Unsecured trade creditors in mid- to large-sized chapter 11 cases are frequently targets of distressed-debt traders looking to buy unsecured claims. These traders make their money in a variety of ways, principally on the assumption that the claims they buy today will be worth more later either in the distressed-trade market or upon plan distribution. For creditors who are unfamiliar with the jargon and practices of the distressed-debt market, this can sometimes lead to lawsuits. In one such case, the seller of a claim sold the claim on terms agreed to on a phone call. On the phone call, the buyer said the trade was subject to further documentation “on customary terms.” Later the buyer informed the seller that the trade was actually subject to the buyer locating another buyer to buy the claim at the stated price. Needless to say, the market price for the claim went down and the buyer reneged, claiming that it was only acting as a “riskless principal.” A lawsuit ensued.
Debt trading in bankruptcy claims has grown along-side debt trading, generally creating its own market for claims and opportunities for traders. The mismatch of sophistication between a typical seller and a typical buyer of a chapter 11 claim can be large. Fortunately, several bodies of guidance have emerged in recent years to bridge that gap. The primary source of “customary terms” is the attachment to an LSTA sample trade confirmation. This trade confirmation may be in the original LSTA form or it may be on the buyer’s letterhead without reference to the LSTA origin. The content may be accessed at www.lsta.org. In April 2007, the LSTA published a User’s Guide for the standard form explaining various legal consequences of the form and its terminology.
So what is a “riskless principal,” and how do you know if you are dealing with one? A riskless principal is a party that “has on or prior to the Trade Date agreed with the other party that its obligation to complete the Transaction is subject to successful completion of the purchase from or sale to a third party of the Debt specified in the Confirmation.” LSTA Standard Terms and Conditions (“Confirm Conditions”). In turn, the LSTA Distressed Trading Confirmation (the “Confirm”) provides for the possibility of the buyer being the riskless principal or the seller being the riskless principal. For the most fun, the seller can be the riskless principal and the transaction subject to the seller obtaining the claim from its immediate prior seller, in which case the “flip representations” provisions of the Confirmation will apply.
From the User’s Guide and the Confirm Conditions, whether a buyer or a seller is acting as a riskless principal can only occur “on or prior to the Trade Date.” Confirm Conditions ¶18. Trade date, in turn, is the date on which the “trade becomes binding [which]…usually occurs during the course of a telephone conversation or exchange of electronic messages….” User’s Guide, p. 6. The “settlement date” is the date upon which all closing conditions have been satisfied. User’s Guide, p. 3. The settlement date is typically 20 days after the trade date, unless contrary terms appear in the Confirm.
In the case that a term required to be agreed to upon the trade date is not agreed to, it is not part of the trade. Most Confirms specify that they are governed by New York law. In turn, in 2002, the state passed legislation extending to bank debt trading from the New York Statute of Frauds. Specifically, the Statute of Frauds’ requirement that a contract be in writing to be enforceable does not apply to:
(i) for the assignment, sale, trade, participation or exchange of indebtedness or claims relating thereto arising in the course of the claimant's business or profession (including but not limited to commercial and/or bank loans, choses in action arising under or in connection with loan agreements and private notes, and including forward sales), but only to the extent that such indebtedness or obligation was not incurred by a natural person primarily for personal, family or household purposes….
N.Y. Gen. Obl. Law §5-701(i). Within this parameter, then, the provisions of the User’s Guide making the trade effective when the oral agreement is reached would control the parties’ rights and obligations. User’s Guide, p. 6. After the trade, the parties execute the confirm and, under normal circumstances, settle the trade within 20 days. If the settlement date is delayed, the Confirm Conditions typically provide for delayed settlement compensation. ¶6.
Other provisions that may produce controversy are the seller’s representations, warranties and indemnification obligations. Many trades of bankruptcy claims require the seller to indemnify the buyer for certain kinds of adverse, post-settlement changes in the amount realizable from the claim. These changes would not typically include changes in the market for that debt, but changes in the allowability of the claim or other impairments to its face value. In the bankruptcy context, these may take the form of a repurchase obligation or other settlement procedure to compensate the buyer. A seller will want to minimize the scope of its representations and indemnities in the Confirm Conditions and/or the final claim purchase documentation.
In the case of the super-secret, undisclosed, riskless principal, the parties settled after some dispositive motions were granted. To avoid litigation, the LSTA Web site has valuable guidelines and forms. Clients should be warned that oral contracts are enforceable in some circumstances and be aware of the pitfalls of claims trading and the parties’ legitimate expectations of the outcome.