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Distressed Debt: Top Ten Issues to Consider When Dealing in Trade Claims
Trade claims offer a potentially lucrative investment for a sophisticated investor, especially as the number of opportunities expands due to the credit crunch and current economic conditions. There are, however, specific risks and issues associated with investing in trade claims. This Client Advisory gives an overview of the Top Ten Issues to Consider When Dealing in Trade Claims and presents strategies for managing them.
10. Equitable Subordination (Enron)
Equitable subordination may occur in bankruptcy cases when a creditor has committed bad acts. Section 510(c) of the Bankruptcy Code permits a bankruptcy court to assign a claim a lower priority than other similarly situated claims due to bad conduct by the claimant. Conduct that could cause a court to equitably subordinate a claim includes (i) fraud and other illegal acts, (ii) non-arm’s length transactions with the debtor, (iii) breach of fiduciary duty, and (iv) a creditor’s use of the debtor as an alter-ego.
In August 2007, a U.S. District Court decision related to the Enron bankruptcy case held that claims against a debtor may sometimes be equitably subordinated, even if the alleged wrongdoer assigned the claim to an innocent third party. The District Court distinguished between claims that are transferred by sale and by assignment. Impairments associated with a claim, such as equitable subordination, travel with it when it is transferred by assignment. The District Court held that an impairment does not travel with a claim that is transferred by sale.
The District Court’s decision remanded the matter to the bankruptcy court for further proceedings in accordance with its order. A trial is expected in the bankruptcy court in early 2008. The bankruptcy court will, among other things, decide whether the transaction at issue was a sale or assignment and therefore, whether the bad conduct of the transferor should travel with the claim and result in it being subordinated in the hands of the innocent transferee.
Great care must be taken to ensure that the transaction documents for a trade claim accomplish what the parties bargained for - a sale or assignment.
9. Preference Risk
Trade claims carry a heightened preference risk because they often involve a more lengthy, complex course of dealing with the debtor than other claims. The buyer of a trade claim could also be affected by preferential payments unrelated to the trade claim it purchased that were received by the seller.
Under section 502(d) of the Bankruptcy Code, a bankruptcy court must disallow claims by a creditor that has received preferential payments and has not repaid them, even if the preferential payments are unrelated to the claims that are actually being asserted. As a result, if the seller has received a single preferential payment within the applicable preference period and does not repay it, other claims must be disallowed. For most creditors, the preference period will be 90 days. In the case of a creditor that is an insider of the debtor, however, the preference period is extended to one year.
Properly drafted representations and warranties coupled with an appropriate indemnity provision should provide buyers of trade claims some comfort. The buyer of a trade claim can also reduce this risk by conducting due diligence and asking the seller the right questions in respect of its prior course of dealing with the debtor and researching the seller’s relationship with the debtor in publicly available sources, such as the bankruptcy court’s docket.
8. Discovery Obligations - JP Morgan v. Winnick
In J.P. Morgan v. Winnick, a U.S. District Court held that the buyer of a claim was responsible for providing discovery, including documents and witness testimony, even though it was not one of the original lenders under the credit agreement. The lawsuit was brought by the administrative agent for a syndicate of lenders, alleging intentional and negligent misrepresentations by the borrower with respect to some of its financial covenants under the credit agreement. The court found that it would be unfair for the buyer of a claim to benefit from the lawsuit brought by the administrative agent without complying with the obligations of the claim such as providing the discovery requested of it.
Since trade claims typically have a longer and more complex history than other claims, a buyer could find asserting its claim in a future lawsuit even more problematic than did the buyer in Winnick. For example, it appears, from later rulings in the case, that the seller in Winnick did eventually provide the required discovery. The seller of a trade claim may not have a reliable system for retaining records or the resources or inclination to provide them. As a result, it might not even be possible for the buyer of a trade claim to provide the required discovery and it might therefore find itself unable to bring a lawsuit related to its trade claim.
In order to minimize this risk, transaction documents for trade claims should include carefully drafted covenants by the seller to assist in providing documents in such circumstances and reasonable further assurances, including a pledge of cooperation if there is required discovery.
7. Claims Objections
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 dispute the amount of a claim well into its bankruptcy case. This leaves plenty of time for a creditor to sell a trade claim it has asserted against the debtor, before the debtor raises these issues.
If the debtor files an objection to the trade claim after it has been sold, the buyer may need to show the validity of the claim or the amount of the claim. In a worst case scenario, the claim could be disallowed or substantially reduced. As a result, the buyer of a trade claim must insist on receiving documents from the party that initially filed the claim establishing the validity of the claim at the time of the trade. In order to have recourse against the seller, transaction documents should include representations with respect to the validity of the claim and terms that permit the buyer to recover the difference from the seller if the trade claim is reduced or disallowed.
6. Last Minute Changes Approved by the Bankruptcy Court
Bankruptcy courts may shorten the notice period for interested parties to respond to a motion under certain circumstances. Recently, for example, in In re Calpine Corp., et al., the bankruptcy court made changes to the debtors’ chapter 11 plan on approximately one day’s notice, which impacted the payout to equity holders. It permitted the short notice on the grounds that the changes to the debtors’ plan did not rise to the level of “material” under the Bankruptcy Code. When some equity holders moved for the court to reconsider its order approving the debtors’ revised plan, alleging among other things that they did not have sufficient time to review and respond to the proposed changes, the court denied their motion.
Last minute changes to a debtor’s plan may also impact holders of trade claims, since the plan determines the payout on and treatment of all claims. The buyer of a trade claim can arrange to receive notices of motions, including those by the debtor to change the terms of its plan, by filing a notice pursuant to Bankruptcy Rule 3001 upon purchasing the claim. If a motion is made to change the terms of the debtor’s plan in a manner that would adversely impact the buyer, it is essential to respond to the motion by the objection deadline in order to be heard by the bankruptcy court and to have the opportunity to appeal an order entered by the bankruptcy court.
5. NOL Orders
Bankruptcy courts often enter orders generally referred to as NOL orders (see, e.g., the cases of Northwest Airlines, Delta Air Lines, Calpine, Delphi, Mirant and W.R. Grace & Co.) designed to protect a debtor’s ability to use its past net operating losses to offset taxable income earned in future years under §172 of the Internal Revenue Code. The ability to carry forward net operating losses may be one of the debtor’s most valuable assets. Section 382 of the Internal Revenue Code, however, limits a company’s ability to use its net operating losses if a significant change in ownership has taken place.
Bankruptcy courts have entered NOL orders for the purpose of protecting the debtor's ability to carry its net operating losses forward and apply them to reduce future taxes. Often, this interferes with the ability of creditors to trade unsecured claims such as trade claims. Such orders may be requested by the debtor’s counsel on the theory that unsecured claims against the debtor may be converted into equity under the debtor’s plan. Trading in unsecured claims could accordingly result in a change in ownership under §382 of the Internal Revenue Code.
The consequences of violating an NOL order can be drastic. Some NOL orders have provided that transfers not in compliance with the order are void and others have forced transferees in violation of the order to sell down, which could obviously have bad results. It is important, when purchasing a trade claim to check whether an NOL order has been entered and, if so, whether its terms would effect the parties to the transaction. Buyers and sellers of trade claims should be sure that they fully understand any NOL orders and can comply with their terms. In addition, the transaction documents should include appropriately drafted representations with respect to any NOL order.
4. Influencing the Treatment of Trade Claims in the Bankruptcy Case
Holders of trade claims may consider taking an active role in the debtor’s bankruptcy case in order to maximize the payout on their trade claims. An official committee of unsecured creditors is appointed in most large bankruptcy cases by the U.S. Trustee and groups of creditors may sometimes choose to form their own unofficial ad hoc committees that are independent from the official creditors’ committee. If holders of a sufficient amount of trade claims act in concert they may be able to block acceptance of the debtor’s plan. Under the Bankruptcy Code, for a class to approve the plan, holders of at least two thirds of the amount of claims must vote in favor. As a result, if holders of more than one third of a class organize they may be in a powerful position to influence the debtor’s plan.
Buyers of trade claims need to be aware, however, that some bankruptcy courts, including the U.S. Bankruptcy Court for the Southern District of New York, interpret Bankruptcy Rule 2019 to require disclosure of sensitive information by members of official and ad hoc committee members, such as the amount paid for their claims and date on which they were acquired.
In deciding whether to purchase a trade claim, a buyer should assess to what degree it will be able to influence the debtor’s plan to increase the payout on its trade claim, including whether the requirements for active participation would impose unacceptably high burdens on it.
3. Receiving All Proceeds of Trade Claims
The payout on trade claims may be made in a different manner than on other distressed debt. Cure costs, to cite one example, may be paid by the debtor at the time it assumes a contract. The Bankruptcy Code permits a debtor to decide whether to assume or reject executory contracts, and this often occurs well in advance of the Debtor’s plan. Section 365(b) of the Bankruptcy Code requires the debtor to cure defaults under a contract at the time it is assumed by the debtor, including monetary defaults.
Transaction documents for a trade claim need to take the various sources of payment into account, clearly state that payments from those sources belong to the buyer and require that the seller forward them to the buyer if it receives them.
Indemnification provisions related to a trade claim may create unexpected results. Since trade claims often have longer and more complex courses of dealing with the debtor it is difficult to anticipate all the issues that may arise at the time of the trade. The bankruptcy court may, for example, disallow a trade claim under §502(d) of the Bankruptcy Code on account of an entirely unrelated payment from the debtor to the seller. If such a payment is preferential or falls into certain other categories of payments that can be recovered by the debtor and the seller refuses to return it the trade claim may be disallowed. In such a case, if the representations in the transaction documents are too narrowly drafted, the buyer would not be made whole.
Parties to trade claims transactions need to pay close attention to the representations and warranties they give and what gives rise to indemnification of the parties.
1. Insolvency of the Seller
Many strategies for managing risk associated with trade claims discussed in this Client Advisory involve the inclusion of representations and warranties in the transaction documents. If the seller of the claim becomes insolvent, the value of these representations and warranties may be dramatically reduced because the seller will not be able to compensate the buyer for its losses or will compensate the buyer for only a fraction of the losses. If the buyer of a trade claim is not familiar with the seller, due diligence on its finances and background will help assess whether this is likely to be a problem.
Each trade claim transaction involves a unique set of considerations and requirements. Understanding the Top Ten Issues set forth in this Client Advisory and identifying which are present in a particular transaction can help reduce risks and maximize profitability.
Questions regarding this advisory may be directed to John J. Hanley (212-238-8722, firstname.lastname@example.org), Aaron R. Cahn (212-238-8629, email@example.com) and Karl Schaffer (212-238-8659, firstname.lastname@example.org).
Enron Corp. v. Springfield Assoc., L.L.C. (In re Enron Corp.), 379 B.R. 425 (S.D.N.Y. 2007). Additional discussion of this case, in a separate Client Advisory, is available at: http://www.clm.com/publication.cfm/ID/142.
 J.P. Morgan Chase Bank v. Winnick, et al., 228 F.R.D. 505, 507 (S.D.N.Y. 2005).
 Case No. 05-60200, U.S. Bankruptcy Court for the Southern District of New York.
 Executory contracts are generally those in which performance is due from one party.
Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
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