Amended Rule 2019 and Its Effect on Disclosure Requirements

Distressed opportunity in the U.S. is shaping up to be the best opportunity in a lifetime. —John Paulson, February 2009[1]

As John Paulson, manager of New York-based hedge fund Paulson & Co., noted, even in a maligned economy there remains much opportunity for the investor with cash. Purchasers of distressed assets, commonly known as distressed investors, have become influential in corporate bankruptcy proceedings. A distressed investor seeks to purchase when the market value for the bankruptcy claim is below what the distressed investor views as the claim’s true value. Nearly any type of claim may be traded, providing liquidity to the seller, though likely at a discount to the distressed investor who purchases. Similarly, equity securities in bankruptcy may also be held or acquired by distressed investors.

 In re Northwest Airlines Corp., 363 B.R. 701 (Bankr. S.D.N.Y. 2007), introduced some confusion as to whether informal (ad hoc) committees of distressed investors must file disclosure statements concerning claims or equity interests held in bankruptcy under Federal Rule of Bankruptcy Procedure 2019. Northwest held that an ad hoc group or committee, though not a formal committee under the Bankruptcy Code, must file a Rule 2019 disclosure statement. A split between bankruptcy courts on the issue followed. Some courts required disclosure from ad hoc committees. See, e.g., In re Washington Mutual Inc., 419 B.R. 271, 274-75 (Bankr. D. Del. 2009) (following Northwest in ordering disclosure from an informal group of creditors with distressed claims). Others did not. See, e.g., In re Premier International Holdings, 423 B.R. 58, 74-75 (Bankr. D. Del. 2010) (disagreeing with the holdings in Northwest and Washington Mutual in deciding that Rule 2019 did not require disclosure from an ad hoc committee).

This article will summarize why the Federal Advisory Committee on Bankruptcy Rules chose to amend Rule 2019 and will examine certain changes under Amended Rule 2019. Unless Congress acts against it, which is not expected, Amended Rule 2019 will go into effect on Dec. 1, 2011. Amended Rule 2019 clarifies disclosure requirements with the effect of extending disclosure to ad hoc groups or committees of distressed investors.

I. The Reasons for Amendment of Rule 2019
It has become common practice for distressed investors to form ad hoc committees when participating in a chapter 11 case. The committee structure allows its distressed-investor members to retain the same legal counsel, and thus share the burden of legal fees. Once assembled, the ad hoc committee and its counsel will pursue interests common to the group’s members. Through committee organization, distressed investors have the dual advantages of greater leverage in the bankruptcy process and unified, cost-efficient advocacy by common counsel. As one commentator noted, “[t]he theory behind ad hoc committees is that multiple creditors or equity-holders singing together in chorus is better than a cacophony of individual creditors or equity-holders each singing its own tune.”[2]

Decided in February 2007, Northwest held that an ad hoc committee of equity security-holders must disclose, pursuant to Rule 2019, the amounts owned by members of the committee, the times when acquired, and any amounts paid therefore. At the time of the decision in Northwest, the legal community noted its potential to chill participation in bankruptcy proceedings by hedge funds acting as distressed investors. Characteristically, hedge funds strongly disfavor disclosure as it exposes proprietary information and investment strategy.

In the fallout of Northwest, two trade associations with strong ties to hedge funds, the Loan Syndications and Trading Association and the Securities Industry and Financial Markets Association, sought the repeal of Rule 2019.[3] The Advisory Committee decided against repeal and published an amended Rule 2019 for comment in August 2009.[4] The trade associations ceased to advocate repeal after the Advisory Committee published the proposed amendments.[5] What followed was a rigorous debate during the comment period over the published Rule 2019 amendments. Fourteen organizations or individuals submitted written comments, and seven witnesses presented testimony in a February 2010 hearing on Rule 2019 before the Advisory Committee.[6] After the Advisory Committee evaluated this feedback and incorporated certain changes, the Supreme Court adopted the amendments on April 26, 2011.[7] Amended Rule 2019 was then submitted to Congress and, as noted, is likely to go into effect on Dec. 1, 2011.[8]

Amended Rule 2019 and its Effect on Chapter 11 Advocacy
Clearly, the Rule 2019 amendments did not result in the repeal of Rule 2019 as originally advocated by financial services trade groups. Amended Rule 2019 did, however, bring clarity where there existed a difference of opinion among bankruptcy courts on whether ad hoc committees must disclose certain key information. Key changes to Rule 2019 will be summarized here, and the potential impact of such amendments will be assessed.

Disclosure Requirements Extended to Include Informal Committees
Amended Rule 2019 requires disclosure by “every group or committee that consists of or represents, and every entity that represents, multiple creditors or equity security-holders that are acting in concert to advance their common interests….” Fed. R. Bankr. P. 2019(b)(1) (amended 2011). “Represent” is defined by Amended Rule 2019 as to “take a position before the court or to solicit votes regarding the confirmation of a plan on behalf of another.” Fed. R. Bankr. P. 2019(a)(2) (amended 2011).

It is clear that Amended Rule 2019 was written to include ad hoc groups or committees. Whether a group calls itself a “committee,” an issue in the divergent bankruptcy court opinions, is not material in determining whether Amended Rule 2019 applies. In this way, an area of past confusion is resolved. Furthermore, counsel to the group or committee of multiple creditors or equity security-holders is required to disclose on its own behalf should it “represent” the group or committee under the rule’s definition. Lawyers who represent these ad hoc committees must be aware of this requirement, made clear through Amended Rule 2019.

Requirements for Disclosure under Amended Rule 2019
A new definition for the term “disclosable economic interest” is included in Amended Rule 2019. The definition is broad so as to cover any position that could potentially affect the bankruptcy proceeding, and includes “any claim, interest, pledge, lien, option, participation, derivative instrument, or any other right or derivative right granting the holder an economic interest that is affected by the value, acquisition or disposition of a claim or interest.” Fed. R. Bankr. P. 2019(a)(1) (amended 2011). Information on the nature and amount of a disclosable economic interest must be provided on a member-by-member basis. Holdings of the group or committee in the aggregate is not sufficient under the disclosure requirements of Amended Rule 2019. The nature and amount of each disclosable interest must be disclosed as of the date the group or committee was formed. Fed. R. Bankr. P. 2019(c)(2)(B) (amended 2011).

The version of Amended Rule 2019 published for comment in August 2009 required the disclosure of purchase price information.[9] Not surprisingly, the distressed-investor community balked at disclosure of such information under any proposed rule. Objection to the disclosure of purchase price was expressed by advocates for distressed investors during the comment period.[10] Objectors argued that price information was not generally relevant to any issue in a chapter 11 case and that, if relevant, such information could be obtained through discovery or pursuant to the court’s inherent power to compel its disclosure.[11] Objectors also argued that information on price, if disclosed, would reveal distressed investor strategy.[12] Finally, objectors argued that such a requirement would make formation of ad hoc committees less common and decrease participation by distressed investors in the bankruptcy process.[13]

Amended Rule 2019, as adopted by the Supreme Court and submitted to Congress, will not require the disclosure of price information. The date of acquisition by quarter and year of each disclosable economic interest, unless acquired more than one year before the petition was filed, is required. Fed. R. Bankr. P. 2019(c)(2)(C) (amended 2011). In this way, neither purchase price nor specific date is mandated under Amended Rule 2019 disclosure.

Some issues may remain to be worked out in practice. For example, assuming that market value is reasonably stable between the time of purchase and the time of the disclosure statement, and the member of the group of committee only has one disclosable economic interest in the bankruptcy case, will not the purchase price be reasonably calculable? Similarly, assuming stable market value and only one disclosable interest acquired in a quarter, will not the purchase price be reasonably calculable by noting the difference between the last two disclosure statements? As a rejoinder, “purchase price” and “amount” (which connotes “value”) may be two very different figures. Still, the possibility of calculating purchase price paid by distressed investors from Amended Rule 2019 disclosure statements is worth noting.

An Exclusion for any Indenture Trustee
The current Rule 2019 does not specifically address whether indenture trustees fall within its ambit. Amended Rule 2019 now specifically exempts indenture trustees from its disclosure requirements. Fed. R. Bankr. P. 2019(b)(2)(A) (amended 2011). Even though an indenture trustee may represent separate parties with possibly differing interests, the indenture instruments define the indenture trustee’s duties and, as a result, disclosure under Amended Rule 2019 is not required. Similarly, Amended Rule 2019 excludes other entities from its coverage that act under formal legal arrangements of trust or contract law.

III. Conclusion
At a time when ad hoc committees of distressed investors have become common and are growing increasingly influential in chapter 11 cases, Amended Rule 2019 brings clarity to disclosure requirements. The Advisory Committee has resolved the question that courts have disagreed on in cases such as Northwest and Premier. While Amended Rule 2019 clearly extends disclosure requirements to ad hoc groups or committees of distressed investors, such investors can at least take comfort that they will not be required to disclose the purchase price. Surely, distressed investors, debtors and bankruptcy lawyers alike can appreciate a straightforward rule as set forth in the recent amendments.