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Bankruptcy Claims Trading: Part I

posted by Adam Levitin

Let me turn to a true bankruptcy nerd topic tonight—corporate bankruptcy claims trading. Bankruptcy claims trading is the buying and selling of claims against a bankrupt corporate debtor. (Trading in consumer bankruptcy claims is an issue that has not been academically explored to the best of my knowledge.)

Bankruptcy claims trading is virtually unregulated in the U.S. Although claims trades can effect changes in corporate control, they are not subject to securities or mergers and acquisitions regulation. There is also little case law on bankruptcy claims trades; my next post will address a very recent decision in the Enron bankruptcy that is the most significant to date.

So who on earth would want to buy a bankruptcy claim?

The key point for understanding bankruptcy claims trading is that there is frequently significant value in a bankrupt company that can be realized through reorganization and/or asset sales. Claims trading is a way of investing or divesting in the company’s reorganization process. Essentially the course of a reorganization becomes a market in itself. There are significant risks, costs, and delays inherent in larger Chapter 11 bankruptcies. Payouts are speculative and can take years to receive. Selling a claim allows a creditor to cashout now at a certain price.

But who would want to buy into a Chapter 11? There are a few different (and non-exclusive) types of Chapter 11 investors. First, there are claims purchasers who are simply looking to capture a spread between the price they pay for a claim and the payout on the claim. Second, there are claims purchasers who are looking to acquire the so-called “fulcrum security”--the claims that will leave them the residual owners of the reorganized company. These purchasers are using claims trading as a way to acquire the reorganized debtor. Third, there are claims purchasers who are seeking to affect the course of the reorganization or simply acquire information about the debtor’s operations and assets, perhaps with an eye to purchasing specific assets or perhaps for competitive reasons. Finally, there are greenmailers, who purchase a blocking position (a plan of reorganization must be approved at least 1/2 in number and 2/3 in claim amount of an impaired classes of creditors) and use it to extract a greater payout in a plan of reorganization.

The advent of widespread claims trading means that membership in the community of creditors may vary throughout a bankruptcy, with significant effects on parties’ incentives and negotiation leverage. There’s a debate within the chapter 11 community as to whether claims trading is a positive development. On the one hand, it lets those creditors who want out to get out and lets parties who want in to get in on the reorganization. As I’ve pointed out elsewhere, the exit possibility created by claims trading has an important spillover effect on primary capital markets; the ability to avoid the uncertainty of being a creditor in bankruptcy increases the risk tolerance of originating lenders, which lowers the cost of capital. On the other hand it can be very disruptive to a reorganization. A debtor can reach a deal with a creditor one day only to find out the next day that the creditor has sold the claim to another party. And so the negotiation starts all over again.

The primary purpose of this post is describe the claims trading market, but that’s hard to do because there’s a lot we don’t know. Claims trading is an OTC market. No one has a handle on the size of the US bankruptcy claims trading market, either in terms of face value of claims trading hands or the volume of transactions. Academic articles from around a decade ago mention the hundreds of billions, but it is not clear how anyone could arrive at any number; the data simply doesn’t exist. There is broad consensus, though, that there is a large and growing market in claims.

The reason that we don’t know the extent of the claims trading market is because it is largely invisible in court records. Federal Rule of Bankruptcy Procedure 3001(e) requires that notice be filed with the court when a claim is transferred. Many types of claims are filed by the holder of the claims’ legal title, rather than beneficial interest. This means that beneficial interest can change hands without the claim itself being transferred. In other words, economic ownership can change hands without a Rule 3001(e) filing being necessary. For example most large loans are participated. Participations typically involve the agent bank retaining legal title to the entire loan, but keeping beneficial title to only a fraction of the loan’s value. The other participants in the loan can freely trade their beneficial interests. Likewise, bonds are often held in street name—State Street Bank or Merrill Lynch will be the registered owner—but the beneficial title (and economic interest) will be held by someone else. Accordingly, it is rare to see a Rule 3001(e) filing for either bank loans or bond debt. This means trades in two huge categories of claims are invisible to anyone but the parties to the trades.

What we can see are primarily trades of claims for unsecured non-bond debt—trade and vendor claims. My perusal of dockets in major chapter 11s indicates that there is an active market for these claims, which can range from the exterminators’ $40 claim to claims for hundreds of millions. It also appears as if trade claims have become a more active market in recent years, particularly in the automotive industry. (Hopefully I'll have this all fleshed out in a future empirical paper.) There are several companies that specialize in buying trade and vendor claims, but major financial institutions and investment funds also buy these claims as part of their investing strategies, especially if they appear to be the fulcrum security. It appears, though, that there are actually multiple overlapping markets for bankruptcy claims—there are different groups of purchasers looking to make money on the spread, some specializing in trade debt, some in bonds, and some in bank debt, and then more active purchasers, looking to obtain control, might be purchasing up and down the capital structure. We also see that some claims trade hands multiple times. Notably, the prices at which claims trade (and hence the profitability of trades) are almost never visible.

The mechanics of the claims market are not well known outside of the trading community. Some trading is direct between buyers and sellers, but some goes through brokers. There are no indices. Recently the Unsecured Creditors’ Committee in Dana Corp.’s chapter 11 began listing the contact information of claims purchasers on its website to help creditors obtain maximum value for their claims. (Full disclosure, when practicing at Weil, Gotshal & Manges, LLP I represented an OEM in Dana’s bankruptcy.) The Dana Creditors’ Committee’s actions raise the possibility of creditors’ committees creating clearinghouses for claims. There have been some attempts to standardize the documentation of claims trades. For loan trades the LSTA has standard transfer documents. I suspect there is similar documentation for bonds. Several of the major unsecured debt purchasers have also created standardized documentation.

What we have then, in corporate bankruptcy claims trading is an unregulated residual securities market in which virtually all purchasers (but not all sellers) are sophisticated parties. In my next post I’ll discuss the recent Enron decision and the problems that can arise in claims trading.

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Comments

"For example most large loans are participated. Participations typically involve the agent bank retaining legal title to the entire loan, but keeping beneficial title to only a fraction of the loan’s value. The other participants in the loan can freely trade their beneficial interests."

This is not true. Most large loans are syndicated, not participated. While your description of a participation is right, in a syndicate, each lender is in privity with the borrower. There is no legal/beneficial distinction, and the agent holds no loans as "agent" although it may as a principal. The agent only serves an administrative function, receiving and disbursing payments, holding a possessory lien as agent for the lenders and sometimes distributing financial reports.

Trading in syndicated loans normally requires the agent's consent, and pre-bankruptcy trades also usually require the borrower's consent, which is not to be unreasonably withheld.

"I suspect there is similar documentation for bonds."

Soemtimes, but the norm is that even distressed bonds trade through brokers or over Bloomberg with no more documentation than an individual gets when he or she trades stocks in a discount brokerage account.

I wonder what impact credit default swaps might have on trading. Do you know?

Claims trading is not new. It may be much more active now, but the transparency issues have been with us for a long time.

MT properly corrects me on the syndication/participation distinction. I'm curious, though, why we don't see more Rule 3001(e) filings for syndicated loans. Any idea as to the explanation? I have to think that it is not because of a lack of trading. Surely there are depositary institutions that have particular pressures to get non-performing loans off their books.

lmclark inquires about credit default swaps (a type of credit insurance) and their impact on claims trading. I've written a bit on CDS and claims trading, but don't think they have much direct interaction. My paper can be downloaded at . As far as I know, though, CDS are only used pre-bankruptcy--indeed, bankruptcy would likely be a default event triggering a swap. The only linkage that comes to mind for me, is that if the risk of claims trading goes up, it raises the cost of CDS. For an excellent paper on the impact of CDS on the bankruptcy process, see Stephen Lubben's "Credit Derivatives & the Future of Chapter 11" .

At least when I was papering distressed debt trades in the mid-1990s, most bank debt was both syndicated and often participated. The syndication works as the first poster above described, with each lender being in privity with the borrower but an agent bank handling administrative matters. If one of the lenders wanted to sell (assign) part or all of its interest in the loan or facility, consent of the agent was required. This is where participation came in--the lender could sell its economic interest in the loan to another institution, but that sale would not be transparent further up the chain. So when there was a payment by the borrower, it would go from the agent to the original lender then the original lender would be obligated under the participation agreement to forward the payment to the new lender. Same thing, only work it backward if it was a credit facility and funding was needed: the agent would notice the original lender, who would then ask the new lender to pony up.

In response to Adam's 3001(e) question, normally the debtor and thec court allow the agent bank to file a proof of claim for the entire bank debt to reduce the original paperwork burden and the 3001(e) paperwork burden. The advisors in the case usually know who the big holders of the debt are (because, being big holders, they will be either active in court or in active communication out of court with the debtor) and no one really worries about the litle holders.

Thanks for the great post Adam. As you say, there’s a lot we don’t know about the murky world of claims trading. That works to the advantage of claim buyers in many instances. Don’t get me wrong, claim buyers provide a very valuable service to creditors who want to cash out. However, the fact is that vulture investors thrive on secrecy, especially the lack of pricing transparency in the claims trading marketplace.

The vast majority of creditors in actively traded cases are small, unsophisticated vendors. They have no reliable way to research the market rate for their bankruptcy claims (as you point out, claim buyers are not required to publish the purchase price in their 3001 filings). I’ve spoken to more than a few creditors who got low-balled on pricing because they took the first offer they received without knowing the true market value of their claim. What these creditors really need is a “blue book” for bankruptcy claims that publishes the latest market rates.

Regarding the size of the market, I’ve been tracking the sale of bankruptcy claims in the most actively traded cases for the past 3 months. Here’s what I found. From July 2007 through Sept 2007, there were 1,592 claims transferred. Total face value for these claims was $ 800,932,221. There were over 60 different claim buyers, although the market is dominated by 20-25 buyers. One major caveat - this data is limited to 3001(e) filings (which, as you mentioned, generally do not include the trading of banks loans and bond debt).

I was surprised at two things: how active the claims trading market is and the size of the trades (many below $1,000). My research is part of a new service called Claim Trading Alerts (www.ClaimTradingAlerts.com). I email subscribers weekly (or monthly) summaries of the latest claim trading activity with links to reports and graphs on our website. I would more than happy to offer the data at no charge to academics doing research in this area.

Bankruptcy claims trading can only occur with "insider" dealings. It is a market that also get bent out of shape by "non-disclosure" of "conflicts of interest".

A party can seize control of a BK estate simply by buying up the claims that are the "key" votes to a plan.

Again such issues require "insider" knowledge that it is not a wasted effort.

The Code prevents one from profiting on a "connected" acquisition of a claim that would then become Equitably Subordinate under Section 510.

A big story is soon to break on the eToys saga, that will make a discussion about this and other related issues a hot topic.

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