Investing in Bankruptcy Claims as a Cash Investment

Profitable Or Significant Loss?

Creditors have the right to payment from a debtor, even when they file for bankruptcy. A bankruptcy claim can be secured by the debtor’s property or it can be unsecured. In chapter 11 plans of reorganization, claims are classified by their relative rights against the debtor. The amount recovered by any class of claims will depend on the aggregate value of the debtor’s assets left after payments are made to the senior classes, according to the waterfall of distributions in the plan of reorganization. The percentage is calculated by dividing the claim amount by the sum of all allowed claim amounts in the class.

Many creditors are willing to sell their claims against a debtor to an investor for a cash payment. This is because of the uncertainty of the amount of distribution, along with how long the bankruptcy process will take. The investor may be interested in purchasing a bankruptcy claim for a number of reasons. An investor may try to influence the overall restructuring of a company by purchasing several bankruptcy claims. It may be purchasing other debt positions as part of an investment strategy, or it could just view a claim in a particular case as a good investment. Investors will pay a discounted price for a claim to take over the creditor’s rights against a debtor to receive distribution, regardless of the reason.

To determine whether to invest, an investor can estimate the expected recovery from a claim by calculating the amount of claims with higher priority, and the total asset value available for paying claims in the class where a particular claim resides.

Calculating claim recovery is the “easy” part; there will be risks to watch for. Three critical risks bankruptcy purchasers face when purchasing a claim are:

1. Recovery risk
2. Notional amount risk
3. Counterparty credit risk

A misjudgment or misfortune tied to any one of these risks can undermine the entire “sound investment decision.”

Recovery Risk: What Will the Debtor Distribute to Your Class of Creditors?

Recovery risk is the risk that a class of claims will be paid less than anticipated. This could happen because

1. The debtor realized less than expected for assets;
2. The bankruptcy process was longer and more expensive than planned or expected; or
3. The class of claims received less preferable treatment than expected.

In the Delphi bankruptcy cases¹, the debtors realized far less than anticipated for their assets. General unsecured creditors of the Delphi debtors were supposed to receive distributions close to the full amount of their claims early on. The cases dragged on, and in early 2008 financing that was expected to fund distributions to creditors plans evaporated as the company’s valuation tanked. Holders of general unsecured claims ended up with only a single-digit percentage recovery. All might have been different had the plan become effective earlier.

In the Visteon bankruptcy cases, the debtor’s collective enterprise valuation was revisited multiple times. Estimations of recoveries for holders of unsecured claims rose from 0 to about 50%. Similarly, early in the Lehman Brothers chapter 11 cases, claims against the Lehman debtors were trading in the single digits. Ultimately, the disclosure statements estimated recoveries to fall between close to 20% and the high 20s in the cases, depending in part on the particular debtor and their precise classification. Some claims even ‘double-dipped’ for recoveries against debtors for the same claims.²

How Can A Class Of Claims Get “Less Favorable” Treatment When The Plan Sets The Terms?

In the Charter Communications bankruptcy cases (a large corporate case with a multi-level corporate and capital structure) the recoveries for holders of certain senior claims against certain affiliate debtors may have been reduced. This was due to the court applying a valuation of the total enterprise instead of each affiliate debtor separately in the context of confirmation.

Notional Amount Risk – Is Your Claim Amount Valid?

Notional amount risk is when a bankruptcy claim receives less than similar claims in the same class. This can occur if the claim is found to be invalid (in part or in whole) or it can also occur because some disability of a prior holder of the claim was applied to disallow the claim.

This can include, perhaps, the entity you purchased it from. Claims are reviewed and challenged in the claims resolution process. This often takes place after confirmation of the plan of reorganization. A claim may be objected to on one or more of any number of grounds (see below) and negotiation and/or litigation may ensue.

The potential damage from a failure to address the notional amount risk can be illustrated by the following example. Assume an investor purchases a $100m claim for $30m and expects a total recovery between 35% and 40%, for an upside of $5m to $10m. Assume further that – as a surprise to the claim investor — the debtor disputes the claim amount and the parties after some litigation agree to allowance of the claim at $70m. At this point, the claim investor has paid 43% of the new face amount of the claim, and his expected upside has vanished (plus he is forced to absorb the litigation costs).

During the claims resolution process, a claim may be disallowed (or allowed in a reduced amount) for reasons such as:

• The debtor’s books and records indicate a lower amount;
• Because the debtor is found to have had the right to set off against the claimed amount a debt owed by an earlier holder of the claim to the debtor;
• Claim also may be subject to disallowance because a prior holder (or the current holder) of the claim received a preferential transfer from the debtor;
• Claim may be subordinated to other claims of its class because an earlier holder or current holder of the claim behaved inequitably.

Claims purchasers can address this notional amount risk by performing more thorough due diligence before purchasing the claim. They can also negotiate for effective representations & warranties, indemnities, and other protections in the claims purchase contract.

Counterparty Credit Risk: Can the Claims Seller Make You Whole?

Counterparty credit risk is the third risk factor to consider. It can arise when a claim purchaser must look to its seller for indemnification for breaches of representations and warranties under the claim purchase contract.  It can also arise when distributions from the debtor’s estate have been directed to the claim seller as the record holder of the claim.

If the seller itself becomes insolvent or the subject of a bankruptcy case, the purchaser may lose all practical recourse against it for breaches of the claim purchase contract. It can also lose claims for distributions directed originally to the seller as the record holder.

Factual and Legal Diligence May Protect Claim Investors

Investors looking to make a play in the bankruptcy claims markets can seek to minimize the risks described above through appropriate factual and legal diligence. Factually, investors need to discern the status of the bankruptcy case and where it could be headed. It is also prudent to understand how the debtors’ corporate structure and intercompany claims & guarantees may increase or dilute a particular claim’s recovery.

Further, it’s important to examine the original holder of the claim. What (if any) defenses or objections can the debtor have against that claimant and the claim?

With an understanding of the risks posed by the purchase of a claim, the bankruptcy claims investor should carefully negotiate the claims purchase transaction documents to protect itself from these risks and maximize its investment.

We think you’ll also like:

1. Dealing with Corporate Distress 09: All About “Claims” in Bankruptcy
2. Dealing with Distress for Fun & Profit— Installment #18—How to Confirm a Chapter 11 Plan
3. 90 Second Lesson: Carve-Outs for Unsecured Creditors

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can watch at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Help, My Business is In Trouble!
2. Bankruptcy Claims Trading
3. Bankruptcy Transactions 301: Advice for the Advanced Practitioner

This is an updated version of an article originally published in August 2013 and previously updated October 4, 2019.]

©2024. DailyDAC^TM, LLC d/b/a/ Financial Poise^TM. This article is subject to the disclaimers found here.

1. The bankruptcy of a large company like Delphi usually takes the form of several or many bankruptcy cases, one for each debtor-affiliate involved in the overall enterprise. Thus, there are the Delphi cases, the Visteon cases, and the Lehman cases, each with multiple chapter 11 debtors.
2. A “double-dipping” claim is a claim that can recover from multiple debtors, e.g., there is a right to payment against one debtor as principal obligor, and a second right to payment from an affiliated debtor, either as guarantor or co-borrower. “Double-Dipping” is relatively rare for general unsecured claims, though secured lenders’ claims are often against each of the main debtor’s subsidiaries and co-borrowers under a credit agreement and often benefit from affiliate guaranties.