Confidential Securities Trading v. Disclosure Requirements Of Bankruptcy Rule 2019

by Carlos A. De la Paz March 15 2010, 16:32

I. Introduction 

Bankruptcy reorganizations do not come without their fair share of issues. As large companies teeter on the verge of bankruptcy, affected parties begin to configure their positions. Some creditors, before a bankruptcy, will sell their claims in the debtor’s estate to interested third parties. Of course, these third party investors wouldn’t buy these claims unless they thought they could receive a return on their investment. However, sometimes these third party investors have incentives to receive less back on their claims in the bankruptcy reorganization process. This not only creates a stall in the reorganization process, but it can also force other creditors to receive less back on their claims. 

This paper focuses on these abusive third party investors and the rule that is used to combat these types of abusers, Rule 2019 of the Bankruptcy Code. Rule 2019 requires disclosure of these third party investor’s economic interests so the court can evaluate whether or not they are an abuser. However, some of these third party investors engage in secretive securities trading, which is largely unregulated by the Securities Laws, therefore one can see the opposition they would have against disclosure. They have maintained the position that Rule 2019 was not meant to cover them because they are not the type of person Rule 2019 was meant to cover; a committee. In the traditional sense, they are not an official committee. They are ad hoc committees. An examination on the history of Rule 2019 might shed more light on whether or not these ad hoc committees were meant to be covered. It will then be useful to examine the Rule 2019 in today’s bankruptcy proceedings and the effects the proposed amendments might have. Finally two solutions will be presented that might bring equilibrium between disclosure and non-disclosure.

 

II. History of rule 2019 

Rule 2019 has not come without its issues. “The disclosure requirements of Rule 2019 has a lengthy history in corporate reorganization cases.” [1] The predecessor to Rule 2019 was 10-211 under the former Chapter X of the Bankruptcy Act, which was adopted following a report by Justice William O. Douglas (“The report”). [2] The report identified several problems that were present in the bankruptcy code. [3] More specifically, problems that was associated with committees during the bankruptcy reorganization process. [4]

The unofficial committees, the report addressed, were called “protective committees.” [5] These committees, usually sponsored by the debtor, would solicit proxies to individual creditors who would then grant control over their claims to these “protective committees.” [6] Essentially Douglas was concerned that these “protective committees” were controlling the reorganization process, hanging outside investors up to dry. [7] He attacked these abuses by finding an owed fiduciary duty by these “protective committees.”

In Douglas’ report, he stated that these committees owed a fiduciary duty to the investors they represented, based on the claims they would purchase from these individual creditors. [8] He then came to the conclusion that these “protective committees” were violating their fiduciary duties, and that the existing laws were inadequate to protect the public investor from these violations. [9] Douglas’ recommendation was to have any committee representing more than twelve creditors or stockholders to disclose their economic interests during the reorganization proceeding, so that theBankruptcy Court can adequately evaluate if there will be abuse. [10]

The reports recommendation was adopted in Chapter X of the former Bankruptcy Code and later as rule 10-211 in the 1978 Bankruptcy Code, which would later become Rule 2019. [11]

 

III. Current Rule 2019 and its disclosure affects on security holders

These “protective committees” are no longer present in today’s restructuring cases. [12] The committees that are created today are by creditors who seek to collectively share their costs and increase their leverage within the bankruptcy case. [13] However, recently we have seen otherkinds of creditors that have become involved in bankruptcy reorganizations; creditors who have a credit default swap agreement (“CDS”) for their claim in the bankruptcy case. [14]

A CDS is a type of insurance contract for a security holder. [15] An investor will purchase a CDS contract against a certain security. In the event that the security defaults on its payments, the CDS contract will make payments to the investor just like an insurance policy. [16]

These CDS agreements have now made their way to bankruptcy reorganization cases. Funds will invest in the securities of failing companies, at a discount, in hopes that the securities are undervalued. [17] They will then get these securities insured by these CDS agreements. [18] This in turn creates an incentive for these security holders to receive less on their claims in a bankruptcy proceeding because they will then be made whole by these CDS contracts. [19] Some bankers and lawyers involved in these restructuring efforts have said that many companies stand to default because of the existence of these CDS contracts, that the creditors holding these CDS’ hold out to efforts towards restructuring. [20] 

During a bankruptcy proceeding, these creditors would form ad hoc committees, unlike the traditional committees that are created under the bankruptcy regime. [21] Subsequently, the debtor or other creditors will usually attack the economic interests of these ad hoc committees. However, the members of these ad hoc committees do not want to disclose their economic interests because it will require disclosure of their security trading secrets. [22] The issue then becomes whether or not these ad hoc committees are the types of committees Rule2019 were meant to cover?

Standing in the forefront of this particular issue is the Delaware Bankruptcy Court. Judges in this Court seem to be split on whether or not Rule 2019 covers ad hoc committees. Judge Sontchi in in re Premier International Holdings disagreed sharply that Rule 2019 extends to ad hoc committees. [23] He then went on to explain that any amendments to Rule 2019 to increase the required disclosures would have no affect to those not already covered by the rule. [24]

Judge Sontchi’s decision was in complete opposition to that of his counterpart, Judge Walwrath’s in in re Washington Mutual Inc. [25] Judge Walwrath used the currently proposed amendments to Rule 2019, which will force disclosure by ad hoc committees, as evidence of Rule 2019’s coverage of ad hoc committees. [26]

 

IV. Proposed amendments 

Currently Rule 2019 states that “every entity or committee representing more than one creditor or equity security holder. . .shall file a verified statement setting forth” their economic interests. [27] The proposed amendments are simple. They will require “disclosure by all committees or groups that consist of more than one creditor or equity security holder, as well as entities or that represent more than one creditor or equity security holder. [28] It also authorizes the court to require disclosure by an individual party in interest when knowledge of that party’s economic stake in the debtor would assist the court in evaluating the party’s arguments.” [29] In essence, not only represented traditional committees would be subject to the disclosure rules, but also ad hoc committees. [30]

 

V. Solution

Striking equilibrium between disclosure and non-disclosure presents a problem. If we don’t allow disclosure, then we might be teetering with the survival of large companies when they can be a going concern after reorganization. On the other hand, if we allow too much disclosure then we might be putting a cap on liquidity to distressed securities. As mentioned earlier, sometimes investors buy securities in distressed companies if they view those companies as undervalued. Not only does the company that’s sitting on the line of bankruptcy need more liquidity in their security, but also the creditor selling the security would sometimes rather sell their security to an interested third party than risk getting less back on their claims through bankruptcy. If we require too much disclosure, then this could potentially decrease the demand on these securities by interested third parties.

Any attempt to reach equilibrium between these two schools of thought would require concessions on both sides of aisle. A sensible solution would be to have confidentiality agreements in place before an ad hoc committee gives in to disclosure. These confidentiality agreements would not be displayed to the public and would preserve the confidential nature of these investors trading secrets. Another solution could be to require a closed-door disclosure before disclosures are made to all the parties in a bankruptcy proceeding. More specifically, the presiding judge could hold a private hearing in which he will determine if the economic interests of one party need to be disclosed. Subsequently, we could pass discretionary standards bankruptcy judges would need to adhere to when deciding whether or not disclosure is needed. This would prevent discretionary abuse by the presiding judge. 

 

VI. Conclusion 

Rule 2019 presents a valid problem in business reorganization cases. There are many interested parties to the process that have competing claims. Striking an equitable balance between these two parties would unquestionably require them to meet in the middle. The parties fighting for non-disclosure must be open to some form of disclosure, confidential disclosures at the bare minimum. The parties fighting for disclosure must be open to disclosures with confidentiality strings attached.

 

[1] In re Washington Mut., Inc., 419 B.R. 271, 277 (Bankr.D.Del. 2009).

[2] Id.

[3] Alexander L. Sparkle, The Rule 2019 Battle: When Hedge Funds Collide With The Bankruptcy Code,73 Brook. L. Rev. 1411, 1418(2008).

[4] Id.

[5] Id.

[6] Id.

[7] Daniel J. Bussel, Coalition-Building Through Bankruptcy Creditors' Committees, 43 UCLA L. Rev. 1547, 1556 (1996).

[8] Sparkle, supra note 3.

[9] Sparkle, supra note 3, at 1419

[10] Id.

[11] Id.

[12] Sparkle, supra note 3, at 1460

[13] Id.

[14] Megan McArdle, Do We Hare Credit Default Swaps ForThe Wrong Reasons?, The Atlantic, Apr. 17th 2009, available at http://www.theatlantic.com/business/archive/2009/04/do-we-hate-credit-default-swaps-for-the-wrong-reasons/16296/

[15] Matthew Phillips, The Monster That Ate Wall Street, Newsweek, Sept. 27th 2008, available at http://www.newsweek.com/id/161199

[16] Id.

[17] Ilan D. Scharf, Show And Tell: Ad Hoc Committees' Rule 2019 Disclosures Under Examination, 28Am. Bankr. Inst. J. 58, 58 (2009).

[18] McArdle, supra note 14.

[19] Id.

[20] Henny Sender, CDS derivatives are blamed for role inbankruptcy filings, Financial Times, Apr. 17th 2009, available at http://www.ft.com/cms/s/0/12f16208-2ae6-11de-8415-00144feabdc0.html?nclick_check=1

[21] Scharf, supra note 17.

[22] Id.

[23] In re Premier International Holdings, Inc., et al., No.09-12019 (Bankr. D. Del. 01/20/10).

[24] Id.

[25] supra note 1.

[26] Id.

[27] 11 U.S.C. § 2019(a)

[28] Pending Rules Amendments, US Courts (Effective Dec. 1, 2011) available at http://www.uscourts.gov/rules/newrules6.htm

[29] Id.

[30] Bob Eisenbach, With Revisions To Bankruptcy Rule 2019 Under Review, A Second Delaware Bankruptcy Decision Goes The Other Way On Whether The Rule Requires Informal Committees To Disclosure Their TradesInthe (Red), Jan. 27th 2010, available at http://bankruptcy.cooley.com/2010/01/articles/business-bankruptcy-issues/with-revisions-to-bankruptcy-rule-2019-under-review-a-second-delaware-bankruptcy-decision-goes-the-other-way-on-whether-the-rule-requires-informal-committees-to-disclose-their-trades/

 

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