March 2016

Claims Trading Warps the Bankruptcy System Honest Debtors Are Hampered by “Self-Interested Meddlers”

The Bankrupcty Code was designed to enable honest debtors to reorganize and get a fresh start. But the growing number of claims traders purchasing these debts from lenders is warping the process, contends Kenneth A. Rosen, a nationally recognized bankruptcy expert.



Kenneth A. Rosen, Partner, Lowenstein Sandler LLP

Kenneth A. Rosen, Partner, Lowenstein Sandler LLP


An article in the October 22, 2015 New York Times Sunday Magazine by Mattathias Schwartz contends that litigation financing is warping the legal system. Schwartz writes that litigation finance is creating a financial arms race, with speculative money driving up the already high costs of litigation. For those unfamiliar with the practice, lenders are financing plaintiffs in lawsuits with the goal of profiting from the eventual settlements. “It’s hard to imagine how billions in outside capital won’t end up changing the justice system. The only question is how,” Schwartz writes.

This type of speculative investment has already changed the world of bankruptcy where a vibrant market for trading unsecured claims exists. Trade
creditors often are almost as desperate for cash as their customers in Chapter 11. They may not understand the extra value of 503(b)(9) status (claims for goods received by the debtor within 20 days of the petition date). They usually do not have (and cannot readily obtain) a feel for the dividend that the case likely will yield. Based on their experience, they believe it takes too long to see a dividend. So fast money — any money
— looks attractive.

Bank debt is bought and sold as a matter of course. Prices can be tracked on websites such as Markit.com. Once I would have said the business of a bank is lending money. Today the business of a bank is originating loans. In the old days (I dislike sounding like my father), a bank would work out a troubled credit with the customer. Today it is easier for the bank to sell the loan.

Secured and unsecured bonds are freely traded. Portfolio theory claims that the market is efficient and reflects all publicly known information about a debtor. That really is not so. The market for bonds reflects information known only to a close-knit community of bondholders who play in that space. Bond purchases and sales are typically done for arbitrage, but bonds also may be acquired to gain control over the issuer or gain leverage over another bondholder.

When Indebtedness Is Sold

In the Times article, Schwartz cites historian Max Radin, who said that the Roman taboo on litigation finance sprang from the belief that “a controversy properly concerned only the persons actually involved in the original transaction, not self-interested meddlers.” Is it any different when when indebtedness is sold in a bankruptcy case?

When this occurs, the parties to the original transaction change. The original debt holder’s goal was to maximize the recovery on its claim. A turnaround takes time, and patience is necessary. When claims against an insolvent debtor are sold, however, the holder seeks a return on the purchase price of the claim. One can argue that the motivation of the original holder and of the transferee are the same, but the transferee may
not want to give the debtor the time required to restore value, preserve jobs or avoid a bulk sale at a fire sale price. If the transferee can obtain a high enough return based on the claim’s purchase price, rather than based on the face value of the claim, it will do so.

The Bankruptcy Code is designed to enable honest debtors to get a fresh start. Congress determined that reorganization trumps liquidation. The
benefits of reorganizing rather than liquidating are both social and economic. The emotional and social costs that trickle down to a debtor’s creditors during bankruptcy, including loss of shareholder investment, loss of jobs and realizing nominal value for assets, cannot be ignored.

Distorting the Bankruptcy Process

Claims trading and the allowance of claims at face value when claims are acquired at a fraction of face value distorts the bankruptcy process. If someone acquires a claim at a discount, for let’s say 35 cents, they view a 50 cent recovery in liquidation as a “win” and want it accomplished quickly. In contrast, someone who invested $1.00 and may get 50 cents in liquidation has a much greater incentive to work with the debtor to achieve a successful turnaround and the societal goals of Chapter 11.

The Bankruptcy Code also balances the interests of the debtor against the interests of its creditors. The key word is “balance.” The Bankruptcy Code has provisions for the debtor’s exclusivity to file a plan of reorganization and for protection under the automatic stay of section 362 (injunction against creditor actions), but the code also gives secured creditors the right to adequate protection and gives creditors the ability to seek conversion of a debtor’s Chapter 11 case to one under Chapter 7 (liquidation).

The Bankruptcy Code drafters never envisioned that a situation would arise in which claim holders had a dollar of bargaining power where the consideration for the claim was a fraction of a dollar. I understand that the original claim holder gave roughly equivalent value for the dollar of claim. The claim’s transferee did not. The Bankruptcy Code has never been amended to take this new reality of claims holders who bought claims at a deep discount into account. Nor is the transferee required to disclose its purchase price, which may reveal much about the transferee’s genuine motivation.

Bond, trade and bank claims may be purchased for various reasons. If the purchaser desires to “loan to own,” an honest debtor may lose the opportunity to reorganize as it deems appropriate if the transferee creditor’s goal is obtaining control rather than reorganization. If the secured creditor is inflexible in facilitating restructuring of its claim, or if the holder of a block of unsecured claims rejects a plan, the debtor may lose the battle to reorganize.

Correcting the Lack of Transparency

The Bankruptcy Code has rules for determining which creditors may vote in favor of a plan of reorganization. Generally, creditors who hold two thirds in dollar amount and one half in number of the allowed claim are deemed eligible to vote on the reorganization plan. Consequently, creditors owning claims that exceed one third of the dollar amount of votes cast have a potential blocking position.

While the Bankruptcy Code section 1126(e) enables a debtor to ask the court to “designate” any entity whose acceptance or rejection of the plan was not in good faith, litigation can be expensive and risky. So the struggling debtor may end up making concessions driven by its inability to litigate.

On the surface, the Federal Rule of Bankruptcy Procedure 2004 enables a party to seek discovery of persons with information relevant to the prosecution of the bankruptcy case. Absent extraordinary circumstances, the rule normally has been interpreted as blocking inquiry into a claim’s purchase price. Though the rule references “any matter which may affect the administration of the debtor’s estate,” a debtor seeking to learn the purchase price of a claim – which might yield insight into the claimholder’s motivation and action in the bankruptcy case — typically is met with an unreceptive court absent a creditor’s flagrant behavior.

Issues with this rule could be remedied through an amendment mandating that any creditor that is not the original owner of a claim (or claims) it holds, file a statement with the bankruptcy court stating the purchase price of the claim, the date of purchase and whether the transferee (including the transferee’s related parties) holds other claims against the debtor.

There also should be disclosure stating whether the transferee is working with other creditors as a group or committee. Furthermore, the owner of the claim(s) should state whether it (including its affiliates and related parties) has a direct or indirect interest in any entity that competes with the debtor. Additional disclosure would provide the debtor, the court and all interested parties with the ability to balance the playing field. Designed by Congress before claims trading became prominent, the field has become unbalanced because of claims trading.

Such a rule would create transparency through disclosure. Disclosure does not mean that the creditor’s vote on a plan of reorganization automatically will be “designated.” Nor does it mean that requests for relief by the transferee creditor will be denied. What it does mean is the court and the parties in the case will have a better understanding of the case dynamics. No one should fear transparency, even “self-interested meddlers” in bankruptcy proceedings.