Upon the filing of a bankruptcy petition by a debtor in a U.S. chapter 11 proceeding, any attempts to collect debt by a creditor are halted. As a result, creditors face the daunting prospects of either waiting out the debtor’s bankruptcy case – not knowing when, how much, or even if they will ultimately recover on their claims – or engaging in what could be a drawn out and expensive dispute with the debtors to protect their right and enforce their claims.
What many creditors may not realize is that there is an active marketplace for the purchase and sale of bankruptcy claims.
The claims trading market has developed in recent years, not only in the type and size of the claims changing hands and volume of activity, but also in the complexity of the underlying transactions and level of sophistication of the participants. Mega-cases like Lehman and Madoff still dominate the space, but there is activity in cases of all sizes and sectors and in jurisdictions beyond New York, Delaware and Texas. According to data provided by TrollerBK.com, in 2016 there were more than 7,300 reported claims assignments in 427 different cases with a face value of more than $26 billion (not including unliquidated claims) in the U.S. This statistic covers only publicly filed transfers, and does not include transactions which settle by participation or other structure. Further it only covers U.S. cases – as in most jurisdictions outside the U.S., there is simply no publicly available data to get an accurate sense of the size or scope of the market. In the U.S., the Lehman bankruptcy continues to be a gift that keeps giving to claims traders and their attorneys, accounting for over 30% of the number of trades and more than 75% of the face amount of all U.S. trades in 2016 according to TrollerBK.com.
This article will discuss the claims trading marketplace generally, focusing on its general characteristics, motivations for participants, documentation basics, business and legal structuring considerations, and risks borne by sellers and purchasers in these transactions. This article is the first in a series on the topic of claims trading and is intended to be a summary overview; subsequent articles will delve into the topics raised herein in greater detail.
Claims trading, simply put, is the purchase and sale of claims held by creditors against debtors in a bankruptcy proceeding. This includes claims for goods sold, services rendered or damages asserted by contract counterparties such as landlords or professional service providers. Terminated financial contracts (e.g., ISDA agreements) form the basis for another frequently traded type of claim in past years, particularly in the Lehman case.
These transactions are typically privately negotiated deals between sophisticated, “big boy” counterparties. There are no electronic settlements and no public exchanges; instead, parties negotiate, execute and deliver written contracts (either bespoke or in the form recommended by a trade association). Although it has never been finally determined by the U.S. Supreme Court, the view of most commentators and market participants is that bankruptcy claims are not securities and, therefore, federal securities laws do not apply to claims trading transactions.
The reasons for selling a claim usually are quite apparent. Selling a claim allows a creditor to eliminate the risk and uncertainty of a bankruptcy proceeding. The seller gets to lock in a certain recovery now as opposed to something unknown in the future. This is particularly important at quarter- or year-end; or when the seller itself is being sold, liquidating or otherwise winding down.
The motivations for a claims purchaser may differ, depending on the specifics of the underlying bankruptcy case or even the type or size of the claim purchased. Often times a claims purchaser may be trying to accumulate a debt position in order to influence the overall restructuring. They could be purchasing not only claims but other types of debt such as loans or bonds, or otherwise be involved in an arbitrage or hedging strategy. The purchaser could simply believe that the “price is right” and the asset (or the debtor itself) is undervalued. Finally, the purchaser may not even be the end purchaser of the claim, and instead could be “making a market” in the claims or brokering a transaction.
The original sellers of claims can be vendors, suppliers, landlords, or any business which faces exposure to a bankrupt counterparty. Buyers are typically distressed debt investors, such as institutional asset managers and hedge funds. In some transactions there is a broker. This role is filled from institutions ranging from specialized, boutique claims brokerages to the trading desks of Wall Street banks.
One party typically not involved in the negotiation of a claims trading transactions is the debtor itself, as generally a debtor has no ability to consent to (or reject) a transfer of a claim against it. There are circumstances, however, when the trading of claims against a debtor can be restricted (for example, if there is an NOL order on file permitting the debtor to carry its net operating losses forward which restricts a change in the underlying ownership of the debtor).
The first step in documenting a claims transfer is often executing what is known in the market as a trade confirmation. The trade confirmation records the basic agreed upon terms of trade, such as price, quantity and any special conditions to closing. Under New York law, it is not necessary for a trade confirmation to be executed in order for it to be enforceable (as a “qualified financial contract”, it is eligible for an exemption from the statute of frauds).
The trade confirmation should include any due diligence which the purchaser will request as a part of its evaluation of the transaction. Depending on the type of claim, this usually includes the claim “backup” (e.g., contracts, purchase orders, proofs of delivery, invoices, etc.), as well as the proof of claim if one has been filed, and any other correspondence with the court, the debtors or their advisors.
Assuming the diligence is found to be acceptable, the parties next negotiate a form of purchase and sale agreement. While there is no standard form purchase and sale agreement for claims in the U.S. (in contrast to the assignment of a syndicated loan, which is often settled using Loan Syndications and Trading Association documentation), there are certain market standard terms and conditions which are commonplace in most claims trade transactions.
Once the agreement is final, the parties typically exchange a funding memo and file a transfer notice with the bankruptcy court pursuant to FRBP 3001(e) under the Bankruptcy Code. Only very basic information needs to be filed with the court (the name and address of the parties, and the amount and claim number, if available yet, of the claim assigned). The purchase price does NOT need to be disclosed publicly. It is important to note that FRBP 2019 does, however, require certain disclosures about the economic interests of creditors in bankruptcy cases.
Finally, as with any deal and depending on the type of claim, underlying jurisdiction of the case, or complexity of the transaction, there may be ancillary documentation to be executed and exchanged (such as escrow agreements, powers of attorney, or proxy forms).
Certain issues frequently arise over the course of negotiating the purchase agreement. It is prudent, but not always possible, for the parties to discuss these issues at the time of trade. For example, what level of recourse is expected by the purchaser in the event the claim is impaired or disallowed? What representations and warranties is a seller willing to make? Has the seller committed any “bad acts” that could cause the claim to be subordinated? Will the seller agree to indemnify the buyer in the event there is a “clawback” of distributions due to a preference? Can the purchase hold back a portion of the purchase price in the event the claim is not yet allowed? Are there any contingencies which need to be met before the parties will agree to close the transaction? Who will defend the claim (or, more often, who will bear the cost of the defense) in the event there is an objection filed by the debtors?
Similarly, there are certain legal issues which often come up during the negotiation of a claims trade deal. Do the parties wish to settle the trade via a legal assignment of the claim (which, as referenced above, necessitates a public filing in the bankruptcy case); or would they prefer to close as a participation, where the seller of the claim remains the record owner but distributions (and voting rights) are passed on to the purchaser? What is the governing law for the transaction documentation? The default tends to be New York in the U.S. and England for European transactions, but there may be other procedural or local law requirements which must be satisfied because of the jurisdiction of the underlying case.
Generally speaking, it is customary in the bankruptcy claims trading marketplace for the seller of the claim to bear the risk of claim impairment. That means the seller retains the risk that the subject claim is treated differently than all other similarly situated claims due to a defect, or in the event of an objection on or disallowance of the claim (regardless of the seller’s knowledge or responsibility). This risk allocation is commonly reflected by a “put back” right of the purchaser in the event of claim impairment negotiated into the purchase agreement. Of course, such a right is only valuable if the seller is actually able to pay the purchase price back to the buyer, which is why the first step many prospective purchasers take – even before conducting due diligence on the underlying claim itself- is to conduct an assessment of the solvency and creditworthiness of the target seller.
On the other hand, the buyer customarily bears the risk of recovery on the claims. In short, this means “caveat emptor” – if the price fluctuates and the buyer receives less for the claim than what he paid for it, then (so long as this reduction was not caused by an impairment) it is the buyer’s risk and the buyer’s loss.
Although some commentators argue that a claims trading market turns bankruptcy cases into the “wild west” and makes it prohibitively difficult for a debtor to proceed with an orderly reorganization, most agree that it is a market which provides a welcome source of liquidity to creditors with exposure in bankruptcy cases. Based on data calculated by TrollerBK.com, that market was reported to be more than $6 billion in non-Lehman U.S. cases last year. In subsequent articles, we will discuss the issues presented in this introductory article in greater detail.
Timothy C. Bennett is senior counsel with Seyfarth Shaw LLP and the leader of the firm’s Global Distressed, Illiquid and Special Situations Trading practice area. He regularly represents sellers and buyers of loans, claims and other types of distressed debt.