Jack Butler examines the role of claims trading in Chapter 11 Bankruptcy cases
The below article originally appeared in The Examiners Bankruptcy Blog Section of The Wall Street Journal and was written by Hilco Global Executive Vice President Jack Butler.
Claims trading is often identified as a driving force behind the changing chapter 11 landscape. Renowned bankruptcy lawyer Harvey Miller believed that claims trading dramatically changed the dynamics of the reorganization process because “[d]istressed debt traders have different motivations and objectives than the old line relationship banks and trade creditors. Quick and significant return on investment is the imperative to the traders.”
Ironically, the drafters of the original bankruptcy statute in 1898 were so concerned that claims trading would impair a debtor’s ability to obtain a “fresh start” that Congress adopted provisions intended to subject claims trading to intense oversight from bankruptcy courts. Those oversight provisions were mostly circumvented by buyers and sellers, and they were eliminated when the modern bankruptcy code was adopted in 1978. The code was later amended in 1991 to require claims purchasers to provide notice that a claim had traded hands during a bankruptcy case and to allow other parties to object to the transfer. Two decades later, the bankruptcy rules were amended to supplement disclosures about claims trading. However, these renewed oversight efforts haven’t led to meaningful judicial intervention or adjudicated claims transfers objections.
The size, influence and utility of today’s secondary debt trading markets bear little resemblance to claims trading in colonial times, when investors purchased debts owed by the original colonies to soldiers, farmers and merchants at a fraction of their face value—except when it comes to two crucial characteristics. Now, as then, sellers dispose of their claims in order to create liquidity and avoid risks associated with delay, cost incurrence and value erosion. And then, as now, sophisticated investors acquired debt claims only at substantial discounts to achieve oversized returns when finally paid in whole or in part by the obligor. Claims purchasers have never been altruistic. Investors bought post-Revolutionary War claims at a quarter or less of their value seeking to quadruple their returns when the American government eventually paid in full.
Critics of existing claims-trading practices argue that holders of claims acquired at a discount distort the balance between debtors and creditors fashioned by Congress in the bankruptcy code. Yet the historical existence of claims trading in the U.S. dating back to colonial times (as well as congressional actions taken in 1898, 1938, 1978 and 1998) belies the notion that Congress was unaware of claims-trading practices or that it is somehow improper for debt purchasers to assert the face amount of the purchased claim against the obligor who incurred the debt.
Recent academic research also tends to highlight some potential benefits (and risks) of the secondary debt markets on the bankruptcy process itself. For example, in their forthcoming peer-reviewed original research article on the ownership and trading of debt claims in chapter 11 restructurings, to be published in the Journal of Financial Economics, Professors Victoria Ivashina, Benjamin Iverson and David C. Smith observe that “companies with higher debt concentration at the start of the case are more likely to file prearranged bankruptcy plans, to move quickly through the restructuring process, and to emerge successfully as independent going concerns [emphasis added].” They also conclude that higher ownership concentration within a debt class is associated with higher recovery rates to that class. While the trading of claims during bankruptcy concentrates ownership further, it isn’t associated with subsequent improvements in bankruptcy outcomes and may increase the likelihood of liquidation.
The propriety of claims trading in the bankruptcy process was robustly debated by reform commissioners in the 2014 Report and Recommendations of The American Bankruptcy Institute Commission to Study the Reform of Chapter 11 of the U.S. Bankruptcy Code. While acknowledging the increasing presence and arguable influence of claims trading in chapter 11 cases, we concluded there was nominal value to recommending additional disclosures and rejected any specific restrictions on claims trading or the participation of claims traders in chapter 11 cases. While some commissioners expressed different views about whether what an investor paid for a claim or why it purchased the claim should be relevant to the merits or substantive legal issues in a dispute in the case, we agreed that if a court decided that price or motive should matter in specific situations, courts already have means to determine and sanction inappropriate conduct through the claims subordination and vote designation processes.
Claims trading doesn’t warp the bankruptcy system; instead, it creates liquidity and often prevents follow-on bankruptcies by creditors who are able to sell their claims for prices that they are willing to accept from sophisticated investors who assume the risks of the specific case—and the standing and right to be heard and to be active. Bankruptcy courts can and should determine and sanction inappropriate conduct by claims traders through the claims subordination and vote designation processes to preserve balance and fundamental fairness in the system.