Taking the Punchbowl Away from the Party
Business bankruptcies in the US can be big business for hedge funds trading in distressed debt.¬† But that business may be sharply curtailed – or effectively eliminated – if proposed new disclosure rules in bankruptcy take effect.
In a recent series of articles dealing with these proposed changes, the Hedge Fund Law Report (HFLR) has explored their anticipated impact on hedge funds’ participation in bankruptcy proceedings – and has graciously included¬†in its analysis a couple of quotes by members of South Bay Law Firm.
Some background may be helpful.
Hedge Funds and Rule 2019
Hedge funds have become major participants in recent bankruptcy proceedings, in which they often form unofficial or ad hoc committees in order to aggregate their claims and benefit from the additional leverage such aggregation provides.¬† For example, a committee might seek to consolidate a “blocking position” with respect to a class (or classes) of the distressed firm’s debt, then negotiate for financial or other concessions regarding¬†the debtor’s reorganization plan.¬† Though their investment strategies may differ, hedge funds are typically uniform in their insistence on the privacy and confidentiality of their investments.¬† Further, such secrecy is viewed as necessary to protect the funds’¬†proprietary trading models from duplication.
The fiercely guarded¬†privacy of hedge funds contrasts sharply with¬†the¬†insistence on disclosure that pervades American Bankruptcy Courts.¬†¬†The two¬†have never co-existed comfortably.¬† Bankruptcy Courts and other parties¬†seeking to look behind the veil of secrecy surrounding a participating¬†group of funds have¬†looked for help to¬†Bankruptcy Rule 2019.¬† That Rule essentially requires disclosure of certain information from informal “committees” in a bankruptcy case.
Rule 2019¬†traces its roots to the correction of abuses¬†unearthed in the 1930s, when a series of hearings conducted for the SEC by [as-of-then-yet-to-be-appointed Supreme Court Justice] William O. Douglas uncovered the frequent practice of inside groups (so-called “protective committees”) working with bankrupt companies to take advantage of creditors.¬† Douglas’ investigation uncovered “[i]nside arrangements, unfair committee representation, lack of oversight, and outright fraud [that] often cheated investors in financially troubled or bankrupt companies out of their investments.”
Hedge funds do not occupy the same role as¬†the “protective committees” of 70 years ago.¬† But¬†creditors have nevertheless relied on the Rule’s provision to claim that¬†ad hoc committees must “open the kimono” to reveal not only their members’ purchased positions in the debtor,¬†but the timing and pricing of those purchases.¬† This most hedge funds will not do – at¬†least not without without a very stiff fight.
Reaction to this use of Rule 2019 has been mixed.¬† In a pair of decisions issued in 2007, the Bankruptcy Courts for the Southern District of New York and the Southern District of Texas went in opposite directions, finding that ad hoc committees in the respective cases of Northwest Airlines Corp. and¬†Scotia Development LLC must comply (in New York) or were exempt (in Texas) from the provisions of Rule 2019.¬† The measure of hedge funds’ resistance to this disclosure is gauged by the fact that in the wake of the court’s decision in Northwest Airlines, several funds withdrew from the case rather than divulge the information otherwise required of them.
Proposed Amendments to Rule 2019
On August 12, 2009, the Advisory Committee on the Federal Rules of Bankruptcy Procedure¬†weighed in on this dispute by proposing a significant revision¬†of Rule 2019.¬† The Rule has been essentially re-drafted.¬† According to the Committee Notes, subdivision (a) of the Rule defines a “disclosable economic interest” – i.e., “any economic interest that could affect the legal and strategic positions a stakeholder takes in a chapter 9 or chapter 11 case.”¬† The term is employed in subdivisions (c)(2), (c)(3), (d), and (e), and – according to the Rules Committee that drafted¬†it – is¬†intended to extend beyond claims and interests owned by a stakeholder.
In addition to applying to indenture trustees (as the Rule presently does), subdivision (b) extends the Rule’s coverage to “committees . . . consist[ing] of more than one creditor or equity security holder,” as well as to any “group of creditors or equity security holders that act in concert to advance common interests, even if the group does not call itself a committee.”¬† If these extensions of Rule 2019 weren’t broad enough, subdivision (b) goes even further.¬† It permits the Court, on its own motion, to require “any other entity that seeks or opposes the granting of relief” to disclose¬†the information specified in Rule 2019(c)(2).¬† Although the Rule doesn’t automatically require disclosure by an individual party, the court may require disclosure when it “believes that knowledge of the party’s economic stake in the debtor will assist it in evaluating that party’s arguments.”
Subdivision (c) – and, in particular, (c)(2) – is the heart of the Rule.¬† It requires disclosure of the nature,¬†amount, and timing of acquisition of any “disclosable economic interest.”¬† Such interests must be disclosed individually – and not merely in the aggregate.¬†¬†The court may, in its¬†discretion, also require disclosure of the amount paid for such interests.
Subdivision (d) requires updates for any material changes made after the filing of an initial Rule 2019 statement, and subdivision (e) authorizes the court to determine where there has been a violation of this rule, any solicitation requirement, or other applicable law.¬†¬†Where appropriate, the court may impose sanctions for any such violation.
Though¬†potentially broad-reaching, one of the obvious flashpoints for the amended Rule’s application will be on the¬†continued participation of hedge funds in Chapter 11 cases.
WIll the Amendments Work?
Are the amendments necessary?¬† Or helpful?¬† And how – if at all – will they affect the participation of hedge funds or other parties in Chapter 11 cases?
Comments gathered by HFLR suggest that¬†certain aspects of the amendments may, in fact, assist in blunting the effect of credit default swaps – derivative securities through which the holder of distressed debt can shift the economic risk of¬†the debtor’s¬†obligation to a non-debtor third party, and therfore refuse to negotiate with the debtor.¬† But other¬†provisions may, in fact, permit abuse similar to the type perceived by William O. Douglas’s original investigation: The debtor’s management¬†may¬†use the new Rule in collusion with a friendly committee (or other creditors) to harrass, embarrass, and pressure¬†an individual creditor, who may not be in an economic¬†position to resist this treatment.
Some hedge funds have offered the argument that Rule 2019’s disclosure requirements run afoul of the Bankruptcy Code section 107’s protection of¬†“trade secrets,” which may be protected from the public through the sealing of papers filed with the Court.¬† But is¬†a hedge fund’s trading information in a specific case¬†really a “trade secret?”¬† HFLR quotes South Bay Law Firm’s Michael Good, who notes that “Where hedge funds are concerned, the plausibility of a ‚Äėtrade secret’ argument depends upon what can or can’t be reverse engineered, something that only people with access to and familiarity with the funds’ ‚Äėblack box’ trading models and expertise in understanding them can know.”
To date, Bankruptcy Courts have not been persuaded by the “trade secret” argument.¬† The Bankruptcy Court for the Southern District of New York specifically rejected it in¬†Northwest Airlines.
Even so, Bankruptcy Courts have questioned whether or not case-specific trading information (such as the timing and pricing of a fund’s purchase) is truly relevant to the disclosure issues that arise before them.¬† HFLR cites to the Delaware Bankruptcy Court’s¬†handling of¬†similar concerns raised by parties¬†in the Sea Containers bankruptcy case, where the court ordered attorneys for a group of five bondholders to “revise the 2019 statement to provide the information that’s required by 2019(a)(1), (2), and (3) but not (4) [subsection (4) requires disclosure of the purchase price, which is the information considered most sensitive by hedge fund managers] because I don’t think that [the purchase price] is relevant in any way.”
Many practitioners agree with this assessment.¬† South Bay Law Firm’s Good opined that the Sea Containers court’s balancing of interests “is probably right. I don’t know that it is truly problematic for parties, hedge funds or others, to disclose who they are or what are their aggregate holdings.¬† The problems more commonly arise with the revelation of the price at which they purchased distressed securities, and occasionally with the timing of the purchase.¬† Though it might be relevant in certain circumstances, trading information is often far less relevant than identifying the participants in bankruptcy, their relationships with one another, and the conflicts of interest that can surface through the disclosure of these relationships.”
Why all the fuss, anyway?¬† What’s really at stake with these amendments?
On the one hand, Temple law professor Jonathan Lipson has argued in a recent article¬†that the business bankruptcy process serves an important informational function for the markets and for the economy generally by “outing” poor corporate practices and systemic inefficiencies that can only be addressed and corrected after they’ve seen the light of public scrutiny.¬† Consequently, the proposed amendments should keep the bankruptcy process honest – and are therefore necessary.
But other scholars¬†have suggested elsewhere that the glare of public scrutiny will keep many well-heeled investors out of the distressed investment market altogether.¬†¬†According to them, hedge funds are widely perceived as facilitating more competitive financing terms and increased liquidity in the debt markets.¬† They are also particularly useful in the restructuring process because they can make different types of investments (debt and equity) in a single company.¬† Additionally, their exemption from traditional regulation allows them to quickly adapt their investment strategies to the situation at hand.¬† The proposed amendments to Rule 2019 – and even the proposed application of Rule 2019 in its present form – may effectively remove this “market lubricant” and may further deprive distressed firms of the liquidity they need at a time when they need it most.
Comment on the proposed amendments is due by February 16, 2010.
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