Hedge Funds and the Changing Face of Corporate Bankruptcy Practice
The Case of Alpha Partners
Alpha Partners is a fictional hedge fund with $2 billion in assets under management that it invests in distressed companies. DebtorCo is a once-prominent manufacturing company that fell on hard times and filed for bankruptcy protection. Alpha Partners holds $10 million face value of DebtorCo's publicly traded bonds, which it bought at a discount. It also holds $20 million of DebtorCo's secured bank debt purchased prior to the chapter 11 filing from Big Bank, also at a discount. After the bankruptcy filing, Alpha Partners purchased unsecured trade claims having a $10 million face value at a steep discount. Additionally, Alpha Partners has a significant "short" position in DebtorCo's stock.
Varied Holdings Create Complex Incentives
Alpha Partners is a new kind of actor on the bankruptcy scene, with a complex bundle of financial incentives. While traditional "vulture" investors might focus on a particular undervalued segment of a debtor's capital structure, Alpha Partners and funds like it will likely have holdings at various levels of the capital structure. Such varied holdings present different strategic alternatives that may put Alpha Partners at odds with the interests of more conventional creditors. Another key distinction between Alpha Partners and traditional players in the bankruptcy world is the time horizon of its investment. Banks and private equity firms frequently get involved early in the process with a view toward long-term gains through restructuring. While some hedge funds pursue long-term investment strategies, the liberal redemption policies offered by most hedge funds require more short-term strategies in order to maintain sufficient fund liquidity. Thus, hedge funds like our fictional Alpha Partners are more likely to look for short-term returns not necessarily tied to the successful reorganization of the debtor.3
As a consequence, although Alpha Partners holds a sizeable portion of Debtor-Co's secured debt, it will not necessarily act as Big Bank might have been expected to act because its diverse holdings mean that its interests are not purely aligned with those of the secured debtholders. As with other traditional participants in secured credit facilities, Big Bank would have taken actions consistent with the aim of preserving the overall "going concern" value of the debtor by providing post-petition financing and long-term workout solutions, thus ensuring a continued stream of interest. Alpha Partners, in contrast, may be more inclined to force a sale of the underlying assets (even at a discounted price) to realize quick gains on debt purchased at a discount from its face value.
Similarly, although it holds trade debt, Alpha Partners does not have the typical incentives of a trade creditor. Trade creditors are usually motivated by the prospect of transacting future business with DebtorCo and thus are hoping for DebtorCo's successful reorganization in addition to recovering on their claims. Alpha Partners, on the other hand, is focused solely on the maximization of value to the classes of claims in DebtorCo that it holds without regard to DebtorCo's future success as a going concern.
Finally, because of its "short" position, Alpha Partners is not motivated to pursue the overall maximization of value for all constituencies of DebtorCo's bankruptcy estate. Rather, Alpha Partners is interested only in the fate of its particular holdings and is adverse to the interests of equityholders. Indeed, Alpha Partners hits a grand slam on its investment if DebtorCo recovers enough value to pay off its bank, unsecured and trade debt, but does not recover enough money to provide a return to equityholders. Thus, unlike a more traditional creditor who might be indifferent to the fate of equityholders, Alpha Partners actually profits from poor returns for equityholders.
Hedge Funds May Not Easily Fit into the Traditional Committee Structure
Hedge funds with diverse holdings, such as Alpha Partners, do not fit neatly into the formal committee structure provided for by the Bankruptcy Code.4 As a large unsecured creditor, Alpha Partners may be eligible to serve on DebtorCo's official creditors' committee. However, due to the fact that Alpha Partners bought its debt at a discount, its ownership of different classes of debt may create tension, and possibly pose economic conflicts, with other unsecured creditors. Further, if Alpha Partners wishes to serve on the official creditors' committee and thereby receive material, nonpublic information about DebtorCo, it will have to agree to cease trading of DebtorCo's debt and equity.5 The choice of whether or not to become "restricted" with regard to its trading may be a tough one for Alpha Partners. While it craves as much information as possible about DebtorCo, it may be loathe to lock up its investments in the company for a significant period of time.
Instead, Alpha Partners may choose to team up with other large investors in a particular class to form an ad hoc committee for that class. Although such an ad hoc committee lacks the statutory benefits of an official committee—most notably the payment by DebtorCo of the committee's professional fees—such committees offer similarly-situated creditors an avenue to increase their leverage within the bankruptcy case and to share legal and other expenses. Ad hoc committees are particularly effective when their members hold a blocking position with respect to a class of claims.6
If the DebtorCo bankruptcy case is particularly complex with multiple layers of debt of differing structural and legal priorities, there may be a number of ad hoc committees formed to share legal costs and advance common agendas. The primary downside of having multiple ad hoc committees, of course, is the potential for protracted litigation. Because Alpha Partners and its fellow ad hoc committee members are narrowly focused on maximizing the return on their particular investments, regardless of whether or not DebtorCo successfully reorganizes, they will not shy away from litigation, even if that litigation has the potential to jeopardize the overall reorganization.
In general, ad hoc committees, unlike official committees, are not bound by fiduciary duties to the broader creditor constituency, remaining free to pursue their parochial interests.7 The freedom from fiduciary obligations allows the members of such committees to trade their positions without restriction—a major advantage for hedge funds seeking the ability to easily exit their investments. But that freedom comes at a price. Without trading restrictions, ad hoc committees will likely not have access to material, nonpublic information that may be important to a full understanding of the case.8
Larger institutions may be eligible to receive nonpublic information without forgoing their ability to trade by erecting an ethical wall. Given the lean staffing of most hedge funds, however, it is likely that a single individual or a small group of individuals will be responsible for all the fund's investments in a particular debtor. Thus, if a hedge fund serves on an ad hoc committee and elects to become restricted and receive confidential information, that fund may be restricted from trading any of its positions (not just those represented by the ad hoc committee) due to the difficulty of creating and maintaining ethical walls. This has become a high-profile issue both inside and outside bankruptcy as the SEC continues to scrutinize the trading practices of hedge funds that lend to distressed companies and that may have access to nonpublic information.9
Hedge Funds May Raise Novel Disclosure Issues
The case of Alpha Partners also raises an interesting disclosure issue: Is Alpha Partners required to disclose its short position in DebtorCo's stock when counsel for the ad hoc committee files a statement under Bankruptcy Rule 2019?
Bankruptcy Rule 2019 requires that:
every entity or committee representing more than one creditor or equity securityholder and, unless otherwise directed by the court, every indenture trustee, shall file a verified statement setting forth (1) the name and address of the creditor or equity securityholder; [and] (2) the nature and amount of the claim or interest and the time of acquisition thereof unless it is alleged to have been acquired more than one year prior to the filing of the petition....10
Those requirements, however, relate to present holdings of claims and interests in the debtor itself. Because a short seller does not hold stock of the debtor—the short seller borrows the debtor's stock and sells it, with the hope that the stock value goes down before the short seller is required to return the borrowed stock—Rule 2019 may not technically require disclosure of the interest. However, if Alpha Partners becomes active in the bankruptcy process, advocating for or against a reorganization plan, then the fact of its short position is certainly relevant to understanding Alpha Partners' motivations and objectives. We may then see a trend in which courts mandate more complete disclosure from active hedge funds than that which is strictly required by Rule 2019, including, for example, the disclosure of short positions and positions in potential buyers of the debtor, as well as credit derivatives and other structured instruments that sophisticated investors might employ to manage risk.11
In addition to the disclosure tool of Bankruptcy Rule 2019, bankruptcy courts may find that they have other tools at their disposal to supervise the conduct of hedge funds. For instance, if hedge funds are found to have deliberately acted in a manner intended to scuttle a company's prospects to successfully reorganize, a bankruptcy court could fashion equitable remedies, including the equitable subordination of claims12 or designation of votes in favor of the plan.13 Because the liquidity provided by hedge funds has become so important to debt markets and to the bankruptcy process generally, courts must be careful to craft equitable remedies that respond to egregious, bad-faith conduct without threatening the overwhelming majority of hedge funds that respect the rules of the bankruptcy system.
The range of issues described above all manifest a broader cultural shift brought about as hedge funds seek to realize their particular objectives through the bankruptcy process. Simply stated, the focus of many hedge funds on the maximization of relatively short-term returns is often in tension with the Code's traditional emphasis on the rehabilitation of debtors.14 As a consequence, bankruptcy cases with intensive hedge fund participation can be expected to feature more complex and fractionalized committee structures, novel disclosure issues and more aggressively litigated disputes. Responding to these developments will require creative adaptation on the part of bankruptcy courts and practitioners.
1 See Geithner, Timothy F., "Hedge Funds and Derivatives and Their Implications for the Financial System," Remarks at the Distinguished Lecture 2006, sponsored by the Hong Kong Monetary Authority and Hong Kong Association of Banks, Hong Kong (Sept. 15, 2006) (transcript available at www.newyorkfed.org/newsevents/speeches/2006/ gei060914.html). Mr. Geithner, President and CEO of the Federal Reserve Bank of New York, describing improvements in market conditions since the late 1990s, noted that "[i]n terms of enhancing overall market efficiency, the growth of [hedge funds, private equity funds and other leveraged financial institutions] can be expected to provide benefits in terms of improved liquidity, price discovery via arbitrage, diversity of opinion and diversification opportunities for investors."
2 See Sender, Henny, "Debt Buyers vs. The Indebted," Wall St. J., Oct. 17, 2006, at C1; Anderson, Jenny, "As Lenders, Hedge Funds Draw Scrutiny," N.Y. Times, Oct. 16, 2006, at C1.
3 See Sender, supra n.2.
4 Such committees are comprised of holders of claims or interests in particular classes and serve as fiduciary representatives for all holders of such claims and interests. See 11 U.S.C. §1102 (authorizing the appointment of such committees of creditors and equityholders as the U.S. Trustee deems appropriate).
5 In order to perform their function as fiduciaries, particularly investigation of the debtor's financial condition and participation in the formulation of a plan, members of official committees must necessarily have access to confidential information. Accordingly, entities sitting on official committees cannot trade when in the possession of such material, nonpublic information absent appropriate ethical screening measures isolating employees sitting on the committee from those with trading authority (see this month's article on chapter 11 and securities laws on page 36).
6 In order for a class of claims to accept a reorganization plan, holders of at least two-thirds of the aggregate claims must cast votes in favor of the plan. 11 U.S.C. §1126(c). Thus, if more than one-third of the debt is held by members of an ad hoc committee, that committee's support becomes essential to a consensual confirmation process.
7 Hedge funds should be aware that there may be circumstances in which a court will impose fiduciary obligations on ad hoc committee members, thereby circumscribing their range of action. In Young v. Higbee, 324 U.S. 204 (1945) (Black, J.), a group of preferred stockholders objected to confirmation of a debtor's chapter X reorganization plan and appealed from the confirmation order. Had the appeal been successful, the recoveries to all holders of preferred stock would have increased, while those to holders of junior debt would have decreased. The appeal was dropped, however, after the appellants sold their preferred shares to holders of junior debt. The Supreme Court held that although the confirmation objection and appeal were not expressly brought on behalf of all preferred shareholders, because the success of the objection/appeal would have benefited all similarly situated holders, the original objectors/appellants were deemed to have done so on behalf of all preferred stockholders. Accordingly, those shareholders would be accountable to all preferred stockholders for their actions in dismissing the appeal in connection with the sale of their interests.
8 Ad hoc committees may be able to work around having trading restrictions imposed on them by delegating responsibilities to their financial and legal advisors, and by entering into short-term confidentiality agreements limited to specific issues. As the proceedings progress to their resolution, however, the need for information may become too great, and the members of the committee may have no choice but to restrict themselves.
9 See Anderson, supra n. 2.
10 Fed. R. Bankr. P. 2019(a).
11 See In re CF Holding Corp., 145 B.R. 124 (Bankr. D. Conn. 1992) (entering order requiring more complete Rule 2019 disclosure).
12 11 U.S.C. §510(c) (authorizing equitable subordination of claims). Equitable subordination is a remedial, not penal, measure to account for misconduct by claimholders that has resulted in injury to other creditors or resulted in an unfair advantage to the wrongdoer, but must not be inconsistent with general bankruptcy principles. Benjamin v. Diamond (In re Mobile Steel Corp.), 563 F.2d 692, 700 (5th Cir. 1977); see, also, United States v. Noland, 517 U.S. 535 (1996) (citing Mobile Steel's articulation of the standards for equitable subordination).
13 11 U.S.C. §1126(e) (authorizing designation of the vote of an entity that was solicited or voted in bad faith). Designation of votes is a sparingly-used remedy and requires that the party seeking to disqualify a ballot show conduct or fact that in itself constitutes bad faith, a very heavy burden. 7 Collier on Bankruptcy ¶1126.06 (15th Ed. Rev. 2006); see also In re MacLeod Co., 63 B.R. 654, 655-56 (Bankr. S.D. Ohio 1986) (designating vote of a creditor that used its vote in an attempt to destroy the debtor's business).
14 See Miller, Harvey R., "Chapter 11 Reorganization Cases and the Delaware Myth," 55 Vand. L. Rev. 1987, 2014-16 (Nov. 2002) (discussing the impact of distressed debt trading on traditional bankruptcy culture of reorganization).