Bankruptcy Claims Trading: Part II

I’ve greatly enjoyed my stint blogging at Credit Slips for the past two weeks. It’s given me new respect for the energy and commitment of the blogosphere community, and I’ve learned at least as much as I’ve taught. Bob Lawless has already posted a very kind goodbye, but before I go back to lurking, I have one last post to make, namely a follow-up to my general introduction to bankruptcy claims trading.

Claims trading, like any other investment, has risks. The question is what risks does one assume when one purchases a bankruptcy claim?

There are (at least) three sorts of risks specific to bankruptcy claims. First, there are risks that inhere in the claim—it might not be allowed in full by the court for any number of reasons—for example, the underlying debt might not be valid or enforceable or the claim itself might be statutorily capped or have been filed after the bar date. Second, there are bankruptcy risks—even if the claim is allowed in full, the payout under the plan might be minimal or non-existent. A valid claim does not translate into a recovery of 100 cents on the dollar in most cases. And third, there are counterparty risks—risks relating to the seller of the claim. For example, the seller could have already sold the same claim to someone else. Or the seller might be selling an invalid claim (which circles back to risks that inhere in the claim).

Until recently, there was little law on the extent of the counterparty risks assumed by a bankruptcy claims purchaser. For example, if the seller had done something untowards (but not necessarily illegal) to the debtor before the sale of the claim, would the claim’s purchaser have to answer for the seller? Specifically, if the claim could have been disallowed in the hands of the seller for conduct unrelated to the claim, could be be disallowed when in the buyer’s hands? Or if the claim could have been equitably subordinated (demoted in priority) in the seller’s hands, could it be equitably subordinated in the buyer’s? Put another way, are bankruptcy claims negotiable? Do all defenses travel with the claim? Or are certain of the debtor’s defenses cut off against a good faith purchaser for value, as they are with checks and securities? How to bankruptcy claims (a federal right) fit vis-a-vis regular commercial law (which has primarily been developed at state law).

The chief benefit of negotiability is that it increases liquidity by lowering transaction costs through reduced counterparty risk. There is less diligence that needs to be done on a negotiable instrument than on a non-negotiable one. Accordingly, if we think there is virtue in a having a robust market , negotiability is a way to foster the market’s development. The downside to negotiability is that bad actors as well as honest yeomen can easily sell their wares; the market does not punish bad actors by making their wares illiquid.

Enron’s ongoing bankruptcy is providing the first test of this issue. (Yes, despite confirmation of a plan of reorganization in 2004, there is still plenty of litigation about who will pay and who will get paid). Briefly, a bunch of banks participated in some legitimate loans to Enron. Separately from the loans, these banks were alleged to have done sundry misdeeds, such as aiding and abetting Enron’s accounting fraud. The banks sold off most of their interests in the loan participations. These interests turned into bankruptcy claims held sometimes by direct purchasers from the banks, but more frequently by tertiary transferees or parties farther down the line. The purchases all occurred before Enron filed any suit against the banks.

Enron moved for the claims to be disallowed or equitably subordinated in the hands of the claims’ purchasers on account of the claims’ originators’ behavior. The Bankruptcy Court for the Southern District of New York ruled that the claims could be disallowed or subordinated in the purchasers’ hands. In essence, the Bankruptcy Court adopted a Mummy’s Curse theory of counterparty risk: once a claim has been touched by a bad actor, the claim—and anyone who holds it—is also tainted. The Bankruptcy Court emphasized that because the purchasers purchased bankruptcy claims, they could not avail themselves of a good faith purchaser defense. The Bankruptcy Court was particularly concerned that if a claim were freely negotiable, it would enable bad actors to launder the claims and escape their comeuppance in court.

The ruling went up to the District Court on interlocutory appeal (including a ridiculous fight over whether the amicus filing of Yale Law School lecturer Eric Brundstad should be accepted). In a ruling in late August, the District Court reversed the Bankruptcy Court. The District Court’s opinion (which the Bankruptcy Litigation blog generously notes tracked my article on equitable subordination very closely). Although the District Court introduced some strange, non-standard terminology (distinguishing between an assignment and a sale as opposed to an assignment and an assignment for value, and then applying its new terminology retroactively to past caselaw), it strikes me (not surprisingly) as basically on the money. The District Court essentially stated a good faith purchaser for value protection in the claims trading market. This means that good faith will become the focal point for any attempt to disallow or subordinated traded claims on account of the originators’ behavior. Unfortunately, the District Court has declined to certify the case to the Court of Appeals for the 2d Circuit, which means that a review of the District Court’s opinion will take some time in coming, if at all. All of this leaves the claims trading market feeling good, but less secure than if there were a 2d Circuit opinion that would bind all District judges.

The claims trading market is fascinating in and of itself and also as one of the few examples of a thriving market for legal claims in the United States. Generally speaking, a litigation claim cannot be bought or sold (except to the counterparty in litigation, when settling). But a bankruptcy claim is just that—a litigation claim, based on an alleged debt. The Enron case also shows the problems that can arise when markets develop faster than the law (a problem we are getting a peek at now with credit derivatives and securitization). Bankruptcy claims trading is not new, but its rise post-dates the Bankruptcy Code of 1978, and courts are still struggling to figure out how, if at all, to regulate the claims market.

Comments

[John Pottow]

Adam -- Great post(posts). If you're not too vested in the argument because of your article, what's the best argument you can make for the other side? For example, I know of a couple areas in the code where its straight loss allocation and there's no good-faith defense (e.g., initial transferees of fraudulent transfers).

[Adam Levitin]

John— I think the best counterarguments lie in the policy realm; textually, I don’t think the Code is particularly helpful one way or another. For example, I don’t think one can read a lot into the lack of a good faith defense for initial transferees of fraudulent transfers because when Congress wrote the Code there was only minimal claims trading. Let me put forth four policy counterarguments.

The major policy argument in favor of making claims negotiable is that it is necessary to protect a major market in distressed debt. The argument relies on the debatable assumptions that courts should care about protecting markets and that the market cannot protect itself.

First, is protection of markets a factor courts should consider in their decision-making? Or is this a policy concern that should be dealt with by legislatures? There is a strong judicial minimalism case against considering market impacts, unless Congress has specifically directed the courts to do so. (We’ll see if this matters in Stoneridge.) But as a matter of legal realism, of course courts care about market impacts. As one structured finance attorney told me, securitization’s best defense is that the market has become “too big to fail.”

The role of market impacts in judicial decision making tracks the central business bankruptcy policy debate—should bankruptcy be a market process or a safe harbor from the market? As a positive matter, bankruptcy has historically been separate from the market in most respects. Once the bankruptcy line was crossed, a special set of rules came into play, and parties’ behavior was subject to the oversight of the court under equitable principles. Distressed debt traders, however, are used to the rules that govern outside of bankruptcy and see little reason why bankruptcy should be different. We see this with the recent debates about Rule 2019 disclosures. Bankruptcy claims are not securities (yet); they are subject to a different regulatory regime, and claims purchasers should expect this. Conversely, if claims purchasers want the negotiability benefits of securities, they should be prepared to accept other aspects of securities regulation. (Of course, bankruptcy claims could be negotiable without being securities.)

Second, why can’t the claims market protect itself? Is counterparty risk really different from other types of risk? Can it be priced around or insured against? I don’t know, but while Enron was on appeal from the bankruptcy court, the claims trading market did not shut down, even if in specific cases there might have been a less robust market. There are certainly some people willing to take a gamble, and with a diversified portfolio, perhaps it shouldn’t matter.

Third, there’s the concern about claims washing. If claims purchasers are protected, then bad actors will be able to sell off their claims and limit the chance that they will have to pay the price for their malfeasance. Here I think there’s an argument that whatever rules apply outside of bankruptcy should apply in bankruptcy—the obligor should have the same defenses to the claim outside of bankruptcy as inside. So if the bankruptcy claim were based on a negotiable type of debt, it would be treated differently than if based on a non-negotiable type of debt. This isn’t exactly an argument against the District Court ruling in Enron, but an argument for a more nuanced approach that would prevent defenses to claim from either being created or cut off because of a bankruptcy filing. (Fwiw, if the District Court had affirmed, it would have made it harder for banks to sell their CLOs/CDOs.)

Finally, I think there is a distinction between claim disallowance and claim subordination. It’s hard for me to accept that a claim that is invalid in the hands of a seller could become valid in the hands of a purchaser. That’s just alchemy. If the claim itself isn’t valid, it shouldn’t matter who holds it. Compare this to negotiable instrument law—negotiation cuts off only some (personal) defenses against the obligor. Other (real) defenses remain valid regardless of negotiation. I would put most issues concerning claim validity in the second category. Subordination, as I have argued, is different because it isn’t a defense to a claim—it is about the intercreditor relationship, not the creditor-debtor relationship. So arguably Judge Scheindlin should have gone one way on subordination and the other on disallowance.

I do not think this is a one-sided slamdunk issue; there are certainly good reasons to be concerned about the effects of claims trading in general. But it is important to emphasize that bankruptcy judges (and practitioners) only see the bankruptcy effects of claims trading, many of which are negative. The bankruptcy community does not see the positive, indirect effects of claims trading. What I argued is that (at least theoretically) claims trading affects the generally lending market and lowers the cost of capital, but that it helps keep companies out of bankruptcy. I’m less certain of the market argument than when I wrote my paper, but I distressed debt investing seems like it’s here to stay.

[John Pottow]

Thank you for your nuanced and thorough answer. Great stuff. I guess the other factor I'd add to the hopper (and I'm agnostic as to which way this cuts) is whether we think there's a superior inequity-smoking-out party. We could say that the buyers of debt prevent a good market moment to kick the tires of the underlying claim, and so we can ferret out the infirmities at this juncture by charging them with a duty of diligence (by visiting the consequences of the "tainted" claim on them). But then you've got to pursue what would be the underlying empirical suppositions. That's at least the framework I'd add. J.