Maneuvering in the Shadows of the Bankruptcy Code: How to Invest in or Take Over Bankrupt Companies Within the Limits of the Bankruptcy Code

• Citation: Vol. 30 No. 1
• Publication year: 2013

Maneuvering in the Shadows of the Bankruptcy Code: How to Invest in or Take Over Bankrupt Companies within the Limits of the Bankruptcy Code

Sam Roberge

MANEUVERING IN THE SHADOWS OF THE BANKRUPTCY CODE: HOW TO INVEST IN OR TAKE OVER BANKRUPT COMPANIES WITHIN THE LIMITS OF THE BANKRUPTCY CODE

Sam Roberge^*

Abstract

Profiting off of bankrupt companies? Sounds impossible. It is not:—and this Article explains how to do it. When a company declares bankruptcy, all levels of its capital structure are for sale. Investors have two alternatives: (1) purchase these "claims " against the company at a discount, and turn them into profitable investments once the company exits bankruptcy; or (2) take over the bankrupt entity, in a bankruptcy version of a hostile takeover.

There is risk: the Bankruptcy Code empowers judges to punish investors whose purchase or vote of a claim was "not in good faith." But the Bankruptcy Code provides little statutory guidance on when to punish claims purchasers. In that absence, many bankruptcy judges have used the legislative history of the bad faith statutes as evidence of Congress's skepticism of bankruptcy investments and takeovers. This Article disagrees with that approach. After examining the legislative history surrounding the framing of the current and former bad faith statutes, this Article argues that the same history pointed to by judges does not show Congressional disapproval of these types of investments. Moreover, the thrust of recent amendments to the Bankruptcy Code potentially shows that Congress approves of bankruptcy investments. Accordingly, this Article provides a practical and theoretical roadmap to demonstrate the good faith of an investor's action in the face of judicial scrutiny.

"A slowdown in large corporate [c]hapter 11 filings in 2012 didn't stop distressed investors, who bought and sold more than $41 billion worth of bankruptcy claims last year."—Dow Jones Daily Bankruptcy Review, January 28, 2013.

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Introduction

To most investors, bankruptcy is bad news. To certain investors, however, bankruptcy spells opportunity. Specifically, bankruptcy represents an opportunity to invest in bankrupt companies' distressed debt. In addition, although they do not happen very frequently under state corporate law, hostile takeovers frequently occur in bankruptcy.¹ This Article explores the legal theory and practice of claims trading under chapter 11 of the Bankruptcy Code ("Code")—the mechanism by which investors invest in or take over bankrupt companies.

Broadly speaking, bankruptcy claims investors fall into two categories. In the first, investors purchase discounted claims in the hopes that their eventual payout will be higher than the purchase price ("Passive Investors"). In the second, investors purchase claims with the hope of executing a strategic transaction, such as a merger ("Strategic Investors"). Where appropriate, this Article flags areas of law where courts' treatment of Passive Investors differs from treatment of Strategic Investors. Accordingly, readers can focus on the sections most applicable to their cases, clients or business.

Claims trading is a $41 billion dollar per year industry.² By way of comparison, the claims trading industry is larger than the market capitalizations of approximately 80% of all S&P 500 companies.³ This Article aims to explain this large and important industry, as well as to provide guidance for both courts that regulate it and investors that intend to make money within it.

In a claims trading market, investors purchase claims against the debtor from the debtor's creditors, usually—but not always—at a discount.⁴ Then, investors attempt to profit from the debtor's bankruptcy by doing nothing, tweaking the debtor's plan of reorganization, or proposing their own plan.⁵

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Once the debtor emerges from bankruptcy, the investor is hopefully left with a return on the debt or an equity stake in the reorganized debtor.⁶

That is the upside. Here is the downside: there is a risk that a bankruptcy court will designate (disqualify) the investor's vote in the bankruptcy process because of the Code's prohibition against bad faith when voting claims.⁷ The law surrounding when an investment or takeover constitutes bad faith is unsettled.⁸ Some bankruptcy courts have held that investments in, and hostile takeovers of, bankrupt companies can constitute bad faith.⁹ Bankruptcy judges have looked at the legislative history surrounding the framing of the bad faith statutes to argue that Congress intended to block bankruptcy hostile takeovers.¹⁰

This Article examines the specific legislative history of the current and predecessor bad faith statutes to argue that the history does not, in fact, support a broad ban on takeovers. For example, examination of one of the bad faith statutes reveals that some bankruptcy courts quote a Congressional witness's testimony as a definitive statement of what Congress intended to accomplish by passing the bad faith statute.¹¹ This Article argues that the legislative history gives reason to be skeptical of courts' analysis and provides a practical means for guiding them to a different result.

In addition to relying on legislative history, bankruptcy courts criticize takeovers by citing general principles derived from the Code.¹² This Article argues, however, that many principles from the modern Code support a robust claims trading system, including hostile takeovers. Given the bankruptcy courts' thin justifications, this Article provides a starting point to push back on their disapproval of investments and hostile acquisitions through chapter 11 claims trading. Finally, moving from theory to practice, this Article concludes by offering several strategies for future claims purchasers to minimize the risk of vote designation and maximize the return on their investment.

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I. Bankruptcy Code Background

Before delving into the nuts and bolts of claims trading, it is important to review the key parts of bankruptcy law relevant to acquiring and voting a claim in a chapter 11 restructuring. Specifically, these elements of bankruptcy law relate to plan confirmation, rejection, and challenging an outsider's acquisition of voting claims. These provisions provide the rules of the game for investing in or taking over a debtor, and they are discussed with an eye towards gaining an advantage in the plan proposal and confirmation process.

A. Chapter 11 Plan of Reorganization

Once a company declares bankruptcy under chapter 11, the debtor's existing management becomes the "debtor in possession" ("DIP").¹³ The company's creditors may then file a proof of claim with the bankruptcy court where the debtor filed.¹⁴ A claim, among other things, details how much money the creditor is owed.¹⁵ That claim is the creditor's ticket to participate in the bankruptcy process, entitling the creditor to receive cash, assets, or equity of the postbankruptcy entity as well as to vote on the plan of reorganization.¹⁶ The plan, and one's position within it, is extremely important, because the plan not only determines the value creditors receive on their claims, but ultimately the allocation of control over the entity that emerges from the bankruptcy process.¹⁷

The debtor has the exclusive right to propose a plan of reorganization for the first 120 days after filing the chapter 11 petition.¹⁸ If the debtor files a plan within the 120-day period, creditors may not file competing plans until 180 days have elapsed.¹⁹ Thus, the debtor has 180 days to solicit votes exclusively, provided that it files within the first 120 days. Based on these rules, the debtor has the advantage of putting its plan on the table first, increasing the chances that it will be confirmed. Investors purchasing claims of an entity that has already declared bankruptcy must remember that the debtor has this first-mover advantage.

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B. The Road to Plan Confirmation

The debtor's plan must first divide creditor claims into classes.²⁰ Creditors' claims in the same class must be substantially similar to the other claims within the class.²¹ For example, a debtor cannot classify secured claims with shareholders' claims. This is because different claims will have different interests and incentives that affect how the creditor will vote during the plan confirmation process. Often, a debtor's chapter 11 plan will classify certain claims as entitled to the debtor's residual value—the "fulcrum security."²² Owners of the fulcrum security will hold equity in the reorganized debtor.²³ Which creditor class translates into the fulcrum security depends on the value of the debtor's collateral and assets.²⁴ If the debtor can pay back its secured debt in full, the unsecured creditors hold the residual claim on the estate.²⁵ If the debtor cannot, then the junior lien-holders will usually own the fulcrum security.²⁶

Once the creditors are divided into their respective classes, certain classes then vote on whether to accept or reject the plan.²⁷ Only classes which are "impaired" by the plan—that is, classes whose rights have been negatively affected in some way—may vote.²⁸ Unimpaired classes are deemed to have accepted the plan,²⁹ while fully impaired classes are deemed to have rejected the plan.³⁰ Because the plan confirmation process only cares about impaired claims, purchasers will try to buy up these important votes.³¹

C. Plan Confirmation

The easiest route to plan confirmation occurs when all creditor classes vote in favor of the plan. Individual debt classes are deemed to have voted in favor

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of a plan if at least two-thirds of the amount of the claims, and over one-half of the number of claims, have voted in the affirmative.³² For example, if a class consists of five trade creditors, each holding one claim worth $100, then at least four creditors (totaling $400 out of the $500 that the class claims are worth) must vote for confirmation for the class to vote in favor of...