The dynamics of Chapter 11 cases have changed radically over the past four years. Long gone are the days (1978 though 2000) when a debtor, working with its relationship bankers and influential creditors’ committee, controlled the reorganization process and was able to emerge from Chapter 11 with a new balance sheet and ostensibly rehabilitated business operations. Not-so-long gone are the days (2001 through 2003) when large investment funds purchased the loans, securities and claims of debtors with highly complex capital structures and legal issues and constructively worked with (or influenced) management to emerge from Chapter 11 as a stronger, more competitive enterprise.
The current Chapter 11 environment is dramatically different. Today, ad hoc committees, generally consisting of hedge funds and other distressed investors, are major players in the Chapter 11 process and their emergence has made the restructuring process more complex to navigate. The bankruptcy tools once efficiently used by debtors to bind dissenting creditors to the terms of a plan of reorganization have lost some of their efficacy. That may soon change. A recent, and seemingly innocuous opinion, by the Honorable Allan L. Gropper, of the U.S. Bankruptcy Court for the Southern District of New York, interpreting a mundane Bankruptcy Rule (i.e., Bankruptcy Rule 2019) in the Chapter 11 case of Northwest Airlines, may signal the beginning of the end of certain of today’s influential ad hoc committees. This result could breathe life back into the debtors’ bankruptcy tool box.
It’s Good To Be The King
Chapter 11 was created to provide distressed businesses with time to reorganize their operations, fix their capital structures and provide a fair distribution to their stakeholders based on going-concern value. In general, from 1978 through 2000, when a company commenced a Chapter 11 case, its major stakeholders were its long-time commercial bank lenders, the holders of high-yield bonds, trade creditors and shareholders. Due to the absence of a mature and liquid bankruptcy trading market and because loan syndications, collateralized debt obligations and credit derivative swaps weren’t ubiquitous, the stakeholders were more or less captive to the debtor’s preferred restructuring path. Therefore, the relationship banks were focused on minimizing losses, unsecured creditors sought out membership on official creditors committees to attempt to influence the process and shareholders were, for the most part, shut out. This allowed debtors to control the Chapter 11 process, which allowed good companies with bad balance sheets and bad companies with bad balance sheets to emerge from Chapter 11.
The Perfect Storm
Then, the perfect storm hit. In 2001, the U.S. economy was rocked by the dotcom collapse, the telecom meltdown, September 11 and massive accounting frauds. This forced large, complex and well-known companies into Chapter 11. Sophisticated investors focused their attention on these situations and began to purchase loans, claims and securities with the intention of converting them to equity. These investors - both hedge funds and private-equity funds - restricted their trading ability by entering into confidentiality agreements and receiving material, non-public information. The receipt of this information enabled the investors to analyze the debtor’s operations, business plans and projections, and work with management to create emergence plans that were likely to lead to long-term, post-restructuring success. Debtors, together with these constructive, relatively long-term thinking investors, were able to emerge from chapter 11 stronger than they were when they entered. And, these investors realized fabulous returns.
The Gold Rush
The success of these investors garnered the interest of other investors looking to put their capital to work in asset classes that would generate substantial returns. As the hedge-fund industry grew significantly, many of these new funds set their sights on the distressed world. But a funny thing happened on the way to the Chapter 11 forum. The large, sophisticated funds began focusing more on making leveraged loans to companies in distress, “saving” them from the grip of Chapter 11, and less on purchasing or trading loans, claims and securities of Chapter 11 debtors. These leveraged loans (and the overall increased liquidity in the marketplace) reduced the supply of Chapter 11 cases (and, therefore, the supply of bankruptcy paper to trade). Yet, due to the increased number of distressed hedge funds, many of which focused on trading, rather than control, the demand for Chapter 11 loans, claims and securities increased.
The resulting disequilibrium created a liquid, mature and sophisticated market for distressed claims, securities and loans. Each Chapter 11 case has become its own mini trading exchange where the entire capital structure of a Chapter 11 debtor can change hands in a matter of days. An increasing number of investors engaged in today’s Chapter 11 process are traders, as opposed to the investors of old who focused both on short-term trading (if necessary) and long-term value creation (their preferred course). It is axiomatic that traders cannot tie their hands and restrict their ability to trade. As a result, trading-oriented funds rarely enter into confidentiality agreements and, therefore, are not provided with material, non-public information, which would allow them to work with the debtor to establish a business plan focused on long-term wealth maximization.
To gain influence without receiving confidential information, the traders join together to form ad hoc committees. These ad hoc committees retain professionals and attempt to influence the pace and scope of the debtor’s restructuring. Because the members of the ad hoc committees are not restricted, debtors must communicate and negotiate with the ad hoc committee’s professionals, not principals. This makes it difficult for debtors to use their bankruptcy tools to negotiate workable plans of reorganization and emerge from Chapter 11.
A Seemingly Innocuous Opinion
The influential role of this new type of ad hoc committee may soon diminish. Attorneys for ad hoc committees are required to file a statement with the Bankruptcy Court under Bankruptcy Rule 2019. Among other things, Bankruptcy Rule 2019 requires the disclosure of “the amounts of claims or interests owned by members of the committee, the times when acquired, the amounts paid therefore, and any sales or other disposition thereof.” In practice, it is rare for each of the members of ad hoc committees to disclose this information. Until, perhaps, now.
On February 26, Bankruptcy Judge Gropper issued an opinion, in the Northwest Airlines Chapter 11 case, holding that an ad hoc equity committee failed to comply with the disclosure requirements of Bankruptcy Rule 2019 and ordered the ad hoc committee to file a modified 2019 statement within three business days. The ad hoc committee’s 2019 statement disclosed, as is current practice, the members’ holdings in the aggregate. Judge Gropper held that each member of the ad hoc committee was required to disclose the amounts of claims and interest owned, when the claims and interests were acquired, the amounts paid for the claims and interests and any sales of the claims and interests.
Hedge funds are understandably reluctant to tell the world (or a debtor, for that matter) the amount of their claims or interests owned, the price they paid for these claims and interests, or the date on which claims and interests are bought and sold. As would be expected, the ad hoc committee asked Judge Gropper to extend the deadline for or stay the filing of a modified 2019 statement and to file the modified 2019 statement under seal. Specifically, the ad hoc committee explained that the relief requested was “necessary and appropriate to ensure that the Ad Hoc Committee and its members do not suffer truly irreparable harm by being forced to reveal trade secrets, confidential research, development, and commercial information.”
Debtors, currently frustrated by today’s dynamics, may attempt to use Judge Gropper’s opinion to change the course of their Chapter 11 cases. It should be expected that Chapter 11 debtors will ask bankruptcy judges to require ad hoc committees to modify their 2019 statements and provide “the amounts of claims or interests owned by the members of the committee, the times when acquired, the amounts paid therefore, and any sales or other disposition thereof.” Rather than complying with this requirement, ad hoc committees may attempt to file the 2019 statements under seal (although it is unlikely that the ad hoc committees will want the debtor or other official committees to see this information) or simply dissolve. Thus, this seemingly innocuous opinion on a mundane Bankruptcy Rule by Judge Gropper may change the current dynamics of Chapter 11 cases.
(Opinions expressed are those of the author or authors, not of Dow Jones Newsletters.)
Jonathan S. Henes is a partner in the restructuring group of Kirkland & Ellis in New York. He can be reached at email@example.com