitfalls for Type 2 and 3
Investors Type 2 investors purchase private debt, such as bank or
trade debt, to receive higher recoveries under the plan, hopefully
including post-petition interest. To ensure such higher recoveries,
purchasers of private debt often buy enough claims to secure blocking
positions within their class. A creditor will have a blocking position
within a class if it holds more than 1/2 in number and 2/3 in amount
of the allowed claims in the class. Type 3 investors typically purchase
small blocks of trade debt, with the goal of establishing standing as
parties-in-interest to participate in particular proceedings. Type
2 and 3 investors should consider a number of issues before purchasing
claims. Purchasers of private debt claims must conduct appropriate due
diligence to ensure that the claims are not vulnerable to
disallowance, subordination or reduction based on the existence of an
avoidable transfer. Some common red-flag situations that could signal
vulnerability of a claim include: •The claim is not
consistent with the debtor's books and records. To avoid this
problem, purchasers should verify that the target claims appear on the
debtor's schedules of assets or liabilities (Schedule D for secured
claims and Schedule F for unsecured claims). Claims that do not appear
on either Schedule D or F (or are scheduled as disputed, contingent or
unliquidated) should be red-flagged for further analysis. If the
schedules have not been made available by the debtors due to
extensions of the filing deadline, purchasers may consider pressing
the claimant to reach a stipulation with the debtor providing for the
allowance of the claim and a waiver of chapter 5 actions. •

The holder of the claim committed misconduct either related or
unrelated to the claim. Purchasers should be aware of the recent
decision in Enron's chapter 11 case holding that claims sold to third
parties are subject to equitable subordination under §510(c) of
the Bankruptcy Code, even the third party had no knowledge of the
claimant's wrongful conduct.2 A claim may be subordinated
under §510(c) if the claimant engaged in misconduct that resulted
in injury to creditors or conferred an unfair advantage on the
claimant.3 Purchasers of bank debt must be aware that
courts may follow the Enron decision and hold that purchasers of
claims step into the shoes of the claimant vis-a-vis pre-petition
conduct, even where there is no wrongdoing on the part of the purchaser.
Purchasers must investigate the claimant's pre-petition dealings with
the debtor and carefully draft indemnification language in their
agreements with sellers, as will be discussed in more detail below.
• The holder of the claim received an avoidable pre-petition
transfer from the debtor. Purchasers of both bank and trade debt
should pay attention to yet another Enron decision holding that
purchased claims can be disallowed under §502(d) of the Code if
the original claimant fails to turn over an avoidable
transfer.4 Section 502(d) authorizes a court to disallow or
reduce a claim to the extent the claimant has not turned over property
subject to an avoidable transfer. Note that the Enron court
rejected the claim purchaser's argument that the application of
§502(d) would impose an unjust penalty on innocent claims
transferees who are not liable for avoidable transfers. Again,
purchasers must review the debtor's pre-petition transactions and assess
whether the seller/claimant received an avoidable transfer. Claimants
attempting to purchase a blocking position or a large claim within a
particular class may want to consult outside counsel or financial
advisors to aid in this assessment. At a minimum, purchasers should
review the debtor's SEC filings to identify any obvious pre-petition
transactions that could give rise to an avoidance action and compile a
list of the debtor's likely targets. • The claim is based on
an executory contract that is assumed under a plan. Parties to
executory contracts and unexpired leases often file
"protective" rejection-damages claims, anticipating that the
debtor may reject the contract. Claims traders who buy these
protective rejection damage claims may have a rude awakening if the
debtor assumes the contract or lease under the reorganization plan.
Pursuant to §365(b)(1)(A) of the Code, a debtor must cure
pre-petition defaults before it can assume a contract or lease. A cure
is not a payment on account of a rejection-damages claim; it is a
payment to a contract counterparty to facilitate the debtor's ongoing
performance under the contract. Under those circumstances, there is no
rejection-damages claim, and the debtor can successfully move to
disallow any rejection-damage claim. Thus, absent some arrangement among
the three parties, the debtor will pay the cure amount to the contract
counterparty, not the purchaser of the rejection-damages claim. The
problem becomes even stickier if the plan provides for full
satisfaction of unsecured claims, with pre-petition interest.
Naturally, the purchaser would hope to receive a distribution on account
of the rejection-damages claim in accordance with the plan treatment.
It is incumbent upon the purchaser to contract around this potential
problem. To the extent possible, purchasers should identify and avoid
buying protective claims. If the claimant believes that the debtor
will likely reject a contract, creating a rejection-damages claim, the
purchaser may require the claimant to compel the debtor to assume or
reject the executory contract or lease. In connection with any agreed
rejection, the parties could fix the rejection-damages claim and agree
to releases of chapter 5 actions.• The claim can be
satisfied at any time during the case. Debtors are not permitted
to satisfy most pre-petition claims outside of a plan or without court
order. The 2005 amendments to the Code afford some enhanced rights for
creditors that could result in the post-petition satisfaction of the
following types of claims: critical vendors, reclamation, utilities,
lessors, employees, taxing authorities and certain financial
contracts. While this is good news for those creditors, the ability to
satisfy these claims could be used as a tactic by the debtor to
eliminate high-maintenance creditors that are participating
aggressively in the case. To avoid the problem of being eliminated,
purchasers of blocks of claims should own a diverse portfolio of
claims, including some that have been previously discussed and also
some traditional pre-petition trade claims that can only be paid under
a plan. • The claim has already been sold to another
investor. When dealing with unsophisticated vendors, it is not
uncommon for those vendors to inadvertently (or intentionally) sell
their valid claim to more than one investor. It is the responsibility
of the investor to ensure that the transfer is properly recorded on
the debtor's claims register. Often the first transfer to be recorded is
deemed the "valid" transfer, regardless of the date the
transfer agreement was executed. It is the investor's
responsibility—not the debtor or claims agent's
responsibility—to identify and resolve this issue. Tips for
Purchasers of Claims • Draft solid contracts and work
with counsel to continuously modify contract provisions as the case
law develops. Although little case law is available to guide
claims purchasers, the trend is to place the burden on the claimant
and purchaser to contract around the issues described above. Purchasers
should not expect much sympathy from the bankruptcy court with respect
to ambiguous contract provisions; purchasers must draft rock-solid
contracts that include, at a minimum: (1) broad indemnification
provisions that take into account the problems described above; (2)
the ability to unwind the transaction if the claim is subordinated
under §510(c) of the Code, reduced under §502(d) of the Code
or disallowed upon the debtor's assumption of an executory contract or
unexpired lease upon which a protective rejection-damage claim was
based; and (3) open access to the claimant's books and records to
enable the purchaser to compile evidence to put on a case in response
to a claim objection. Parties who regularly purchase claims should
consult with counsel and modify contract provisions as the case law
develops. • Develop internal guidelines and devote
appropriate resources to conducting due diligence before purchasing
claims. Purchasers of large blocks of claims must develop internal
guidelines for conducting due diligence. The claims described above
and set forth in the Red-Flag Claims chart should be carefully
scrutinized in accordance with specified criteria. • Follow
the Federal Rules of Bankruptcy Procedure and any rules set by the
court in connection with the transfer of claims. Although Rule
3001(e) of the Federal Rules of Bankruptcy Procedure no longer
requires court approval of a claim transfer, courts often establish
procedures governing certain types of trades. As discussed above,
parties purchasing large blocks of claims should be aware of any court
orders restricting trade, such as an NOL order described above.
Parties should also comply with any additional procedures for recording
transfers of claims that would typically be included in the order
establishing a bar date for filing proofs of claim. With the
multitude of players and the frequency of multiple transfers, valid
transfers are often not properly recorded on the claims register. The
reasons for this are manifold: An intervening transfer document was
not filed, multiple transfer documents were filed together and not all
were noted to be separate transfers, or human error. While these
issues can be corrected through discussions with a claims agent, if
not timely corrected, it can impact voting or even distributions in
certain cases. If the transfer is not accurately recorded as of a voting
or distribution record date, a purchaser may not have the right to
vote or even receive a distribution. Conclusion While
buying distressed debt may be a very lucrative practice, it is not one
to be entered into without the appropriate due diligence and recognition
of risk. An investor must also diligently follow the case and the
claims register to monitor their investment and respond appropriately
to any issues that may arise regarding that investment.

<h3>Footnotes</h3> 1 Any views or opinions expressed in this article
are not necessarily the views or opinions of White & Case, LLP and
AlixPartners, LLP. 2 See Enron Corp. v. Avenue Special
Situations Fund II (In re Enron Corp., 01-16034 (AJG)),
2005 WL 3074189 (Bankr. S.D.N.Y. Nov. 17, 2005). See,
also, Hollander, Evan C. and Mintz, Douglas S., "Claim
Traders Beware: Your Acquisition May Come with Unwanted Baggage,"
18 BNA's Bankruptcy Law Reporter No. 5, 122 (Feb. 2, 2006).

3 See Benjamin v. Diamond (In re Mobile Steel Co.),
563 F.2d 692 (5th Cir. 1977). 4 See Enron Corp. v. Avenue
Special Situations Fund II (In re Enron Corp., 01-16034
(AJG)), 2006 WL 832674 (Bankr S.D.N.Y. March 31, 2006).

Journal Authors

Carrianne Basler

Michelle Campbell Ross

Journal Date

Thursday, June 1, 2006 - 12:00

Bankruptcy Rule

2006

none