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      Insolvency News and Analysis - Week Ending October 24, 2014
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    Posts Tagged ‘“hedge fund”’

    “Equality is Equity”

    Sunday, December 19th, 2010

    The distribution scheme embodied in federal bankruptcy law serves several important functions.  In Chapter 7, the detailed statutory distribution scheme imposes order on the chaos that might otherwise attend the liquidation of business assets.  In Chapter 11, the fixed order of priority claims and the “absolute priority rule” – along with the requirement that similarly situated classes receive identical treatment – provide predictability within the confirmation process and a framework for out-of-court negotiations.

    But not all resolutions of business insolvency afford this level of predictability.  In particular, state and federal receiverships afford the prospect of considerably greater flexibility and discretion on the part of the appointed receiver and the appointing court.

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    The scope of a receiver’s discretion was illustrated early this month by the 7th Circuit Court of Appeals’ approval of a federal receiver’s proposed pro rata distribution of the assets of six insolvent hedge funds.

    SEC v. Wealth Management LLC, — F.3d — 2010 WL 4862623 (7th Cir., Dec. 1, 2010) involved an SEC enforcement action against Appleton, Wisconsin-based investment firm Wealth Management LLC and its principals, alleging, among other things, misrepresentation and fraud.  At the SEC’s request, the Wisconsin District Court appointed a receiver for Wealth Management and its six unregistered pooled investment funds.

    The receiver’s plan, approved by the District Court, was relatively straightforward:  All investors would be treated as equity holders, and would receive pro rata distributions of the over $102 million invested in the funds.  Two investors who had sought redemption of their investments pre-petition disagreed and appealed the receiver’s plan.  The essence of their argument was that Wisconsin law (and Delaware law, which governed several of the funds), required that investors who sought to redeem their investments be treated not as equity holders, but as creditors of the failed funds.  As a result, their redemption claims were of a higher priority than investors who had not sought to withdraw their funds.  The investors also relied on 28 USC § 959(b), which provides that receivers and trustees must “manage and operate” property under their control in conformity with state law.

    The 7th Circuit rejected this argument, finding instead that federal receivers and trustees need not follow the requirements of state law when distributing assets under their control. Holding that “equality is equity,” the court found that to give unpaid redemption requests the same priority as any other equity interest “promotes fairness by preventing a redeeming investor from jumping to the head of the line . . . while similarly situated non-redeeming investors receive substantially less.”

    The Wealth Management decision highlights the flexibility and ambiguity of the receivership system – itself a critical distinction from the well-defined priorities of federal bankruptcy law.  Though the 7th Circuit’s reasoning – rooted in “similarly situated claims” – is consistent with the policy objectives of the Bankruptcy Code, the result is diametrically opposed to the scheme of priorities on which Wealth Management’s investors undoubtedly relied.

    Wealth Management – like many receivership cases – is a case based on federal securities fraud.  But federal and state receiverships are applicable in a variety of contexts – including business dissolutions, directorship disputes, marital dissolutions, and judgment enforcement.  Where a proposed distribution to creditors can be fairly characterized as “equitable” under the circumstances of the case and where it represents a fair exercise of the receiver’s fiduciary duty on behalf of the receivership estate, the flexibility of a receivership may justify its typically high cost.

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    Rule 2019: A Kinder, Gentler, Amendment

    Monday, June 14th, 2010

    The Advisory Committee on Bankruptcy Rules of the Administrative Office of the U.S. Courts has pulled back from its earlier position on the disclosure required of hedge fund and other distressed debt investors participating as ad hoc committees or other, loosely organized creditor groups in Chapter 11 cases.

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    An earlier version of proposed amendments to Federal Rule of Bankruptcy Procedure 2019 would have required such investors to disclose the dates and prices paid for their purchases of distressed securities.  These changes were resisted by investor groups such as the Loan Syndications and Trading Association, and created some press coverage last year (an earlier post on the amendments is available here).

    That said, investors will still be required to reveal the “disclosable economic interest” they each hold in a company, including debt and derivatives. This includes the identity of specific investors and the date such investors acquired their interests.

    Morever, Committee notes to the proposed rule indicate that the previously-contested disclosures of pricing and purchase dates may be compelled through discovery or by the Court acting under its own authority outside the proposed rule.

    A copy of the proposed rule, along with a summary of comments received on earlier versions and the Committee’s advisory notes, is available here.

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    Taking the Punchbowl Away from the Party

    Monday, October 12th, 2009

    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 ‘trade secret’ argument depends upon what can or can’t be reverse engineered, something that only people with access to and familiarity with the funds’ ‘black 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.”

    So What?

    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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    The Stanford Saga – Chapter 5: The Liquidators Strike Back

    Saturday, June 27th, 2009

    Nearly two weeks ago, this blog highlighted further scuffling in the ongoing contest for administrative control between Ralph Janvey – a federal receiver appointed at the SEC’s behest to seize and administer financial assets once controlled by Sir Allen Stanford, and Peter Wastell and Nigel Hamilton-Smith – English liquidators charged with liquidating Stanford International Bank, Ltd. (SIB), an Antiguan entity through which Stanford did significant amounts of business.

    To summarize prior posts – available by linking here – Wastell and Hamilton-Smith have sought recognition of SIB’s Antiguan liquidation through a Chapter 15 case commenced before U.S. District Judge David Godbey in Dallas.  Janvey, along with the SEC and the Internal Revenue Service, vehemently oppose recognition of the Antiguan liquidation as the “main proceeding” in the Stanford entities’ administration.

    In an extensive brief filed earlier in the month, Mr. Janvey – joined by the SEC in separate briefing – detailed his reasons for doing so.  In essence, Mr. Janvey and the SEC claim that the “center of main interests” (COMI) of an investment fraud – which the SEC alleges Stanford perpetrated – is headquartered where the fraud is . . . and not from the presumptive location where the victims were led to believe a legitimate business was run.  They also appear to place heavy reliance on the fact that, though SIB was physically located in Antigua, it was not authorized to do regular business with local residents – and its liquidation therefore resembles numerous hedge fund liquidations that, to date, have experienced difficulty obtaining recognition as foreign “main proceedings” in other US Bankruptcy Courts.

    This week, Mess’rs. Wastell and Hamilton-Smith answered Janvey’s argument.

    In a 25-page reply brief, supported by extensive Appendices, Wastell and Hamilton-Smith explain that Janvey’s “fraud-based” argument is beside the point – as is the fact that SIB was maintained primarily for “offshore” operations in the US, South America, and Europe.

    Instead, the liquidators claim that the extent of SIB’s physical operations in Antigua make its liquidation far different from the “letter-box” entities in Caribbean tax havens that US Bankruptcy Courts have, to date, been reluctant to recognize.  Wastell and Hamilton-Smith rely heavily on a California decision – In re Tri-Continental Exch. Ltd., 349 B.R. 627 (Bankr. E.D. Cal. 2006) – which involved alleged “sham” insurance entities that sold fraudulent insurance policies to US citizens through a network of domestic brokers and agents, but whose 20 employees and only office were operated in St. Vincent and the Grenadines.  Over the objection of a US judgment creditor, the U.S. Bankruptcy Court in Tri-Continental recognized as the foreign “main proceeding” a liquidation commenced through the Eastern Caribbean Supreme Court, holding that even through the fraud was perpetrated primarily in the US and Canada, the debtors’ COMI was in St. Vincent and Grenadines because the debtors “conducted regular business operations” there.  349 B.R. at 629.

    Using this analysis, Wastell and Hamilton-Smith argue that SIB’s Antiguan liquidation should likewise be recognized as a foreign “main proceeding” since, as even Mr. Janvey acknowledges, a debtor’s COMI is tantamount to its “principal place of business” under US law.  According to the liquidators, a debtor’s “principal place of business” is essentially the location of its “business operations,” and their brief refers repeatedly to SIB’s extensive physical and administrative operations in Antigua.  Wastell and Hamilton-Smith appear to tiptoe around Mr. Janvey’s argument that the Court should look to the debtor’s “nerve center” (in this case, the location of executive decisions) where a business’s operations are “far-flung,” using a brief (and conclusory) footnote to draw a distinction between the Stanford entities’ admittedly “far-flung” sales, on the one hand, and its operations on the other – which, according to the liquidators, were concentrated exclusively in Antigua.

    Judge Godbey’s appointed examiner is due to weigh in on these issues shortly after the US July 4 holiday.

    Stay tuned.

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