While we may be a long way from the record-setting corporate default rates and numerous Chapter 11 filings that plagued the market during the height of the credit crisis – most noticeably the Chapter 11 filing of Lehman Brothers Holdings Inc. and its affiliates – the claims trading market continues to present opportunities for both creditors looking to monetize their bankruptcy claims as well as claims traders looking for yield.
This article will highlight some of the key legal issues that market participants should consider before entering the U.S. bankruptcy claims trading market.
Generally speaking, bankruptcy claims trading is the buying and selling of claims against companies seeking relief under the United States Bankruptcy Code (the “Bankruptcy Code”). Section 101(5) of the Bankruptcy Code defines a “claim” exceedingly broadly and includes a right to payment, or right to equitable remedy for breach of performance, if such breach gives rise to a right to payments against a bankrupt debtor. A “claim” can include all sorts of matters, for example, secured and unsecured debt, bank loans, and a variety of contractual obligations and company payables. It is these rights to payment or “claims” that are routinely bought and sold based upon the buyer’s and seller’s expectations of the ultimate recovery in the bankruptcy case.
A trade claim is an unsecured obligation of the debtor that has filed for bankruptcy protection, held by a creditor such as a debtor’s supplier or trading partner, without any type of agent intermediary between the creditor and the debtor. Trade claims may also include claims by landlords, lawyers, leasing companies, unions and employees of the debtor. While vendor claims have historically been the most common type of trade claim, other variations of trade claims such as lease and contract rejection claims (damages resulting from the debtor’s rejection of unexpired leases and executory contracts), as well as swap termination claims (damages resulting from breaking derivative transactions), are also quite common, especially in airline bankruptcy cases, which generate large claims related to the renegotiation of leases and employee collective bargaining agreements, not to mention the Lehman Brothers insolvency, which has generated billions of dollars in swap termination claims. Under the Bankruptcy Code, a claim is allowed in the amount in which it is filed, unless it is disallowed or reduced by a bankruptcy court order. A debtor may attempt to have a claim disallowed or may dispute the amount of a claim well into its bankruptcy case. Such maneuvers leave plenty of time for a creditor to sell a trade claim that it has asserted against the debtor before the debtor raises these issues.
Bankruptcy claims are traded for a variety of reasons specific to each of the market participants trading them. The trading of bankruptcy claims has been utilized by creditors, distressed investors, traders and broker-dealers to provide solutions for difficult situations. Creditors keen on removing outstanding claims from their balance sheets and realizing some value of their outstanding claims while avoiding the risk of a delayed recovery have a market in which to sell those claims for partial recoveries and immediate cash payment. Trade creditors may also be put off by the length and complexity of the bankruptcy process, concluding that evaluating the claims and participating in the process is not worth the effort and opting instead to sell their claim at the best available price.
Conversely, distressed investors may hope to make a spread between the price paid to the creditor for the claim and the actual payment of the claim under the debtor’s plan of reorganization. Distressed investors may also purchase bankruptcy claims to control or obtain negotiating power in the outcome of the debtor’s plan of reorganization, or even perhaps obtain an ownership position in the debtor if the plan of reorganization issues equity in the reorganized debtor. In addition, sophisticated distressed investors may have investment strategies that arbitrage several of the debtor’s levels in the debtor’s capital structure, including bonds, equity, bank debt and bankruptcy claims. Broker-dealers, for their part, may get involved in a debtor’s bankruptcy to create a market for claims trading of that specific debtor and to realize a spread by matching potential creditors with potential distressed investors and brokering deals.
Like any other sale transaction, trading bankruptcy claims is not without risks to both buyers and sellers. All buyers and sellers of claims must understand the risks of bankruptcy and know that the ultimate resolution of all claims is, to some degree, out of their control. Understanding the basic risks and issues associated with trade claims and strategies for managing them will ensure that the parties get the benefit of what they bargained for and not be surprised by any unintended consequences. In general, it is market practice in the trade claims market that the selling creditor retains the risk that the transferred claim may be different in some way from what the underlying assignment of claim documents provides. The buyer, by contrast, assumes the market risk as well as the risk of the ultimate recovery, including the treatment of the claim under the plan of reorganization. In each case, the risks retained and assumed by the respective parties are reflected in the underlying assignment of claim of agreement.
Unlike the secondary loan-trading market, which uses standard forms developed by the LSTA, the trade claims market currently does not use standard forms except for the LSTA form of confidentiality agreement that recently has been adopted. While a number of provisions have become standard in the market, the documents used to memorialize the terms of the trade and to effectuate the transfer are still very much bespoke documents. For this reason, and also because of the need to perform the appropriate level of due diligence on the underlying claim, the cost of settling trade claims is significantly higher than the cost of trading bank debt in the secondary market.
The Trade Confirmation
Customarily, once the selling trade creditor selects a buyer and the parties agree upon a purchase price, the buyer sends the creditor a confirmation of the sale of the claim. That confirmation is the first step in closing the trade. The confirmation formally records the terms of the oral trade and provides a written record of the material terms. More often than not, the confirmation also states that the sale of the claim is contingent on the execution of an assignment of claim agreement acceptable to the buyer and the seller.
The Assignment of Claim Agreement
The assignment of claim agreement is the operative document that provides the rights to transfer the claim and that effectuates the transfer of legal and beneficial interest to the claim. Some of the most important and most heavily negotiated terms cover how the purchase price will be paid and what happens if the claim becomes impaired; representations, warranties and indemnities are also key but are beyond the scope of this article.
Payment of the Purchase Price
The purchase price on trade claims can be structured in a number of ways and will depend on how likely the debtor will challenge the claim. The simplest way is for the purchase price to be paid immediately after the parties execute the assignment of claim agreement or within some specified time period, e.g., three business days from the execution of the assignment of claim agreement. However, claim buyers seek to pay in this scenario only if the claim is listed as undisputed in the schedules of liabilities filed with the bankruptcy court or if the claim has been allowed (i.e., recognized as valid) by court order. Frequently, the purchase price is stated in the assignment of claim agreement as a percentage of the scheduled undisputed claim amount. As a result, the payment of any additional purchase price on account of the disputed portion is deferred until bankruptcy court allows the disputed portion of the claim, which may not occur until long after the sale of the claim. Once the portion of the claim is allowed, many buyers seek to limit their obligations to purchase such previously disputed amount in the form of an option, while selling creditors, on the other hand, seek to obligate the buyer to purchase such newly allowed portion of the claim. In either case, the purchase price for the portion of the claim now allowed is usually based on the same percentage rate that was used to calculate the initial purchase price. In addition, if the claim is increased, the assignment of claim agreement should address the treatment of such excess claim.
Experienced claim buyers manage the risk of disallowance by requiring that the assignment of claim agreement include specific impairment provisions requiring the seller either to reimburse – with interest – the buyer for the difference or to repurchase the impaired claim or, if the claim is only partially impaired, the impaired portion of the claim. Impairment protection is more important if there is no order allowing the claim; however, there are risks associated with allowed claims, including the risk that the claim will be reconsidered. The buyer will attempt to define impairment as broadly as possible to give it a remedy in the event of any impairment of the claim, such as the filing of an objection, even though the objection may later be resolved in the selling creditor’s favor, or a preference action affecting the allowance of the claim. In practical terms, this means that the selling creditor might have to refund money to the buyer, potentially with substantial interest, when an objection is filed, only to resolve the objection and receive some of that money back again (but without interest). Given that the obligations to repurchase the claim may arise several years after the claim is sold, the selling creditor may wish to limit the interest rate on any repayments or eliminate the interest rate entirely. To address this problem, a selling creditor may seek to limit the scope of impairment so that the buyer has no remedy until an objection is sustained, an alleged preference is reduced to judgment, or the court issues a final order reducing the claim among other techniques.
While the Bankruptcy Code does not explicitly govern the trading of trade claims in particular, Federal Bankruptcy Rule 3001(e) sets forth certain procedural rules governing the mechanics of claims trading during the debtor’s bankruptcy case. If those procedures are followed, the rights held by the selling creditor are transferred to the purchaser of the bankruptcy claim. If the selling creditor did not file a proof of claim prior to the sale, the buyer could file a proof of claim without any further court involvement. However, where the selling creditor had filed a proof of claim prior to the sale, the buyer must file proof of the sale of the claim with the bankruptcy court to ensure that the claim is properly transferred on the books and records of the bankruptcy court. The bankruptcy court clerk must provide notice of the sale to the selling creditor. The selling creditor then has 20 days to object to the sale; otherwise the clerk will substitute the buyer as the new owner of the claim.
Most assignment of claim agreements include a waiver of notice of transfer of the purchase of claim and the opportunity to object to the sale, and, as a result, objections to the transfer are quite rare. However, if an objection to the sale is made, the bankruptcy court will hold a hearing and decide whether the sale should proceed.
For creditors and investors interested in entering the world of bankruptcy trade claims, this article provides insight into three key issues: risks associated with trading claims, documentation issues and claims trading procedures. An authoritative, comprehensive guide is beyond the scope of this article, as the issues can be highly complex and will vary depending on the nature and specifics of the bankruptcy claim in question. Selling claims is not without risks, some of which are not readily apparent to less experienced practitioners and market participants, and as such, specific legal advice should be sought before any claim is sold.
Mark Pesso is a Partner in the U.S. Finance and Restructuring Group of Clifford Chance. He represents commercial banks in the areas of loan trading in the United States and European secondary loan-trading markets, CDO and loan portfolio transactions, creditors' rights and insolvency law, syndicated lending and related matters. Timothy C. Bennett is an Associate in the Banking and Finance Group of the New York office of Clifford Chance US LLP. He focuses his practice on the representation of financial institutions active in secondary market transactions involving bank debt, bankruptcy claims and other distressed, illiquid or opaque financial products.