Richard D. Thomas, Tipping the Scales in Chapter 11: How Distressed Debt Investors Decrease Debtor Leverage and the Efficacy of Business Reorganization

• Jurisdiction: United States,Federal
• Publication year: 2011
• Citation: Vol. 27 No. 1

TIPPING THE SCALES IN CHAPTER 11: HOW DISTRESSED DEBT INVESTORS DECREASE DEBTOR LEVERAGE AND THE EFFICACY OF BUSINESS REORGANIZATION

INTRODUCTION

Congress drafted chapter 11 of the Bankruptcy Code to provide a forum where creditors and business debtors enter the reorganization process with the common interest of maximizing returns to all creditors through the debtor's rehabilitation,¹while preserving the going-concern value²of the debtor.³

Contravening this purpose, chapter 11 also allows nontraditional creditors⁴to buy claims⁵at a steep discount once a business files for bankruptcy and to demand full payment of these claims.⁶These nontraditional creditors are known as distressed debt investors⁷or vulture funds.⁸For the purposes of this Comment, "DDI" will be used to describe all parties that invest in distressed debt, while "vulture fund" will refer to a DDI that either seeks short-term returns through distressed debt investing, or attempts to take control of corporations when they exit chapter 11.⁹

Often, vulture funds have no interest in a successful reorganization,¹⁰and they use their leverage to obtain short-term returns on investments at the expense of the debtor and other creditors.¹¹DDIs are not bad or malicious; however, like all participants in chapter 11 cases, DDIs are rational actors that attempt to maximize profits. Problematically, there is no individual entity present in a chapter 11 proceeding that represents the preservation of going- concern value or the rehabilitation of the debtor. It is easy to see why traditional creditors have interests inapposite to preserving going-concern value: they want their money.¹²The individuals that comprise the debtor's management may theoretically represent the preservation of going-concern value and the interests of the debtor; however, these individuals are impermanent and have concerns external to the debtor, such as personal well- being and continued employment.¹³Instead, the rules of the game-the provisions of chapter 11-are present to protect going-concern value and promote rehabilitation. The rules are far from perfect. Congress enacted the basic structure of chapter 11 in the Bankruptcy Reform Act of 1978,¹⁴which took effect on January 1, 1979, before claims-trading was a popular investment strategy.¹⁵DDIs are currently able to pursue strategies that the drafters of chapter 11¹⁶did not contemplate and that contravene the policy choices made in creating the system.¹⁷

Specifically, claim flipping¹⁸and betting against the success of reorganization¹⁹are popular strategies used by vulture funds that tend to exacerbate the difficulties of complex business reorganizations. Furthermore, vulture fund involvement decreases a debtor's leverage in negotiations by increasing confusion, thereby delaying productive negotiations.²⁰These delays diminish the value of the estate and prevent a debtor from investing in negotiations because the identities of creditors are not constant.²¹Finally, vulture funds that actively seek control of the debtor through the reorganization process create disincentives for a debtor's management to file a proactive plan for reorganization.²²The culminating effect of nontraditional creditor involvement is to decrease the debtor's ability to preserve going-concern value, which is contrary to the purpose of business reorganization.²³

While distressed debt trading is undoubtedly big business-estimates place the market in the hundreds of billions of dollars²⁴-its consequences for the restructuring process remain recondite outside the bankruptcy community. The negative externalities attributable to vulture funds may have gone unnoticed due to the decrease in reorganization filings experienced in the United States between 2003 and 2007.²⁵However, the recession that began in 2007 with the subprime mortgage collapse created a boom in reorganization filings that will continue into the foreseeable future,²⁶causing distressed debt trading and other detrimental actions of vulture funds to become more prominent across business and legal communities.²⁷Therefore, distressed debt trading will serve as a major obstacle in reorganizations, which stand to be more commonplace in the wake of the subprime mortgage collapse.

This Comment argues that the Bankruptcy Code²⁸should be revised to promote traditional reorganization-as envisioned under the '78 Act-while taking into account the realities of today's market and preserving the positive attributes of claims trading. Specifically, it argues that the Code should be revised in a pro-debtor fashion to restore the balance between debtor- and creditor-leverage. To solve the issues that distressed debt trading creates during reorganization, the Code should be revised to: (1) require disclosure of all holdings that a DDI has in the debtor, and a determination by the court of whether the DDI's interests are adverse to, or in line with, a reorganization; (2) create restrictions on the resale of claims once a creditor has sold a claim to a DDI or other creditor; and (3) allow for a bankruptcy payment to corporate management that files for chapter 11 proactively, but eliminate the payment if creditors successfully argue that management delayed filing a plan and engaged in behavior that increased corporate debt--similar to the tort theory of deepening insolvency.²⁹

This Comment progresses in three parts. Part I provides background concerning distressed debt trading. Part II briefly presents the traditional goals of chapter 11 and argues that predatory distressed debt trading undermines the traditional purposes of chapter 11 reorganization by: (1) draining value from the estate through claim flipping;³⁰(2) providing a forum for predatory DDIs to use leverage through acquired debt to sink negotiations and profit on non- debt investments in the debtor; (3) creating an asymmetry of information in favor of creditors during negotiations, which in turn creates a Lemon's Problem for the Debtor in Possession; (4) creating coercive markets for claims, which drive down the prices of distressed debt; (5) increasing the rates of chapter 11 recidivism by decreasing the leverage that the debtor derives from exclusivity; and (6) decreasing the incentives for management of public corporations to file for chapter 11 protection proactively in an effort to preserve assets for creditors. Finally, Part III posits possible solutions to the problems that distressed debt investing creates for business reorganizations.

I. VULTURE FUNDS: WHAT IS DISTRESSED DEBT TRADING?

"If we were asked-Who made the discovery which has most deeply affected the fortunes of the human race? We think, after full consideration, we might safely answer - The man who first discovered that a Debt is a Saleable Commodity."³¹

The distressed-debt market consists of nontraditional investors purchasing "debt, equity or trade claims of companies in financial distress or already in default."³²Claims-trading offers a beneficial opportunity for two distinct groups: willing sellers and willing buyers.³³Creditors can avoid the cost and hassle of extended chapter 11 negotiations and cut their losses by selling their claims, often at a discount in order to attract buyers.³⁴Conversely, distressed- debt investors have an opportunity "to arbitrage the bankruptcy payment risk for a profit, buying the claims at a lower price than the expected payout."³⁵

Crucial to the distressed-debt trader is the ability to assert leverage in the reorganization process based on the face value of the claim, despite the discount price.³⁶The ultimate goal of the DDI is "to purchase a good seat at the negotiating table in order to influence the terms of reorganization"³⁷to achieve optimal returns on its investment.

The distressed-debt market is significant. Some commentators estimate that

$500 billion changes hands each year within the market for distressed debt.³⁸

In large bankruptcy proceedings, DDIs are commonly among the largest claimholders. When Adelphia Communications filed for bankruptcy in June

2002, three of the largest bondholders were DDIs.³⁹Similarly, when Enron filed under chapter 11, two DDIs acquired $2 billion worth of corporate notes to become two of the three largest claimants in the bankruptcy.⁴⁰

Despite the size and liquidity of the distressed-debt market, it is largely unregulated.⁴¹Many participants are hedge funds that are generally exempt from the Securities and Exchange Commission's disclosure requirements.⁴²

Furthermore, pertinent provisions of the Federal Rules of Bankruptcy Procedure have been hamstrung by congressional amendments and judicial applications that are detrimental to debtors but beneficial to DDIs.

The 1991 amendment to Federal Rule of Bankruptcy Procedure 3001(e)⁴³increased the frequency of claims-trading by eliminating the disclosure requirement for the terms and consideration upon transfer of the claim.⁴⁴The prior version of FRBP 3001(e) contemplated "that the court [would] enter the order of substitution only after a hearing on notice and further [permitted] the court to enter such an order as [was] appropriate."⁴⁵Congress increased the liquidity of the claims through the 1991 amendments to FRBP 3001(e), by limiting the role of the court only to situations when a dispute arises between a transferor and transferee of the claim.⁴⁶Congress states in the advisory committee notes that the purpose of the amendments is "to limit the court's role to the adjudication of disputes regarding transfers of claims."⁴⁷

Before the revision, the court's power in determining the propriety of a transfer stemmed from Sec. 1126(e).⁴⁸Section 1126(e) remains in effect and allows the court to exclude transferred claims from class acceptance⁴⁹by designating those claims as solicited or procured in bad faith pursuant to

Sec. 1126(c).⁵⁰However, the revision of FRBP 3001(e) seriously limits the court's ability to police claims-trading and determine bad faith transfers. The previous version...