In the last post, we discussed the basics of claims trading. In this post, we will look at the topic of insider trading of bankruptcy claims and how that issue is addressed by the Bankruptcy Court. We also will look at the implications of bankruptcy claims trading and how distressed investors can protect themselves so that they do not run afoul of applicable laws.

Insider trading of bankruptcy claims occurs when the purchaser of a claim has acted on material, non-public (i.e., confidential) information. While trading securities on insider information is prohibited under federal securities laws, the prevailing view is that the securities laws do not apply to claims trading. Nevertheless, bankruptcy courts have imposed harsh sanctions (including, but not necessarily limited to, disallowance, subordination, and/or other adverse treatment) when trading claims on insider information has been established.

Members of official committees of unsecured creditors in a chapter 11 bankruptcy need to be cognizant of the prohibition of insider bankruptcy claim trading. Committee members should, and likely will, receive commercially sensitive or proprietary information from the debtor and others. Given that a committee member is a fiduciary who owes both the duties of care and loyalty to its constituency body, he or she is required to hold sensitive or proprietary information in confidence. Failure to hold such non-public information confidential would likely not only negatively impact communications between the debtor and committees, but also likely cause harm to the debtor. However, there have been some courts willing to allow committee members to participate in claims trading if appropriate screening walls have been established.

Trading Restriction Orders

In large chapter 11 cases, often the debtor has generated large net operating losses (NOL) in the months and years preceding the initiation of the chapter 11 proceedings. Subject to certain limitations, the Internal Revenue Code (IRC) provides that NOLs can be used as either carry-backs (i.e., a corporation can use the NOLs to offset taxable income for up to two (2) previous taxable years) or carry-forwards (i.e., a corporation can use the NOLs to offset taxable income for up to twenty (20) taxable years into the future).

The positive tax consequence of NOLs can be lost or restricted (i) if there is a change in ownership through a transfer of a debtor’s stock by its holders, and (ii) if there is a change in ownership through the conversion of debt to equity pursuant to a confirmed plan of reorganization. Essentially, if pre-emergence trading in claims and equity results in persons who are not Qualified Creditors or historic stockholders receiving more than 50% of the equity in the reorganized debtor, the IRC’s more stringent restrictions, which are listed in Section 382, on prospective NOL treatment may apply.

Because of the potential positive tax consequences to the debtor, NOLs are property of the estate that must be protected and preserved. However, since the value of NOLs may be quickly and adversely affected by equity and claims trading, bankruptcy courts in recent years have been willing to enter orders that restrict the trading of a debtor’s debt and other securities during the pendency of the debtor’s bankruptcy proceedings so that the debtor’s NOLs are protected and preserved.

The Bond Market Association and the Loan Syndications and Trading Association have developed a Model NOL Order that attempts to protect a debtor’s NOL by permitting trading of claims, as long as it does not substantially change the ownership structure of the debtor. The Model NOL Order restricts the trading of equity, but permits the trading of claims until (i) the debtor files a plan of reorganization that relies on the Section 382(l)(5) exemption, which is the NOL is preserved as long as debtor’s existing shareholders and/or qualified creditors (held claim for 18months or claim arose in ordinary course of debtor’s business) own at least 50% of the value and voting power of stock after plan confirmation, and (ii) a “sell down” order is entered by the bankruptcy court. Assuming a 382(l)(5) Plan is confirmed, and a party required to comply with the “sell down” order fails to do so, such claim holder forfeits his or her right to any distribution on the portion of his or her claim subject to sell down.

Implications

Restrictions on claims trading, while beneficial to the debtor (e.g., to preserve NOLs), is not beneficial to the distressed debt investor (e.g., hedge funds and private equity firms). Many prognosticators have speculated that the next tide of chapter 11 cases will see a substantial increase in activity by and from hedge funds. Whether this is true or not no one now knows for sure; however, between some recent rulings on claim trading restrictions and hedge fund disclosures, hedge funds may very well be less inclined to be active players in bankruptcy proceedings. In fact, these recent trends may persuade hedge funds to assist debtors in reorganizing outside of bankruptcy.

Corporate defaults are at a 2002 level, and likely will rise as the US economy is headed into the most severe recession in perhaps more than 80 years, which likely will cause a substantial increase in the filing of chapter 11 cases. Although the rate of Chapter 11 filings has increased in 2008 from 2007 levels, as the liquidity crisis eases allowing for the next tide of chapter 11 cases, it is of the utmost importance for distressed debt investors to retain sophisticated bankruptcy counsel who understands fully these recent trends in claims trading (and disclosure requirements) so that these investors are in a position to make informed investment and planning decisions.

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