The Role of Hedge Funds in Bankruptcy Cases

SOUTHEASTERN BANKRUPTCY LAW INSTITUTE, INC.
2008 Seminar: April 3, 2008 (4:05 – 4:45 p.m.)
“THE ROLE OF HEDGE FUNDS IN BANKRUPTCY CASES”
Presented by:
David S. Heller, Partner
Latham & Watkins LLP1
I.
HEDGE FUNDS IN BANKRUPTCY CASES
While there are many uncertainties as we prepare for the next wave of bankruptcy filings,
one certainty is that hedge funds will play an unprecedented role in bankruptcy cases,
further adding to the complexity and unpredictability of the next wave of filings. Hedge
funds will likely impact when certain cases file, how creditors collectively organize and
behave, when and under what circumstances a plan is confirmed, and how much time and
money it takes to complete a bankruptcy case.
Further, while not the focus of this presentation, it is important to note that hedge funds
have played an increasingly significant role in international restructurings over the past
couple years, including taking an important role in large cases such as Parmalat,
Eurotunnel, and EuroDisney, among others. This trend is unlikely to slow going forward.
II.
HOW HEDGE FUNDS GET IN
A.
We will see hedge funds becoming players in bankruptcy cases through either
(a) making or acquiring loans or (b) purchasing equity or, more commonly, debt
securities.
This can include:
1.
Purchasing bonds (usually at a meaningful discount);
2.
Buying debt from banks;
a.
1
Allows institutional lenders a quick out
Jordan M. Litwin, Associate, Latham & Watkins LLP, provided invaluable assistance in the
preparation of these materials.
b.
3.
When a loan is secured, allows fund to come in at the top of the
capital structure (first access to assets, etc.)
Making or buying second-lien loans;
a.
These are loans secured on a second-lien basis by all or part of the
same collateral that secures the borrower’s senior loans.
b.
These loans typically involve heavily negotiated intercreditor
agreements that have been almost entirely untested by the courts.
Examples that have made it to court include:
(1)
In re Aerosol Packaging LLC2: the second-lien lenders
challenged the validity of a pre-petition subordination
agreement. Under the terms of the agreement, the secondlien lenders assigned their voting rights to the first-lien
lender on any plan of reorganization. The court held that
(i) pre-petition subordination agreements are enforceable
post-petition under section 510(a) unless not enforceable
under applicable law (here, Georgia law), and (ii) that the
assignment of voting rights under a plan is permissible
under section 1126(a).
The court ruled that the
subordination agreement was enforceable under applicable
law and upheld the assignment of voting rights.
(2)
In re New World Pasta Company3: litigation ensued in DIP
financing negotiations regarding enforcement of secondlien waivers of DIP financing arrangements in a previously
executed intercreditor agreement. The court deferred
specifically ruling on the intercreditor agreement but held
that intercreditor agreements in place when DIP financing
is negotiated should not be altered by the DIP financing
provisions. (Similar issues were litigated in In re Meridian
Automotive Systems, Inc.4)
2
Blue Ridge Investors II, LP v. Wachovia Bank, N.A. (In re Aerosol Packaging, LLC), 362 B.R.
43 (Bankr. N.D. Ga. 2006).
3
In re New World Pasta, No. 04-02817 (Bankr. M.D. Pa. 2004) (initial DIP financing order
entered May 10, 2004; final order entered July 9, 2004). The second-lien holders’ objection
can be viewed at: 2004 WL 1484987 (filed June 4, 2004).
4
In re Meridian Automotive Systems, Inc., Case. No. 05-11168 (MFW) (Bankr. D. Del. 2005).
2
B.
4.
Making any one of a number of junior loans, such as: stretch A, tranch B,
phantom B tranches, etc.; or
5.
Through post-petition claims trading.
“Rescue lending”:
How do hedge funds provide “rescue lending”?
C.
D.
5
a.
A different risk appetite
b.
A more complex agenda
c.
Lenders of “last resort”?
Funds will invest at multiple (and at times competing) levels in the capital
structure.
1.
One reason funds invest at multiple levels of the capital structure is in an
attempt to hold a “fulcrum” position (the point in the capital structure
where liabilities exceed assets), allowing the holder additional control
and/or influence over the company, and giving the holder an upside with
greater likelihood that its debt will be converted to equity.
2.
Funds will therefore have their hands in many parts of an increasingly
complicated debt structure. No longer will companies filing bankruptcy
simply have senior debt with perhaps mezzanine and/or high yield debt.
In increasingly complex debt structures we see hedge funds as major
players at every level.
Categorizing an investment as a “loan to own”:
1.
Generally, a “loan to own” strategy is considered the lending of money for
the purpose of owning the company rather than earning interest.
2.
One of the most discussed cases on this issue is In re Randor Holdings5
(discussed further in the Case Summaries). In that case, Tennenbaum
Capital Partners (“TCP”) and affiliated funds made equity investments,
and secured loans, prior to the company seeking chapter 11 protection.
Later, TCP entered into an asset-purchase agreement and terms for DIP
financing. After filing bankruptcy, the creditors’ committee filed an
adversary proceeding against TCP, asserting an improper “loan to own”
strategy and seeking to have TCP’s pre-petition secured loans
The Official Committee of Unsecured Creditors of Randor Holdings Corp., et al. v.
Tennenbaum Capital Partners LLC; Special Value Expansion Fund LLC; Special Value
Opportunities Fund LLC and Jose E. Feliciano (In re Randor Holdings Corp., et al.), Adv.
No. 06-50909, Case No. 06-10894 PJW (Bankr. D. Del. Nov. 16, 2006).
3
recharacterized as equity or equitably subordinated. The bankruptcy court
denied the claims in full, ruling entirely for TCP.
E.
A word about “big boy” letters:
1.
These are presale agreements in the private sales of publicly traded
securities to not sue over non-disclosure of material inside information,
ideally entered into between a sophisticated buyer and sophisticated seller;
essentially seeking to avoid liability under the ’34 Act and common law.
2.
Effectiveness of “big boy” letters is unclear and remains untested in many
jurisdictions and only thinly tested in others (including NY and DE). Also
particularly unclear is how well such letters shield liability from
subsequent purchasers not party to the letter and not informed of its
existence.
3.
6
7
a.
R2 Investments v. Solomon Smith Barney6 involved Solomon
Smith Barney (“SSB”) allegedly learning material nonpublic
information in its negotiations with World Access, Inc. regarding
terms of a tender offer. SSB later sold its position to Jefferies
Group under a “big boy” letter. Jefferies Group then sold to Fimat
Group without a “big boy” letter, who in turn sold to R2
Investments without a “big boy” letter. Two days after the sale,
World Access, Inc. made an announcement allegedly disclosed to
SSB previously, which resulted in a 30 percent decline in R2
Investments’ purchase. The matter settled for an undisclosed
amount.
b.
SEC v. Barclays7 involved allegations that Barclays obtained
material nonpublic information through Barclay’s position on the
creditors’ committee. The matter settled for $10.9 million.
The SEC has shown increasing concern regarding hedge fund insider
trading (it announced the formation of a special hedge fund enforcement
task force in July 2007).
R2 Investments v. Solomon Smith Barney, 01-CV-03598-JES (S.D.N.Y. Apr. 27, 2001)
(dismissed with prejudice, July 2007).
SEC v. Barclays, 07-CV-04427 (S.D.N.Y. May 30, 2007).
4
III.
HOW HEDGE FUNDS CHANGE THE DYNAMICS
A.
Before bankruptcy:
1.
2.
B.
8
Funds may find ways to push a company towards bankruptcy, whether
voluntary or involuntary.
a.
Hedge funds, often holding second-lien loans, will have more
leverage over borrowers (and senior lenders) than we have seen
from holders of mezzanine and high-yield debt in the past.
b.
Hedge funds will benefit from restrictive covenants, and we are
seeing funds rigidly enforcing technical defaults, threatening
involuntary bankruptcy, accelerating debt obligations, and suing or
threatening to sue for repayment.
Funds may push companies to restructure outside of bankruptcy.
During bankruptcy:
1.
While funds’ motives and objectives may vary, we may see funds taking
very aggressive and highly litigious positions, resulting in less negotiation
and more direct litigation. This will further add cost and complication to
already more costly and more complicated cases. This approach seems to
change as funds “mature.”
2.
Funds will influence DIP financing as a fund will often have (or claim) a
right, under second-lien financing, to seek adequate protection, object to
use of cash collateral, and object to priming of liens.
3.
How funds interact with senior lenders will, of course, largely depend on
whether the funds’ and senior lenders’ interests coincide or conflict.
a.
Funds holding second-liens effectively have a veto over section
363 sales.
b.
Regardless of the specific scenario, however, hedge funds may
increasingly challenge secured creditors. In In re Refco, Inc.8, for
instance, a group of hedge funds attempted to block a settlement
with a secured lender after the debtor sought to repay a prepetition
loan.
In re Refco Inc., Case No. 05-60006 (RDD) (S.D.N.Y. Oct. 17, 2005).
5
4.
Funds may impact confirmation by, if nothing else, substantially
increasing litigation related to confirmation.
Non-consenting funds holding second-liens may need to be crammed
down, resulting in significant litigation over collateral values, debt terms,
and value considerations.
5.
With respect to Official Committees:
a.
b.
Funds may want to sit on the creditors’ committee, and run (or
attempt to run) the committee.
(1)
One major advantage to the hedge fund here is access to
otherwise inaccessible information.9
(2)
Membership on the committee could prove problematic
where a fund wants the right to trade in debt or securities,
due to concerns surrounding the appearance of impropriety
or actual insider information.
(a)
Funds can try to implement an ethical wall to allow
them to sit on the committee and continue to trade.
However, the thin staffing at most hedge funds
makes this approach problematic. In general, larger
hedge funds (with a larger staff) will likely have an
easier time convincing a court or other creditors that
they have erected a proper barrier within the fund.
(b)
Funds risk claim subordination or other remedies
for violating fiduciary duties as committee
members.10
May seek to establish an official bond committee or official equity
committee.
9
This advantage has changed somewhat since the 2005 amendments to the Code. Section
1102(b)(3) requires the creditors’ committee to provide access to information to holders of
similar claims not appointed to the committee. However, the true implication of this section
still remains to be seen and appears to vary on a case-by-case basis. Further, the sparse case
law that exists on this section, and commentary since the 2005 amendments, suggests that the
committee is not required to provide access to information that is confidential, nonpublic,
proprietary, or subject to privilege or a confidentiality agreement. See, e.g., In re Refco, 336
B.R. 187 (Bankr. S.D.N.Y. 2006); 7 COLLIER ON BANKRUPTCY 1102.08[1] (15th ed. rev.
2007). Thus, some of the information of most interest to a fund is the information least likely
to be shared pursuant to section 1102(b)(3).
10
See, e.g., Citicorp Venture Capital, Ltd. v. Comm. of Creditors Holding Unsecured Claims (In
re Papercraft Corp.), 160 F.3d 982 (3rd Cir. 1998) (discussed further in the Case Summaries).
6
6.
11
12
(1)
The hedge fund Appaloosa Management (Delphi’s largest
shareholder) fought for an official equity committee in the
Delphi11 bankruptcy case,12 arguing that a separate, official
committee was necessary to preserve stockholder recovery
largely due to the debtor’s behavior and reporting
irregularities (the committee was appointed, but Appaloosa
then found itself having to fight to get a seat on the
committee as it was not initially appointed by the U.S.
Trustee even thought it owned over 9% of outstanding
stock).
(2)
As with any other member of an official committee, a
hedge fund will see the advantages to official committees
in having its fees paid by the borrower, increased access to
information, and increased access to the court, while on the
other hand seeing additional disclosure requirements and a
responsibility to act on behalf of all equity or bond holders,
as the case may be.
(3)
The composition of official committees (primarily
unsecured creditors’ committees) and ad hoc committees
may change over the course of a case more so than we have
previously seen.
Rule 2019 implications:
a.
Rule 2019 applies where groups of creditors act under the same
counsel (such as in ad hoc committees). Ad hoc committees may
appeal to creditors like hedge funds, as they allow creditors to
freely associate or disassociate with other creditors, minimize
expenses, speak with one voice, and yet avoid any requirement to
act on behalf of all similarly situated creditors (as is the case with
an official committee).
b.
Usually, an attorney who represents a group of creditors, such as in
an ad hoc committee, files a statement with the court pursuant to
Rule 2019 that simply identifies the creditors being represented
and their aggregate holdings/claims.
In re Delphi Corp., et al., Case No. 05-44481 (RDD) (S.D.N.Y. Oct. 8, 2005).
See In re Delphi Corp., Case No. 05-44481 (RDD) (S.D.N.Y. Dec. 22, 2005) (“Motion of
Appaloosa Management L.P. Pursuant to 11 U.S.C. § 1102(a)(2) for an Order Directing the
United States Trustee to Appoint an Equity Committee in these Chapter 11 Cases”).
7
IV.
c.
In 2007, the Northwest Airlines13 court, considering a 2019
disclosure, mandated disclosure of individual holdings and the full
trading history on the debtor for each creditor represented. The
court rejected the group’s request to file such disclosures under
seal. However, not all courts have accepted that ruling, the most
notable exception being Scotia Pacific14, where the court, soon
after the Northwest Airlines decision, not only declined to require
expanded disclosures under Rule 2019 but ruled that Rule 2019 did
not apply to informal groups that represent only themselves.
d.
The Northwest Airlines and Scotia Pacific cases leave the issue
unsettled. It remains to be seen whether (1) a court will disagree
with the Scotia Pacific court and find that hedge funds in an ad hoc
committee must file a statement under Rule 2019 and, if so, (2)
whether the court buys into Northwest Airlines’ expanded
disclosure requirements or not. The uncertainty surrounding Rule
2019 may discourage hedge funds from forming or joining ad hoc
committees until the issue is resolved.
HOW HEDGE FUNDS GET OUT
The “term” of a hedge fund’s investment varies by hedge fund. And while hedge funds
can be short, medium or long-term investors outside of bankruptcy, their approach in
bankruptcy is generally unpredictable. Nonetheless, we know that hedge funds usually
have more liberal redemption rights then private equity firms, and therefore must always
be concerned about maintaining liquidity when making investments. For this and other
reasons, hedge funds can be unpredictable players.
A.
B.
Quick exit strategies
1.
May seek a quick exit, such as through an asset sale
2.
Hold-up
3.
“Yank a bank” issues — forcing a lender out under certain circumstances
Long-term strategies
1.
May be interested in longer-term strategies, including owning the
company post-bankruptcy
2.
Larger hedge funds generally have more flexibility (more diverse holdings
put less pressure on fund to keep any one investment liquid)
13
In re Northwest Airlines Corp., 363 B.R. 701 (Bankr. S.D.N.Y. 2007).
14
In re Scotia Pacific Co. LLC, Case No. 07-20027 (Bankr. S.D. Tex.).
8
CASE SUMMARIES
In re Radnor Holdings Corp., 353 B.R. 820 (Bankr. D. Del. 2006)
Issue: Whether the Official Committee of Unsecured Creditors properly challenged
what it termed Tennenbaum Capital Partners’ “loan to own” strategy.
Outcome: The Bankruptcy Court held that: (1) prepetition loans made to the debtors
were true debt instruments and would not be recharacterized as equity; (2) equitable
subordination was not warranted; (3) the debtor’s board did not act disloyally by entering into
loan transactions; (4) the lender’s representative did not breach his duty of loyalty as a member
of debtor’s board of directors; (5) the lenders established their secured status; (6) the lenders
were not undersecured for purposes of preference avoidance claim; and (7) Delaware’s equitable
defense of acquiescence barred the claims for equitable subordination and breach of fiduciary
duty.
Summary: After Radnor Holding Corporation commenced chapter 11 proceedings the
Court authorized the Official Committee of Unsecured Creditors (the “Committee”) to file a
complaint against Tennenbaum Capital Partners (“TCP”), and ordered that the trial on the merits
of the complaint would include a determination on the allowance of the $128.8 million claim
filed by TCP. Following eight days of trial, the bankruptcy court entered judgment in favor of
TCP on all counts, allowed TCP’s claim in the amount of $128.8 million, and authorized TCP to
credit bid that claim at any sale of property of the Debtors.
After taking into account the terms of the loan documents, along with the facts and
circumstances surrounding the making of the loans, the court found that the loans made to the
debtors were true debt instruments and should not be recharacterized as equity. In so holding,
the court noted that a “mechanistic” approach to the analysis of recharacterization claims had
been explicitly rejected in the Third Circuit, and instead the court must focus on the intent of the
parties at the time of the transaction as determined through a common sense evaluation of the
facts and circumstances. The court found that the loans were intended by TCP and Radnor to be
true debt investments, and refused to recharacterize them as equity. The court further noted that
if it were to apply the factors considered by other courts in recharacterization cases, the result
would be the same.
In denying the plaintiff’s claims for equitable subordination, the court noted that (a) the
Committee failed to prove that TCP engaged in inequitable conduct; (b) any alleged misconduct
caused injury to Radnor’s creditors or conferred an unfair advantage on TCP; and (c) equitable
subordination of the claim would not be consistent with the provisions of the Bankruptcy Code.
The court held that TCP was not an insider for purposes of equitable subordination since it was
not a person in control of the debtor, and further found that TCP did not engage in any
misconduct.
The court found that the breach of fiduciary duty claims were actually “deepening
insolvency” claims, which were recently rejected as a cause of action under Delaware law, and
9
rejected the plaintiffs claims for breach of fiduciary duty. The court further concluded that TCP
never aided and abetted a breach of fiduciary duty, and indeed found none of the factors of an
aiding and abetting claim had been satisfied. In addition, since the representative of TCP serving
on the board of Radnor did not vote on any transaction relating to TCP, the court found that the
representative had not breached any duty of loyalty owed to Radnor. Additionally, the court
found that TCP had met its initial burden of proof regarding its claim as of the petition date, and
since the Committee had put forth no evidence contesting the validity of this claim, TCP need
present no further proof regarding its validity. Also, since the Committee offered no evidence
regarding the value of the collateral securing TCP’s claim, the court found that TCP was not
undersecured.
After finding that the Committee had failed to prove its case-in-chief regarding equitable
subordination and breach of fiduciary duty, the Court concluded that the Committee’s claims
were barred by the equitable defense of acquiescence,15 since 95% of noteholders and a majority
of the Committee voted in favor of the loans by TCP. Having voted in this manner, the
Committee cannot then argue that the loans should be recharacterized as equity, or that entering
into the loans breached a fiduciary duty.
Finally, the court stated that even if it had found that the Committee prevailed on one or
more claims, the Committee failed to prove a recognizable measure and amount of damages,
since the methodology used by the Committee in calculating damages was indistinguishable
from a deepening insolvency model, and deepening insolvency is an impermissible measure of
damages in the Third Circuit.
15
Generally, the equitable defense of acquiescence bars a shareholder who voted in favor of a
transaction, or accepted the consideration offered by the transaction, to later assert claims
arguing that the transaction was improper. See In re Radnor Holdings Corp., 353 B.R. 820,
848 (Bankr. D. Del. 2006).
10
Citicorp Venture Capital, Ltd. v. Comm. of Creditors Holding Unsecured Claims (In re
Papercraft Corp.), 160 F.3d 982 (3rd Cir. 1998)
Issue: Whether a hedge fund can properly sit on a creditors’ committee while still
trading in claims/equity of the debtor.
Outcome: The Bankruptcy Court ruled that the hedge fund, as a member of the
creditors’ committee, violated its fiduciary duties to other unsecured creditors by simultaneously
sitting on the committee and trading in claims of the Debtor. The Court therefore subordinated
the fund’s claim.
Summary: Citicorp Venture Capital, Ltd. (“CVC”) obtained a 28% equity interest in
Papercraft through its $5.8 million investment in a 1985 leveraged buyout. CVC was also
allowed to seat one representative on Amalgamated Investment Corp’s (Papercraft’s parent)
board of directors, as well as Papercraft’s board and the boards of two Papercraft subsidiaries.
Papercraft ran into financial trouble which led to it filing under chapter 11 on March 22, 1991
with a proposed plan of reorganization already supported by CVC, equity holders and creditors.
When Papercraft filed, it had first and second priority outstanding notes of $147 million,
none of which were held by CVC. Over the next seven months, CVC purchased over 40% of the
outstanding notes (nearly $61 million face value) at a significant discount (paying approximately
$10.5 million), and announced that it was objecting to the previously contemplated plan and
proposing its own plan for CVC to purchase Papercraft’s assets. CVC made these purchases
through its representative on Amalgamated and Papercraft’s boards — the purchases were made
anonymously through various brokers. The purchases were not disclosed to any of the boards
and no approval was ever requested.
At the same time, according to the Court’s findings, CVC was requesting and obtaining
confidential information on Papercraft, including its financial stability and information on its
assets. This information was not shared with the Committee. According to the Court’s findings,
at one point, CVC’s representative on Amalgamated and Papercrafts’ boards directed two CVC
employees to visit a Papercraft subsidiary’s headquarters where they copied financial statements,
held meetings with management, and viewed the facilities. Information shared at this visit and in
subsequent communications between CVC and Papercraft were not shared with the Committee.
CVC formalized an asset purchase offer and Papercraft filed it as part of a plan of
reorganization. Nonetheless, the bankruptcy court approved the original plan filed on the
petition date, rejecting the CVC asset purchase offer and any of CVC’s objections to the original
plan and disclosure statement.
The Committee filed an adversary proceeding against CVC shortly after being informed
of CVC’s purchases since the petition date and its asset purchase offer. The Committee
primarily sought equitable subordination of the claims CVC purchased post-petition. The
bankruptcy court ruled in favor of the Committee, finding that CVC failed to meets its fiduciary
obligation (arising out of its presence on the Committee and representative on the boards of
directors) to act in the best interests of Papercraft and its creditors. The three primary concerns
noted by the bankruptcy court were: (1) the note holders who sold claims to CVC “were
11
deprived of the ability to make a fully informed decision concerning the sale of their claims”
depriving them of the “opportunity to consider pertinent information,” In re Papercraft Corp.,
187 B.R. 486, 497 (Bankr. W.D. Pa. 1995) (internal quotations removed); (2) “CVC’s actions
diluted the voting rights of prepetition creditors and resulted in CVC’s attempt to wrest from the
prepetition creditors [Papercraft’s] valuable assets,” id., at 499; and (3) CVC created a conflict of
interest (accentuated by its ability to purchase the claims at a significant discount,) jeopardizing
its board of directors representative’s ability “to make future decisions on claims as a director
free of [CVC’s] interests as [an] owner of claims,” id., at 500.
After appeals and remands, the circuit court upheld the district court’s equitable
subordination of CVC’s claims.
12
In re Northwest Airlines Corp., 363 B.R. 701 (Bankr. S.D.N.Y. 2007)
Issue: Whether Bankruptcy Rule 2019 compels the members of an ad hoc committee of
shareholders to disclose details regarding the nature of their equity holdings in the debtor.
Outcome: The Bankruptcy Court ruled that Bankruptcy Rule 2019 requires the members
of an ad hoc committee of shareholders to disclose the amount of shares each committee member
holds, the prices each member paid for its shares, and the dates the shares were purchased. In a
subsequent ruling, In re Northwest Airlines Corp., 2007 WL 724977, the Court ruled that the ad
hoc committee could not make its amended Rule 2019 filing under seal.
Summary: In January, 2007, a group calling itself as the “Ad Hoc Committee of Equity
Security Holders” filed a statement pursuant to Rule 2019 that identified the committee’s
members and its aggregate holdings of Northwest stock and claims against the Debtors. The ad
hoc committee—comprised of hedge funds that held Northwest Stock—subsequently moved to
be appointed an official committee and made discovery requests pursuant to this motion. In
response, Debtors filed a motion seeking to compel the ad hoc committee to supplement its Rule
2019 statement to disclose specific details regarding each committee member’s holdings in
Northwest. The ad hoc committee contested the motion and argued that Rule 2019 applies only
to entities or committees representing more than one creditor or equity holder. Since no member
of the committee represented any party other than itself and only the committee’s law firm,
which held no claim or interest in the debtors, represented more than one party, the committee
argued that Rule 2019 did not require further disclosure from the committee’s members.
The Court ruled in favor of Debtors, holding that the plain terms of Rule 2019 require
disclosure of “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.”
The ad hoc committee was subject to Rule 2019 because “b[y] appearing as a ‘committee’ . . .
the members purport to speak for a group and implicitly ask the court . . . to give their positions a
degree of credibility appropriate to a unified group with large holdings.” Accordingly, the Court
ordered the ad hoc committee to supplement its Rule 2019 statement to provide such
information.
Shortly after the Court’s ruling, the ad hoc committee moved to file its Rule 2019
amendment under seal, arguing that § 107(b) of the Bankruptcy Code affords protection to
parties who wish to safeguard “confidential commercial information.” The court denied the
committee’s motion, holding that “any interest that individual committee members had in
keeping such information confidential is overridden by the interests Rule 2019 seeks to protect”
(e.g., “possible conflicts of interest by outside as well as inside financial interests”). In the end,
the funds who chose to maintain their interests and to remain with the committee filed the
required disclosures.
This decision can substantially impact “unofficial” debt or equity committees. More
fulsome disclosure requirements may discourage hedge funds and other strategic investors from
collectively acting in future Chapter 11 cases. Ultimately, debtors may face fewer challenges to
their stand-alone reorganization plans.
13
In re Scotia Development LLC, Case No. 07-20027-C-11 (Bankr. S.D. Tex. Apr. 18,
2007)
Issue: Whether Bankruptcy Rule 2019 compels the members of an ad hoc committee of
noteholders (the “Ad Hoc Committee”) to disclose details regarding the nature of their equity
holdings in, or claims against, the debtor.
Outcome: The Bankruptcy Court ruled that Bankruptcy Rule 2019 did not apply to the
Ad Hoc Committee at all, as the group was not a “committee” within the meaning of Rule 2019,
and therefore the specifics of Rule 2019’s disclosure requirements were inapplicable.
Summary: On March 16, 2007, the debtor filed a motion to compel the Ad Hoc
Committee to “fully comply with Bankruptcy Rule 2019(a) by filing a complete and proper
verified statement disclosing its membership and their interests.” The debtors stated that
“[n]otably absent from the 2019 Statement are (i) any indication of each of the Committee
members’ relative holdings of the Timber Notes; (ii) the time period when each committee
member obtained its interest; (iii) how such interest was obtained and (iv) the price paid for its
note or notes by each committee member – all items of information specifically required by Rule
2019.” See Docket No. 492 at 7-8. The debtor relied heavily on the Northwest Airlines16
decision in making its case.
The Ad Hoc Committee objected and argued that it was not a “committee” as the term is
used under Rule 2019. Importantly, the Ad Hoc Committee stated that it did not purport to
represent any entities or individuals not members of the Ad Hoc Committee, and that, in any
event, any noteholders not then members were free to join the Ad Hoc Committee.
The Bankruptcy Court agreed with the Ad Hoc Committee, and on April 18, 2007, ruled
that the Ad Hoc Committee was not a “committee” under Rule 2019, and therefore Rule 2019
did not apply. Thus, not only did the Ad Hoc Committee not need to file subsequent disclosures,
but even its initial disclosures were apparently unnecessary.
On May 29, 2007, the Bankruptcy Court denied the debtor’s motion for reconsideration.
See In re Scotia Development LLC, 2007 WL 2726902 (Bankr. S.D. Tex. 2007).
16
In re Northwest Airlines Corp., 363 B.R. 701 (Bankr. S.D.N.Y. 2007) (discussed above).
14