Trading Bankruptcy Claims … Watch Out for the Finer Points!
Speculating on “bad debt” dates back to colonial times when investors purchased individual claims at a fraction of their value against the strapped colonies with the hopes that the new government would eventually pay the claims in full. While much has changed since then, bankruptcy claims trading is still in practice by sophisticated investors with the acumen to estimate the timing and amount of payment. For sellers, the practice can significantly expedite liquidity, yet it is not with risk.
Receiving a notice that a borrower, customer or client has filed for bankruptcy protection often serves as the period at the end of a long, difficult sentence. Having a claim — especially an unsecured claim — in a Chapter 11 bankruptcy case often means not getting paid or getting paid very, very little years down the road. And dedicating the resources necessary to determine whether there is any hope of receiving a distribution is the definition of the old saw: “throwing good money after bad.” What many secured and unsecured creditors fail to realize, however, is that in many cases bankruptcy claims have value, and often purchasers are willing to pay that value, or a percentage thereof, to acquire the claim and allow the creditor to wash their hands of the troubled relationship and the bankruptcy process almost entirely. Such purchasers are commonly referred to as “bankruptcy claims traders.”
Speculating on “bad debt” dates back to colonial times. The original 13 colonies owed substantial debts to soldiers, farmers and merchants for their services provided in support of the Revolutionary War and had little or no ability to pay them. Investors purchased these individual claims against the colonies for approximately one quarter of their value, hoping that the new American government would eventually pay the claims in full. The affected citizens received money that they could put to immediate use, and the investors acquired an asset that could potentially quadruple in value. (For a comprehensive history and discussion of claims trading, read the seminal article on the topic: Trading Claims and Taking Control of Corporations in Chapter 11 by Chaim J. Fortgang and Thomas Moers Mayer, 12 Carodozo L. Rev. 1, 25 1990.)
Trading in bankruptcy claims is as old as the original bankruptcy code that created bankruptcy claims in 1898. The drafters of the original code were concerned with the effect of claims trading could have on debtor’s ability to obtain a “fresh start” and included provisions intended to subject claims trading to intense oversight from the court. Buyers and sellers, however, easily exploited loopholes in the code and claims trading went largely unregulated with few negative effects. When the bankruptcy code was overhauled in 1978, the oversight provisions were completely eliminated. Only when the code was amended in 1991 was a new provision added to require claims purchasers to provide notice that a claim had traded hands and to allow other parties to object to the transfer. In practice, claims can be bought and sold with little oversight from the court and are very rarely subject to objection.
Faced with the prospect of a long, drawn-out bankruptcy process that is difficult (and expensive) to influence or even monitor, selling a secured or unsecured claim at the outset of the case may be an attractive alternative. The benefits of selling a bankruptcy claim are many, which include:
- avoiding the administrative and legal expense of pursuing the claim;
- creating immediate liquidity from an illiquid debt; and
- establishing a tax loss.
(Not to mention the psychic benefit obtained from putting what may have been a strained and contentious business relationship behind you.) Claims may be paid in part or, more likely in the case of secured claims, in whole following a sale of the debtor’s business or pursuant to the terms of a plan of reorganization. While most bankruptcy sales typically occur during the first year of the bankruptcy filing, a plan of reorganization may not be implemented for several years and, even if it is implemented in a timely manner, it may provide that claims will be paid incrementally over time from the debtor’s (speculative) profits going forward.
Claims purchasers may acquire claims in an effort to influence the terms of the debtor’s plan of reorganization by shortening the distribution period and improving the amount of any distribution. Claims purchasers are also more likely to push for a sale of the debtor’s business in order to acquire a more immediate and certain return, rather than wait out the reorganization process. Of course, “influencing” the course of a bankruptcy case takes time and substantial resources (read: legal fees), which many claims purchasers — and most unsecured creditors — are unwilling to devote to the process. Further, any attempts to influence the case will likely be met with stiff resistance from the debtor and its professionals, further increasing the cost of administration and reducing the funds available to distribute to claimants. That is why, for most claims traders, at least, purchasing bankruptcy claims is viewed primarily a passive investment opportunity.
Although any type of claim in any amount can be sold if a willing buyer exists, trading in bankruptcy claims is most prevalent in Chapter 11 “mega-cases” like Enron and Lehman Bros. Bankruptcy claims traders are increasingly active in smaller, middle-market cases. For example, in a relatively small bankruptcy case filed in Rockford, IL in 2003, a single claims trader bought several unsecured claims ranging in value from under $1,000 to nearly $50,000. Although purchasers are not required to disclose the price paid for each claim — and many insist that the details of the transaction remain confidential — the case has resulted in only one small distribution equal to 10% of the value of the claims, and this distribution occurred several years after the claims were acquired. Depending, of course, on the amount that the sellers received from the buyer, selling early in this case may have increased the creditors’ realization on their claims.
In mega-cases, secured and unsecured claims may trade hands several times between the date the case is filed and final distribution as sophisticated sellers and purchasers trade in and out of their relative positions. In smaller, middle-market cases, claims are less likely to be re-traded and purchasers are likely to remain invested for the long haul, which can be several years in many cases. Although the purchase price depends on the facts of the case and the willingness of the seller and buyer, the price paid for unsecured claims in smaller, middle-market cases are typically lower than the price in mega-cases because of the increased risk assets and liabilities may be misreported and that the myriad of professionals will eat up any funds which would otherwise be available for distribution to claimants.
The same Rockford, IL case discussed previously provides a cautionary tale to claims purchasers. In that case, after the initial 10% distribution was made, the professionals retained to manage the estate in the “best interests of the creditors” ran up more than $6 million in professional fees and expenses in a mostly futile attempt to recover funds through litigation. If the professionals would have simply distributed all of the funds available in the first instance, the creditors — and the investors that purchased their claims — would have received an additional 10% return on their claims. (Presently, more than nine years after the case was filed, several creditors are now seeking to recover some of the funds paid to the professionals in the case, further delaying any future distribution, if any.)
Of course, claims investors are not in the business of buying claims of dubious value in out-of-control cases. Claims purchasers, who are often former bankruptcy professionals themselves, are sophisticated investors with the resources and acumen to estimate the likely timing and amount of any payment. If they are willing to pay 10% for your claim, they certainly believe that it is worth significantly more than that, but by acquiring the claim, they are also acquiring the risk that the case will fall apart, suffer significant delays or be completely devoured by the professionals retained to manage it.
It should also be noted that selling a claim is unlikely to completely sever the seller’s association with the bankruptcy process. Purchasers are unlikely to assume liabilities including potential claims that the bankruptcy estate may have against the creditor for preferential transfers or rights to setoff. Although all details of the transaction are subject to negotiation, are typically willing to acquire only the value of the underlying claim against the bankruptcy estate.
So, how does a creditor find a purchaser for its claim? In mega-cases, creditors are deluged with mass mailings offering to purchase their claims, but in smaller, middle-market cases creditors have to actively search for a buyer. A quick Google search of “bankruptcy claims traders” reveals dozens of claims purchasers. Beginning in mid-2012, a new site will attempt to create a more transparent and active “over-the-counter” electronic market for claims in virtually all Chapter 11 bankruptcy cases.
“Our goal is to create a liquid and transparent market that provides price discovery and seamless trade execution via standardized transfer agreements to buyers and sellers of claims,” said Todd Zoha, co-founder and CEO of One Exchange Street. “Creditors will be able to review recent transaction prices, submit their ask price, the lowest price at which they are willing to sell their claims, and buyers can submit their bid price, the highest price at which they are willing to buy. We hope that increased transparency and standardized terms will not only increase the number of bankruptcy cases that ultimately experience claim trading but also help balance the asymmetries that currently exist between market participants.”
In bankruptcy claims transactions the finer points of the deal are not required to be and rarely are disclosed. Purchasers attempt to minimize their investment risk by including safeguards that sellers — eager to liquidate their claim and opt out of the bankruptcy case — are often hesitant to negotiate. Such provisions may include the following:
- provisions that the purchase price is payable only when the claim is allowed (this event usually takes place shortly before a plan is confirmed or the debtor’s assets are sold);
- representations from the seller that its claim is valid, liquidated and undisputed;
- assurances that the seller does not owe the debtor money or hold any property of the debtor (the value of which the debtor could offset to reduce the amount of the claim);
- requirements that the seller refund a portion of the payment with interest if the claim is subsequently reduced;
- requirements that the seller refund the purchase price entirely, or by the amount of the purchasers necessary fees and expenses, the claim is objected to; and
- warrants from the seller that the claim is sold to the purchaser free and clear of any liens, e.g., a security interest in seller’s receivables.
Selling a bankruptcy claim can significantly expedite liquidity and avoid a lot of headache and wasted resources, but it is not without risk. When contemplating selling a secured or unsecured claim, sellers should contact an attorney familiar with bankruptcy claims trading and always remember that the terms of such transactions are fluid and negotiable.
Patrick M. Jones is an officer with the Chicago office of Greensfelder, Hemker & Gale, P.C. and frequent author on corporate restructuring topics. Jones regularly represents secured and unsecured creditors, including creditors’ committees, in Chapter 11 bankruptcy cases throughout the United States. Jones also represents buyers and sellers of secured and unsecured bankruptcy claims. Jones graduated with honors from DePaul University College of Law and received his undergraduate degree from the University of Oklahoma. Jones can be contacted at 312.345.5018 or via e-mail at pmj [at] greensfelder [dot] com.