The influence, for good or ill, of hedge funds and other claims traders on the modern Chapter 11 plan process has been the subject of an intense, years-long debate. This column took up the issue nearly five years ago, citing evidence of a largely positive influence from hedge fund financing and other forms of participation in Chapter 11 reorganization cases.1 A recent empirical study confirms, as best it can, that bankruptcy claims trading and claims traders likely do not deserve the criticisms and suspicions to which they continue to be subjected. It also reveals how difficult it can be to examine subjects who do not particularly care to be examined.
In the first major empirical study of activity in the secondary market for both debt and equity claims against companies in Chapter 11,2 law professor Jared Ellias struggles to find objective evidence of elusive behavior. He takes a clever approach to measuring bond trading volume among the creditors of firms in Chapter 11 between July 2002 and July 2012 by hand-collecting data from FINRA’s Trade Reporting and Compliance Engine (TRACE). Though TRACE data is a comprehensive record of corporate bond trading activity, it identifies neither the issuer of the bonds nor the parties to the trades. A bit of public database correlation allowed for discovery of the issuer’s identities, but the traders remain anonymous.
Ellias finds very heavy trading (nearly 400,000 trades, more than seven per trading day on average) among the some 500 bonds issued by about 200 large firms in Chapter 11 from 2002 to 2012, along with a similarly heavy degree of trading in the equities of those companies. Indeed, bonds of issuers in Chapter 11 were among the most heavily traded on the corporate bond market, among both distressed bonds and bonds as a whole. This kind of churning produces one of the principal concerns with claims trading, i.e., that a constantly changing matrix of claimholders might disrupt the plan negotiation process that is the hallmark of Chapter 11 reorganization. In at least 60 percent of the sample cases, trading volume was sufficient to potentially alter the composition of 33 percent of non-priority bond debt claims, enough to upend the pre-filing balance of creditor interests and the entire plan negotiation process. This effect, however, depends on the details of the trading pattern and the traders involved.
A major limitation of this otherwise revealing study thus looms large from the outset.
Without knowing the identity of the traders of these bonds, we cannot know if the observed trading volume represents (1) consolidation sales from many small creditors to one or more larger creditors, (2) a series of serial trades involving the same stake sold multiple times, or (3) trades among largely passive investors on both the sell and buy side, the latter simply hoping to hold for a profit. Any of these would have minor implications for interrupting the negotiation process, as opposed to the contrary hypothesis of new, “activist” outside raiders buying claims, including potentially amassing a 33 percent blocking position to extract hostage value in the negotiating process. Ellias is forthright about acknowledging this key limitation.
He is more sanguine than might be warranted about ways in which the character of “activist” claims traders might be pinned down. The one victory that claims trading detractors have won in recent years is a rule requiring public disclosure of the identity of each member, along with the time of acquisition and nature of their equity and debt stakes in the debtor company, of any “group or committee that consists of or represents … multiple” claimants in a Chapter 11 case.3 Subsequent “material” changes in the composition of such a group (or any fact disclosed with respect to any member) must be disclosed in a supplemental filing. Seizing on this disclosure requirement, Ellias observes that the disclosed membership and claims position of these groups seem to remain fairly stable, with mostly early entry into the case and few supplemental disclosures.
But an additional observation reveals that “activist,” interrupter investors might buy into Chapter 11 more frequently than this study can discern. Only “groups” who “act in concert to advance their common interest” must be disclosed; that is, single investors (and their company affiliates and insiders) need not disclose their presence, much less the timing and nature of their stakes in the reorganizing debtor company. Even a modest sized hedge fund could muster the financial wherewithal to disrupt a Chapter 11 plan negotiation by buying a substantial bond stake, and such a single investor would be required to make no disclosure.
The lawyer for such a fund might file a notice of appearance, which Ellias also tracks, but only if the fund chose to intervene in the court proceedings, and Ellias tellingly finds nearly three times as many notices from attorneys representing single hedge funds than “ad hoc committees” or similar activist groups.
On the other hand, Ellias notes that traditional investors, like mutual funds, usually sell out of their positions long before a Chapter 11 is filed. Activist investors usually will have accumulated their positions in a distressed company well before a bankruptcy filing, so claims trading during bankruptcy is likely a lesser concern than trading before bankruptcy, which does not raise the principal concern of critics.
The study makes a significant contribution to our understanding of the volume – though, crucially, not the nature – of claims trading in Chapter 11 cases. Ellias concludes by noting in addition that the trading of claims not represented by bonds – private equity loans and loan-to-own strategies, for example – is another major missing element of this study. The more we know, the less we understand.