A few months ago we introduced readers to one of Distressed Debt Investing's new contributors: David Karp of Schulte Roth Zabel. His first post was well received by our readers. Now David is back with a series of posts that I think are HIGHLY topical to the current investment environment, especially as more and more investors move into trading claims and bank debt to pick up added returns in less liquid parts of the capital structure.
A problem of course is that with trade claims, there comes a number of salient issues on the more technical aspects of the trade. Buying a registered bond that is represented by an indenture trustee in a bankruptcy brings about it some benefits due to market standardization and history. Conversely buying a trade claim carries unique risks specific to the claim. (A detailed primer on these risks and how the market trades around then can be found in the linked article David co-wrote for Bloomberg Law Report in January 2011) This year those risks have been brought to light due to a number of rulings and case dealing with trade dispute litigation.
A number of courts have recently considered common bank debt and bankruptcy claims trading terms and conditions under New York law, addressing one or more central issues for distressed debt traders and in some cases challenging investors’ fundamental understanding of the effect of “market standard” transfer documentation. While some of the decisions have given the market comfort, others have left distressed investors scratching their heads.
David's next three posts will highlight the impact these cases may have on distressed debt traders and explain how certain of these disputes may have been preventable through better pre-trade diligence and planning.
Part I of this series highlights a dispute between a trade vendor and a bankruptcy claims buyer over when the buyer’s put right, triggered by a potential impairment of the purchased claim, becomes enforceable and whether or not the buyer can rely on the seller’s representations and warranties as forward looking guarantees as to the validity of the claim. Part II will analyze a dispute between a claims buyer and the Debtor’s liquidating trustee over the trustee’s objection to the purchased claim. Part III of this series will explain new 5th Circuit case law clarifying the binding nature of oral agreements for bank debt trades in a manner consistent with the courts of England and Wales confirming for both US and UK based distressed bank debt traders that “done” means “done” and even when trades are subject to documentation and consents.
Enjoy the post!
Part I: “Offensive” Use of Put Right by Bankruptcy Claims Buyer
A recent decision by the Second Circuit highlights a bankruptcy claim buyer’s use of a contractual put right as an offensive weapon to offset an investment turned sour. The Second Circuit vacated a SDNY District Court decision that had denied the buyer’s attempt to enforce its put right triggered by an objection against the claim.
In that case, the buyer, Longacre Master Fund, Ltd. (Longacre), had purchased certain claims against Delphi Automotive Systems from ATS Automation Tooling Systems, Inc. (ATS). In a companion case, Longacre purchased similar Delphi claims from D & S Machine Products, Inc. (D&S). The claim purchase documents in both cases were “full recourse” documents that gave Longacre the right to require ATS or D&S to repurchase their claim, with interest, in the event it became “objected to.”
At the time of the purchase, the distressed investors expected unsecured creditors to receive nearly a full recovery and Longacre paid ATS around 89 cents/dollar for the claims. Delphi’s case did not turn out as most investors anticipated, and the unsecured creditors’ recovery under the confirmed plan of reorganization was far lower than initially expected. After the plan went effective, Delphi’s post-reorganization successor included the ATS claims in an omnibus objection under section 502(d) of the bankruptcy code. A 502(d) objection to a claim asserts that the claimant is subject to a preference action and until that action is resolved, the claims is temporarily disallowed. In this case, ATS had received certain payments from the debtor during the 90-day preference period, making it a potential preference defendant.
After ATS failed to resolve the objection to the claim with the 180-day grace period provided in the Assignment of Claim Agreement, Longacre demanded the refund of its purchase price plus interest. ATS rejected the demand and Longacre then sought to enforce the contract through litigation in the District Court for the Southern District of New York.
Longacre’s suit principally relied on two contract provisions in the Assignment of Claim Agreement. First, it alleged, the omnibus objection constituted an “Impairment” under paragraph 7 of the Assignment of Claim Agreement: “Subject to paragraph 16 below, in the event all or any part of the Claim is ... offset, objected to, disallowed, subordinated, in whole or in part, in the Case for any reason whatsoever, pursuant to an order of the Bankruptcy Court (whether or not such order is appealed) ... (collectively, an “Impairment”), Seller agrees to immediately repay, within 5 business days on demand of Buyers (which demand shall be made at Buyers’ sole option), an amount equal to the portion of the Minimum Claim Amount subject to the Impairment multiplied by the Purchase Rate ..., plus interest thereon at 10 percent per annum from the date hereof to the date of repayment.” Focusing in, Paragraph 7 provides that a claim is impaired when “all or any part of the Claim is . . . objected to . . . for any reason whatsoever, pursuant to an order of the Bankruptcy Court.”
Longacre also asserted that the debtor’s omnibus objection constituted “Possible Impairment” not resolved within 180 days under Paragraph 16 of the Assignment of Claim Agreement: “[I]n the event a possible Impairment is raised against the Claim in the Case and actually received by Buyers (a “Possible Impairment”), Buyers shall promptly notify Seller.... If at any time after the 180th calendar day following the day on which the Possible Impairment was filed against the Claim or otherwise formally commenced (herein, the “Limitation Day”), Seller’s opposition and/or defense against the Possible Impairment has not been fully resolved and is not likely to be fully resolved within a reasonable period of time, then Seller must immediately repay an amount calculated in accordance with paragraph 7, as if there were an Impairment in respect of all or part of the Claim and Buyers had made a demand under paragraph 7.
The District Court did not enforce these provisions as written, but rather granted ATS’ motion for summary judgment. See Longacre Master Fund, Ltd. v. ATS Automation Tooling Systems Inc., 456 B.R. 633 (S.D.N.Y. 20122). The court disagreed with Longacre that the debtors’ omnibus objection constituted an “Impairment” or even “Possible Impairment” because an objection based on section 502(d) is not a substantive objection to a claim. In so doing, Judge Sweet implied that the “objected to” language of the put right only referred to objections that challenged the validity or enforceability of the claim in the hands of the transferee. Analyzing the merits of the objection, the court found that the debtor’s “objection” was actually just a reservation of its right to object to the claim in the future. The court’s reasoning was partially based on a much-criticized decision in Enron II, which purported to distinguish rights and disabilities that travel with a claim based on whether the transfer was done by “sale” or an “assignment.” This curious and much criticized line of reasoning has now come into play in the context of purchases of claims against KB Toys, Inc. There, after neither party could, in the bankruptcy court’s view, adequately articulate the difference between a sale and an assignment, Judge Carey of the Bankruptcy Court in Delaware, rejected the Enron II holding. See In re KB Toys et al., No. 04-10120, 2012 WL 1570755 (Bankr. D. Del. May 4, 2012). Judge Carey’s decision is currently on appeal to the District Court of Delaware in ASM Capital LP v. Residual Trustee of KBTI Trust (In re KB Toys, Inc.), No. 12-716 (D. Del.). Enron II and In re KB Toys et al. will be the subject of Part II of this series.
Contrary to the ATS decision, Longacre’s prevailed in its case against D&S, also decided in the District Court of the Southern District of New York and on principally the same issues. See Longacre Master Fund, Ltd. v. D & S Machine Products, Inc., No. 10-6090 (S.D.N.Y. Feb. 14, 2011). In the D&S case, Judge Pauley broadly interpreted “objection” and found that the put right was triggered by Delphi’s filing of its objection. Given the divergent district court rulings, these cases were consolidated for purposes of appeal to the Second Circuit.
The parties’ appeal papers painted very different pictures of the suits. D&S called Longacre’s action to enforce the provisions as “nothing more than a disingenuous attempt to evade the consequences of its poor investment decision.” Similarly, ATS called Longacre’s efforts “desperate and disingenuous.” Longacre’s pleadings, on the other hand, stressed the “clear, unambiguous terms” of the agreements and that an objection is an objection.
The Second Circuit reversed Judge Sweet’s ruling in the ATS case, holding that “nothing in the language of Paragraph 7 of the Assignment of Claim Agreement requires that the objection be meritorious” and Paragraph 16 requires the temporary return of the purchase price when there is an unresolved “Possible Impairment.” The Second Circuit also held that the mere filing of the omnibus objection triggered ATS’s repurchase obligation, “stating they were ‘objecting to’ the [Claims], and the Bankruptcy Court issued an order stating that the ‘Objection’ was preserved,” regardless of whether the “objection” constituted a reservation of rights. The Second Circuit did, however, remand the case to determine the factual question of whether ATS had knowledge, at the time of the assignment, of a potential impairment of the claim related to a preference payment, which would result in a breach of ATS’s representation that “to the best of ATS’s knowledge, the Claim is not subject to any defense, claim or right of setoff, reduction, impairment, avoidance, disallowance, subordination or preference action.”
In its complaints against ATS and D&S, Longacre also claimed that the actions filed against the original claimholders and the objections by Delphi also caused the sellers to breach their representations and warranties in the Assignment of Claim Agreements. For example, Longacre claimed that the Delphi objection breached ATS’s representations that “the Claim is a valid Claim in the amount of at least $2,138,334.67.” Critically for market participants, enforceability of this type of representation as a forward looking guarantee remains unresolved as neither district court was willing to find, at the summary judgment stage, that the contract unambiguously required representations and warranties to be satisfied after the Effective Date. Judge Sweet, in ATS, explicitly stated that the contract called for the truthfulness of the representations and warranties to be evaluated on the Effective Date because these were not expressly forward-looking. In D&S, Judge Pauley held that a representation that the claim “will not be disputed or defended  is arguably contrary to the reasonable expectation of the parties because it would require D&S to make warranties and representations regarding matters over which it has no control.” This interpretation that the representations and warranties are not in certain cases forward-looking, even though they did not relate to a specific time, is generally inconsistent with claims buyers’ expectations . Unfortunately, these cases will not yield further clarity on the forward-looking nature of reps and warranties because that issue was not the subject of the Second Circuit appeal.
Claims buyers should find comfort in the fact that the Second Circuit’s holding enforced the express language of the Assignment of Claim Agreement in a manner consistent with market expectations of the function and triggers for contractual put rights. Courts, however, may be sympathetic to claims seller’s (especially non-market participants) arguments against claims buyers attempts to use a put right or indemnification offensively, to recover from a bad investment, as opposed to defensively to protect against a specific “impaired” claim. Even though Longacre appears to have overestimated the recovery on the Delphi claims, it was able to mitigate and possibly eliminate its loss through offensive use of its contractual put right. If Longacre prevails on remand in the District Court, it will recover interest on the purchase amount from the trade date until the date the objection was ultimately resolved, which may result in turning its likely loss into a winning trade.
David J. Karp is a Partner in the New York and London offices of Schulte Roth & Zabel LLP, where his practice focuses on corporate restructuring, special situations and distressed investments, distressed mergers and acquisitions, and the bankruptcy aspects of structured finance. David leads the firm’s Distressed Debt & Claims Trading Group, which provides advice in connection with U.S., European and emerging market credit trading matters. David is an avid speaker and writer on distressed investing related issues, recently co-authoring “European Insolvency Claims Trading: Is Iceland the Paradigm?” for Butterworths Journal of International Banking and Financial Law and “Trade Risk in European Secondary Loans” for The Hedge Fund Law Report. David is an active member of the LMA, APLMA, INSOL Europe and the LSTA where he is a member of the Trade Practices and Forms Committee. Erik Schneider and Neil Begley, associates at SRZ, assisted in the preparation of this entry.