The distressed debt investor is cautioned to consult with experienced bankruptcy counsel prior to developing and effectuating a claim trading strategy.

Holders of bankruptcy claims have routinely been willing to sell their claims at a substantial discount in exchange for a prompt and certain cash payment rather than facing the uncertainties of the bankruptcy process and the possibility of a payment in the distant future. Claim purchasers must be wary of the consequences of acting on “insider” information and acting without good faith. Additionally, claim traders must be aware of whether an order has been entered in the bankruptcy proceeding restricting the trading of claims and securities of the debtor. This is the first of a two-part series that is intended to (1) give a brief overview of claim trading by examining claim trading strategy and claims trading restrictions, and (2) discuss the effects restrictions will likely have on distressed debt investors (e.g., hedge funds).

Generally speaking, purchasers of claims, or distressed debt investors, may be classified as either passive or active investors. Passive distressed debt investment needs little discussion as it is based on straightforward, rational economics. A rational distressed debt investor may be motivated to purchase the claims against a debtor if, and only if, he or she believes, after taking into account the time value of money, that the distribution expected to be paid on the purchased claim will be greater than the purchase price of such claim. Assuming (i) the transfer of the claim is absolute, (ii) the requirements of Fed. R. Bankr. P. 3001(e) have been satisfied and (iii) no other motivational factors are involved, this type of investor will likely be an inactive player in a bankruptcy case.

An active distressed debt investor is an investor who is seeking to “actively” participate in the debtor’s bankruptcy proceedings by, for example, forcing a sale of the debtor’s assets or affecting plan voting. In order for an active distressed debt investor to accomplish his or her goals, he or she must have standing (i.e., be a party-in-interest) in the debtor’s bankruptcy proceedings.

As is common in many bankruptcy cases, a person who does not have a direct financial stake in a debtor’s bankruptcy proceedings may wish to purchase some or all of the debtor’s assets. If this type of potential purchaser is unable to purchase provides for him or her to purchase some or all of the target-debtor’s assets. The problem facing this type of potential purchaser is that since he or she is not a “party-in-interest,” he or she is precluded from proffering a plan of reorganization. How can the potential purchaser get around this conundrum? By purchasing a claim of virtually any size of the target-debtor. Once the potential purchaser purchases a claim of the target-debtor, he or she becomes a party-in-interest in the target-debtor’s bankruptcy proceedings. Once a potential purchaser becomes a party-in-interest, and upon the expiration of the exclusivity period, he or she has standing to proffer a plan of reorganization that provides for the sale of the target-debtor’s assets.

Another type of active distressed debt investor is one who purchases a large number of claims to gain leverage to bargain the plan terms with the debtor or who seeks to file a competing plan of reorganization. This type of investor is usually seeking to affect the size and/or timing of distributions set forth in a plan of reorganization.

Other active distressed debt investors may purchase claims in order to affect plan voting to advance a personal agenda. To the extent this type of active investor is able to affect plan voting, he or she may be able to gain substantial leverage over the plan proponents or even other creditors; however, this investor must be careful that he or she does not act in bad faith, which could then designate (i.e., disqualify) a vote of that investor.

This, of course, begs the question of what is “good faith” with respect to plan voting. Since Congress chose not to include the definition of “good faith” in the Bankruptcy Code, its definition has been developed by case law, and thus, is nebulous. One Court stated that:

“Good faith voting does not require nor can it expect, a creditor to act with selfless disinterest…. The test then, consonant with the United States Supreme Court’s standard, is whether a creditor has cast his vote with an “ulterior purpose” aimed at gaining some advantage to which he would not otherwise be entitled in his position…. Ulterior or coercive motives that have been held to constitute bad faith include pure malice, strikes, blackmail, and the purpose to destroy an enterprise in order to advance the interest of a competing business.” In re Gilbert, 104 B.R. 206 (Bankr. W.D. Mo. 1989) (internal citations and quotations omitted).

Another simplistic way to state that a plan vote was made in “good faith” is to argue that it was not made in “bad faith.” Unfortunately, this leads to a similar problem in that the term “bad faith” is not defined in the Bankruptcy Code.

In a frequently cited case involving trading claims, In re Allegheny International, Inc., 118 B.R. 282 (Bankr. W.D. Pa. 1990), the court disqualified votes by Japonica Partners, an investment firm, and confirmed the debtor’s plan. Japonica was not a prepetition creditor of the debtor, but after approval of the debtor’s disclosure statement and after balloting had commenced, Japonica purchased enough claims in two classes to wield a blocking position and to qualify Japonica as a party who could file a competing plan; however, those two classes were diametrically opposed to each other in litigation filed by the Creditor’s Committee against the secured lenders. Japonica presented its own competing plan, which provided that Japonica would acquire control of the debtor. Neither the debtor’s nor Japonica’s plan received sufficient affirmative votes for confirmation.

Japonica’s purpose was to gain control of the debtor, which the court found to be bad faith. The critical fact that resulted in the court’s disqualification of Japonica’s votes was that Japonica was a voluntary creditor who purchased claims to give it unique control over the debtor and the bankruptcy process. Another indication of Japonica’s bad faith was the timing of its purchase and the amounts it paid for the claims. As Japonica approached the attainment of a blocking position, the amount it paid for the claims it purchased increased and then decreased after the critical percentage was reached. Japonica purchased almost exactly the amount it required to block the debtor’s plan.

The court concluded that the facts and circumstances surrounding Japonica’s purchase of claims—Japonica’s intent to take over the debtor, the timing of the purchases, the amount paid for the claims, Japonica was an “outsider” prior to its purchase of claims, and Japonica’suse of its veto power to improve its position—established that Japonica’svotes were acquired and cast in bad faith and would be disqualified.

Other cases have been more relaxed in finding bad faith in the conduct of plan voting. In contrast to the holding in Allegheny International is the holding of In re Marin Town Center, 142 B.R. 374 (N.D. Cal. 1992). In the Marin Town Center case, as in Allegheny International, an “outsider” purchased an undersecured creditor’s claim for the purpose of blocking confirmation in hopes that the creditor could acquire the debtor’s main asset. The fair market value of the asset approximately equaled the amount paid for the claim. The court held that merely exercising a blocking position does not constitute bad faith. The creditor must be exercising the blocking position “for the ulterior purpose of securing some advantage to which the creditor would not otherwise have been entitled.” Id. at 378. “Section 1126(e) does not require a creditor to have an interest in seeing the debtor reorganize.” Id. at 379.

Questions of good faith and bad faith are factual in nature, and sometimes the line between the two is not always clear. The distressed debt investor is cautioned to consult with experienced bankruptcy counsel prior to developing and effectuating a claim trading strategy.