Advanced Distressed Debt Lesson: Trade Dispute Litigation

For the past few months, David Karp, partner at Schulte Roth & Zabel, has contributed a number of fascinating articles on issues pertinent to trading in distressed debt, both domestically and overseas. I have gotten to know David over the past few months and he undoubtedly is one of the best in the field at what he does best: making sure funds and their investments are protected when transacting and executing trades in distressed debt and claims.

He's back with another fantastic, and timely, post. This one concerning a very recent decision related to claims trading in an oldie, but a goodie: the KB Toys bankruptcy and ASM Capital (defined below as Purchaser). This is a long one, but funds and desks transacting in claims will learn a great deal from the post. Enjoy!

Advanced Distressed Debt Trading & Trade Dispute Litigation: Debtor vs. Secondary Market Claims Purchaser

Our last post, Advanced Distressed Debt Lesson: Trade Dispute Litigation: What Distressed Investors Need to Know, focused on a claim buyer’s rights against a claims seller in the event that the specific claim sold is or becomes impaired. This post discusses the risk of impairment in the context of a dispute between the debtor’s liquidating trustee and a claims purchaser. On Jan. 4, 2013, the U.S. District Court for the District of Delaware upheld a bankruptcy court ruling that a so-called “section 502(d)” claim impairment travels with a claim in a typical claims trading transaction, rather than staying with the seller as a “personal disability.” In re KB Toys Inc., et al., Civ. No. 12-716 (D. Del. entered Jan. 4, 2013). Regardless of this district court ruling on these highly debated issues, or the outcome of any potential appeal to the Third Circuit, traders and analysts should focus on the diligence pointers provided by this case, which demonstrate that this trip to court by the claims purchaser might have been avoided.

KB Toys, a mall-based toy retailer, filed for Chapter 11 protection in early 2004. Between the Chapter 11 petition date and confirmation of its plan of reorganization in the summer of 2005 (followed by a second Chapter 11 filing and liquidation in 2008), “Purchaser” acquired 34 trade vendor claims ranging in size from $792.00 to $2.6 million, for a total combined face amount of approximately $7.5 million.

When purchasing multiple claims to build a position, it is not uncommon for claims investors to utilize a “portfolio theory” approach to aggregating claims against one debtor and spreading the risk that an individual claim is or will become impaired across a bundle of small claims, with the expectation that actual losses on any “bad” individual claim would be exceeded by higher returns on the bundle. Appearing to use this strategy, the Purchaser acquired each of the 34 claims on a short-form assignment agreement consisting of one to two pages of basic representations, warranties and indemnities. That being said, the Purchaser’s forms used for the KB Toys claim purchases, redacted copies of which were filed with the court, vary slightly between the different trades and are on a modified short-form recourse structure, meaning the risk of an impairment of a claim should remain with the claims seller through a put right and indemnification for breach of representations and warranties. For a more detailed discussion of recourse structures and claims trading risk allocation structures, see Claims Traders Beware: More Risk Than You Bargained For! Each of the nine purchase agreement forms for the disputed claims included a put right and four out of nine included indemnification for the seller’s breach of representations and warranties, which included, among others, that the claim was valid in the amount specified and that no objections to the claim existed.

In late July 2009, after the Purchaser had settled more than 30 trades and accumulated more than $7 million in face value of claims, the KB Toys trustee filed an omnibus objection to certain claims based on section 502(d) of the Bankruptcy Code. Section 502(d) requires the court to "disallow any claim of any entity from which property is recoverable" under an avoidance action, such as a preference claim "unless such entity or transferee has paid the amount, or turned over any such property, for which such entity or transferee is liable." See 11 U.S.C. § 502(d). The Purchaser may have been surprised to see nine of its claims listed in that objection. The nine claims listed, the largest of which was for only $163,000, totaled about $672,000 or approximately 9.5 percent of the Purchaser’s total position.

In many cases, one of the hallmarks of a portfolio strategy for claims purchasers is less claim and seller-specific diligence and lighter purchase documents in order to facilitate a quick trade and settlement. Light diligence aside, the Purchaser might have easily discovered, in advance of buying the claims, that many of the claims it was buying were subject to potential section 502(d) disallowance. As required of all Chapter 11 debtors, KB Toys had filed a Statement of Financial Affairs (“SOFA”) that listed all payments to creditors of more than $600 in the 90 days immediately preceding the petition date. KB Toys’s SOFA listed the nine claimants from which the Purchaser purchased the claims at issue, including the dates and amounts of the payments from KB Toys to the creditors. While we will delve more deeply into avoidance action law below, certain payments from a debtor in the 90 days prior to its filing can be avoided by the trustee or debtor-in-possession. Had the Purchaser reviewed KB Toys’s SOFA, it would have been aware that those original sellers were potentially subject to preference actions by the trustee and, therefore, their claims were also potentially subject to disallowance under section 502(d). In addition, the original holder of the largest claim was already subject to a default judgment in the amount of $18,181 obtained by the trustee in advance of the Purchaser purchasing the claim. This fact was readily discoverable in a search of the debtor’s case docket.

The public record is unclear on what, if any, efforts the Purchaser took to collect from the original claimholders under the assignment agreements’ put-right or indemnification provisions. We can speculate that such efforts have not been successful to date, as the Purchaser has since gone to great lengths to challenge the trustee’s objection to its nine claims since it was filed in July 2009 — arguing, among other things, that the trustee’s section 502(d) defense does not travel with the claim to the transferee.

As is the case with most assignment of claims agreements, the Purchaser’s assignments are governed by New York law. Unfortunately for market participants (and their counsel), but perhaps fortunate for the Purchaser, the state of New York law as to whether or not claim impairments are specific to the claim can be characterized as murky, at best. This is due to the oft-criticized decision known as Enron II. Enron Corp. v. Springfield Assocs., LLC (In re Enron Corp.), 379 B.R. 425 (S.D.N.Y. 2007) (“Enron II”). In the Enron case, the debtor sought to use section 502(d) to disallow claims held by secondary market transferees. As with the Purchaser’s claims, one of the issues for the court to consider in Enron was the extent, if any, to which a claim subject to section 502(d) disallowance in the hands of the transferor remains subject to section 502(d) disallowance in the hands of a transferee that was not involved in the avoidable transfer that gave rise to the 502(d) defense. The bankruptcy court, in Enron I, held that, since the claims in the hands of the transferor would be subject to section 502(d), the transferees are subject to the same claim disallowance under section 502(d). Enron Corp. v. Avenue Special Situation Funds II, LP (In re Enron Corp.), 340 B.R. 180 (Bankr. S.D.N.Y. 2006) (“Enron I”).

In the appeal of the Enron I decision, Enron II, the district court considered “whether . . . disallowance under 502(d) can be applied, as a matter of law, to claims held by transferees to the same extent they would be applied to the claims if they were still held by the transferor based on alleged acts or omissions on the part of the transferor.” Enron II, 379 B.R. at 427-28. In its opinion, the district court considered the legislative objectives of the statute and cited the “twin aims” of disallowance under section 502(d): to assure equality of distribution of the estate assets and to coerce compliance with judicial orders. Id. at 435. The district court then attempted to make a distinction between the effect of a “sale” versus an “assignment.” The district court described an assignment as a transfer in which the assignee stands in the shoes of the assignor, taking the claim with whatever limitation it had in the hands of the assignor. See id. at 436. In other words,  in an assignment of a claim, all limitations and disabilities of the claim and the transferor travel with the claim to the transferee, whereas in a sale, some limitations and disabilities can travel with the claim, but personal disabilities of the claimant remain with the claimant. Id. The district court looked at the language of 502(d) and determined that the emphasis on the entity suggested that 502(d) is a personal disability of the claimant that travels by assignment. Id. at 443. As to whether or not the Enron transfer was a sale or an assignment, the district court held that this determination required examination by the bankruptcy court of the “nature of the transfers.” Id. at 445-46. However, before the bankruptcy court could make a determination of that issue, the parties settled the claims, leaving claims and distressed debt trading market participants scratching their heads and wondering what exactly makes a transfer an assignment versus a sale.

This leads us back to the Purchaser’s purchases (or were they assignments?) of the KB Toys claims. Faced with the KB Toys trustee’s objection to the nine claims on section 502(d) disallowance grounds, the Purchaser naturally responded by waving the Enron II flag. In response to the trustee’s objections, the Purchaser argued to Judge Carey in the Delaware bankruptcy court that, based on Enron II, the claims at issue were transferred as “sales” and that the language of section 502(d) focuses on the claimant and, therefore, is a personal disability of the claimant that did not travel with the claim in the sale. In re KB Toys, Inc., 470 B.R. 331, 335 (Bankr. D. Del. 2012). Conversely, the KB Toys trustee questioned the analysis of Enron II and the resulting policy concerns and argued that, even if accepting Enron II, the transfers to the Purchaser were assignments and that the Purchaser had at least constructive knowledge of the claims, making the Purchaser’s purchases of the claims not in good faith. Id.

With analysis harkening back to the pre-1978 Bankruptcy Act (and even to case law from 1902), Judge Carey concluded that legislative history and case precedent support the notion that disabilities travel with the claim to the transferee. Id. at 335-37. Judge Carey echoed the analysis in Enron I and questioned the “sale versus assignment” distinction advanced in Enron II. Id. at 337-41. Judge Carey noted that the distinction has been highly criticized and observed that, “even if there exists a clean and principled way to distinguish between assignment and sale, the exercise, in this context, is unhelpful and unrevealing of the appropriate outcome.” Id. at 341.

Judge Carey also rejected the Enron II policy assertion that burdening the transferee with the disabilities imposed on the claim would upset the trading markets as a “hobgobin [sic] without a house to haunt,” because buyers of debt are highly sophisticated and fully capable of performing due diligence before any acquisition. Id. at 342. Even without any due diligence, market players are fully aware of the ever-present possibility of avoidance actions based on preference liability or fraudulent conveyances. Id. Judge Carey observed that the Purchaser could have discovered the potential for disallowance with very little due diligence and could have factored that into the price. Id. The fact that some of the assignment agreements had indemnification for disallowance evidenced the Purchaser’s understanding of the possible risks and its leverage to appropriately protect itself. Id.

Judge Carey also rejected the Purchaser’s argument that it should be protected from disallowance as a purchaser in good faith, reasoning that a purchaser of bankruptcy claims is well aware of the debtor’s financial difficulties and is entering a market in which claims are allowed and disallowed in accordance with the Bankruptcy Code. Id. at 343. In short, purchasers of bankruptcy claims are not entitled to the protections of a good faith purchaser. Id. Judge Carey was careful to point out in a footnote, however, that the ruling only relates to trade claims purchased from an original holder and not to other types of transfers, such as publicly traded notes, etc. Id. at 342 n.14.

The Purchaser then appealed Judge Carey’s ruling to the District Court for the District of Delaware and the appeal papers more or less rehashed the same issues and arguments as presented to the bankruptcy court. Oral argument on the appeal was held on Jan. 4, 2013 and Judge Richard G. Andrews upheld Judge Carey’s ruling. According to the hearing transcript, Judge Andrews’s view of the language of section 502(d) is that it could be read either way, but he nevertheless agreed with the rest of Judge Carey’s analysis. Judge Andrews was particularly focused on the policy rationale that the Purchaser should bear the risk of a section 502(d) impairment because it is in a better position to protect itself, as opposed to other unnamed creditors whose claims would be diluted if transfers had the effect of cleansing claims of such impairments. Feeling that he would not have much to add on the matter, Judge Andrews refrained from issuing a written opinion but welcomed the Purchaser to seek appeal to the Third Circuit to perhaps move closer to a definitive resolution of this issue. We would like to be able to say this ruling, or the outcome of any potential appeal to the Third Circuit, provides clarity on the state of the law in this area, but a Delaware district court ruling, or even a Third Circuit decision on appeal, will not have the precedential force to change the fact that Enron II is still out there and, despite widespread criticism, is still the law in New York.

No matter the outcome, the KB Toys case is a good reminder to the market that disallowance under section 502(d) is a real risk. The sale/assignment, personal/non-personal disabilities distinctions are too vague and legally opaque to be relied on by purchasers of claims. There are many more practical and reliable techniques available for purchasers to protect themselves. First, through due diligence. Even when accumulating small trade claims, work with your attorneys to create a diligence checklist for each debtor you are considering, review the SOFA, the case docket, and do an Internet search on the seller to see if you uncover any potential "insider" (as defined under the Bankruptcy Code) connections to the debtor, which could increase the preference period from 90 days to one year. Second, protect yourself in the trade documents (which you should do in most cases, regardless of the due diligence outcomes). Make sure your documents have strong seller representations, including that the claim is not (and will not be) subject to “disallowance (including, without limitation, pursuant to section 502(d) of the Bankruptcy Code),” avoidance, subordination, or be otherwise impaired. Have a clear indemnification provision for breach of representations and claim impairments. Of course, document-based protections do come with the credit risk of the seller, which brings you back to due diligence.

What should you do if your due diligence does uncover potential section 502(d) issues? Run for the hills? Not necessarily. There are some circumstances in which claims could be attractive even with the potential for section 502(d) disallowance. The potential section 502(d) disallowance can be settled, whereby the amount paid to the seller is used to resolve the trustee’s avoidance action in order to get the claim allowed. Or, the avoidance action could be priced into the trade or the seller might be willing to escrow the avoidance action claim amount until the claim objection is resolved. The bottom line is that even where a purchaser is quickly aggregating small claims through a “portfolio theory” approach, an upfront investment in pre-trade diligence and transaction structuring far outweighs the time, cost and expense required if a dispute arises and it finds itself in court.

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 a frequent 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. Neil Begley, an associates at SRZ, assisted in the preparation of this entry.

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Trade Claims Primer

It gives me great pleasure to introduce a new contributor to Distressed Debt Investing, Joshua Nahas, principal of Wolf Capital Advisors. Wolf Capital is a Philadelphia based advisory firm focused on distressed debt, corporate restructuring, corporate finance advisory and capital raising services. Wolf provides advisory services to hedge funds and private equity funds on distressed investing and provides restructuring services to debtors as well as creditor committees. In his first post, Josh provides a primer on the sometimes esoteric field of trade claims trading and investing. This is a must read for all distressed debt investors. Enjoy!

Trade Claims Primer

Introduction

While bank lenders and bondholders generally represent the largest portion of debtor’s pre- petition claims, upon filing there is a large constituency of other creditors who also possess claims against the debtor at various levels of priority within the capital structure. Because the sale, assignment and transfer of ownership of these claims are not considered securities, securities trading laws do not apply. The lack of uniformity and active market for these claims makes the instruments less liquid and transparent, thereby providing an opportunity for outsize returns for those willing to perform the necessary due diligence and shoulder the liquidity risk.

Vendor claims generally trade at a 10-20% discount to other wise pari passu securities and therefore present a potential arbitrage opportunity for investors. The typical vendor does not wish, or may not be financially able, to wait months or possibly years to receive his money and is usually sufficiently motivated to sell his claim at a discount. A distressed investors may also purchase trade claims as a way to obtain strategic advantage in a restructuring. By gaining control of a larger share of a company’s General Unsecured Claims (“GUCs”), a sophisticated distressed investor can gain leverage to influence negotiations with the Debtor and other Creditors. By purchasing trade claims at a discount to the unsecured debt he already owns, the investor also lowers the effective cost basis of his investment (assuming trade and bonds will receive the same consideration in the reorganization). In addition, if the claims pool is large enough an investor can set up a capital structure arbitrage trade by going long a trade claim and short pari passu unsecured bonds of the same company.

In structuring such a trade, one must ensure that the bond and the claim are at the same entity and that the bond does not have any guarantees or claims on subsidiaries that might make it more valuable. For instance in the case of Nortel Networks, their North American bonds issued at Nortel Networks Inc (“NNI”) had guarantees from their Canadian parent which the trade claims of NNI did not. Thus, one had to segregate the value of the North American and Canadian operations to determine the value of an NNI claim. Fortunately in this case there were bonds issued at the Canadian parent Nortel Networks Corp (“NNC”) that did not have recourse to NNI, so one could subtract the value of an NNC bond from an NNI bond to find the implied value of an NNI claim. Many times this is not the case and one needs to try and apportion the value using information available in the company’s financial statements. If the company has subsidiaries that are not guarantors of its debt then it will segregate the financials of the guarantor and non-guarantor subs. Also, one may look to segment reporting of revenue and EBITDA and attempt estimate how much value may be attributable to the various entities. In a scenario where the investor faces a great deal of uncertainty over valuation and how it will be attributed amongst various entities, he must bid an appropriate discount to compensate for the risk.

Types of Claims

A “Claim” is a right to payment, whether that right is fixed, liquidated, potential or contingent (i.e., based on the outcome of litigation). Claims can fall into different categories: priority, secured, unsecured, contingent, liquidated, disputed or matured. The most common claim to arise out of a bankruptcy filing is a vendor claim or trade claim as they are more commonly known. These claims arise due to the fact that a company’s suppliers ship goods on credit ranging anywhere from 30-90 days. When a company files for bankruptcy it likely to be in arrears on its accounts payable, this increases the amount of debt on its balance sheet (AP), thereby increasing the tradeable instruments in the debtor’s obligations. While trade claims are the most common, there several other types of claims that arise from a bankruptcy filing which provide potential investment opportunities. These include:

• Contract Rejection Damage Claims: Damages resulting from the termination of contracts under Section 365 of the Bankruptcy Code.
• Deficiency Claims: Secured claims that are under collateralized result in a deficiency claim under Section 506 of the Bankruptcy Code for the portion of the claim where there is insufficient collateral securing the claim.
• Pension/OPEB Claims: Collective Bargaining Agreements (“CBAs”), Defined Benefit Pension Plans and other employee benefits that are terminated pursuant to Sections 1113 and 1114 of the Bankruptcy Code give rise to unsecured claims.
• Contingent Claims: Claims that may result from pending lawsuits, environmental damages or other contingent events. Some examples of cases where large contingent claims were involved include the asbestos cases such as Owens Corning, Grace and Armstrong and environmental claims include cases such as Asarco and Tronox.
• Priority Claims: Generally include back taxes and unpaid employee wages and benefits, however, can also include lease deposits up to $2,452 and “Gap Claims” which arise when the Debtor is targeted in an Involuntary Bankruptcy Petition filed by one of its Creditors. All trade debts incurred in the period between the filing of the Involuntary Bankruptcy Petition and potential Entry of the Order for Relief by the Bankruptcy Court will be deemed to have a priority status.
• 503(b)9 Claims: These are claims for goods shipped within 20 days of a company filing for bankruptcy. Unlike other trade claims, these claims are accorded administrative status and are paid in full as long as the estate is administratively solvent.
• Reclamation Claims: Reclamation claims allow for the Creditor to reclaim the goods shipped to the Debtor. These claims arise under state law, §2-702(2) of the Uniform Commercial Code (“UCC”). Once the Debtor files for bankruptcy protection, §546(c) of the Bankruptcy Code preserves a creditor’s state law reclamation rights, those rights are enhanced by the code and create additional requirements and defenses. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”) expanded the reclamation period from 10 days to 45 days prior to a bankruptcy and to 20 days post-petition from 10 days previously. There are a number of requirements that must be met for these claims as well as potential defenses against such claims.

Proof of Claim

In order for the Creditor’s claim to be paid he must file a Proof of Claim (“POC”) with the court. This is done by filling out Official Form 10 within 90 days from the Section 341 meeting of creditors and filing it with the Bankruptcy Court. The date past which a claim can no longer be filed is known as the Claims Bar Date, and claims past this date generally will not be paid, although it is possible to appeal. The POC will have a Docket Stamp on it denoting the date of its filing. The POC must be signed by the creditor, include the amount of the claim, whether there is a perfected security interest and have attached to the POC documentation evidencing the claim such as invoices, purchase orders or contracts.

Sample of Proof of Claim Form 10

Sourcing Trade Claims

Upon filing of its petition for bankruptcy, or within 14 days of filing, the Debtor is required to file its Schedule of Assets and Liabilties and its Statement of Financial Affairs (“SOFA”). The Schedules are the primary source used to locate claim holders. In practice the Debtor routinely is granted extensions to the filing of schedules and it can take some time before a potential investor has the requisite information in order to bid on a claim. Nevertheless, upon petition the Debtor must file a list containing the name, address and claim of the creditors that hold the 20 largest unsecured claims, excluding insiders. For a sophisticated trade claims investor it is possible to begin negotiations to purchase a claim utilizing this information, albeit without knowing whether the debtor is disputing the claim or if the amount of the claim at petition will be the same as what is listed on the Schedules.

The Schedules also contain the name, address, amount of claim and whether that claim is, Contingent, Liquidated/Unliquidated or Disputed. Contingent claims are claims that may arise contingent upon an event taking place in the future, such as an adverse judgment in an ongoing lawsuit or claims related to remediation for environmental damages that are not fully know. A Liquidated Claim is a claim where the dollar amount is known. An Unliquidated Claim is one where the debtor has liability, but the exact monetary measure of that liability is unknown. A tort case where the Debtor has been found guilty, but where the amount of the liability has yet to be established would fall into this category. Disputed claims are claims where the Debtor is disputing the validity of the claim and intends to file an objection to the claim. This generally occurs later in the case in the form of an Omnibus Objection made by the debtor. Below is an example of a Debtor’s Schedule of Assets and Liabilities filed by Tronox Inc.

Purchasing a Trade Claim

In examining the schedules it best to bid on an Allowed Claim. Under Section 502(a), a claim for which a proof of claim has been filed is deemed “Allowed” unless a party of interest (e.g. Bankruptcy Trustee, or the Debtor) objects to the claim, in which case the Bankruptcy Court will conduct a hearing to determine whether, or to what extent, the claim should be allowed. There are instances where the Debtor marks every claim on the schedule as disputed or contingent. This increases the risk and will required extra due diligence as well as the willingness to litigate if need be.

Once a claim holder willing to sell has been located, the negotiation process for purchasing the claim begins. This process can take anywhere from a few days to several weeks depending on the complexity of the issues involved. Since the seller is not a capital markets participant, he may change his mind several times throughout the negotiation process and also increase his offer based on competing bids. Moreover, factors may come into play in the due diligence phase that require a re-pricing or cancellation of the trade altogether. If an investor is bidding on a disputed claim he will need to factor the risk that the claim might ultimately be disallowed into his bid price. In addition, he may want to reduce price of his bid to allow him to negotiate with the debtor for a reduction in claim size in exchange for a stipulation that the debtor will treat the claim as an Allowed Claim.

Due Diligence

Once an initial bid is agreed upon, the parties enter into a trade confirmation, subject to final due diligence. This phase again can take a few days to a few weeks depending on the issues involved. At this stage in the process the buyer will begin examining the documentation supporting the claim. This includes reviewing invoices, purchase orders, or other contracts in order to determine the validity of the claim. It is also necessary to reconcile the amounts on the invoices with what is filed on the POC and the Schedules. If the invoice is for less than what is listed on the POC or what is listed on the POC is less than on the schedules, the purchaser must reconcile these discrepancies before funding, or have the buyer agree to indemnification provisions should the claim be allowed at a lower amount. The purchaser must also confirm that the entity at which the claim he is purchasing is filed corresponds to the entity listed on the supporting invoices as well as have been filed prior to the Claims Bar Date.

The claims purchase will be executed via a custom tailored contract known as a Purchase Sale Agreement (“PSA”). The PSA will contain provisions governing the transfer of the claim, Representations and Warranties and Indemnification provisions. The PSA will required the seller to provide Reps and Warranties on the ownership, validity and lack of any encumbrances on the claim. In addition, the PSA will contain Indemnification provisions, should the claim be impaired or disallowed . This means that if for some reason the purchaser of the claim needs to seek recourse because the seller misrepresented his claim or it was disallowed as a result of actions taken by the seller, , the purchaser must be able to rely on the counter party to indemnify him for his losses. If the counter party is financially unstable, not a well established enterprise, or is itself at risk of bankruptcy, then there is risk that he will not be able to perform his duties under the PSA. When the counter party is a publicly traded company, has, publicly issued debt or has a credit rating, it is fairly easy to do counter party due diligence. However, if the counter party is a small, private business, then counter party risk assessment becomes more difficult. One source of information is Dun & Bradstreet which compiles credit and other financial information on private businesses. In addition, the purchaser can and should ask for financial statements, bank statements, summary of tax returns and other information as needed to gain comfort with the counter party’s credit worthiness. Should legal disputes arise the between the buyer and seller, the PSA should contain provisions for settling the disputes. It is common for the PSA to require disputes to be litigated under New York or Delaware law, courts which routinely handle complex commercial litigation. This also avoids being in the home town court of the seller of the claim. If the claim being purchased is from a foreign supplier whose country is a signatory to the NY Convention of the International Chamber of Commerce (“ICC”) arbitration, then the PSA should include provisions for disputes to be settled via arbitration as courts of signatory countries are required to enforce arbitration judgments conducted in accordance with ICC rules.

Legal Issues Affecting Trade Claims

There are several legal issues that can impact the value of a claim or cause the claim to be disallowed. The following is a brief summary of some of the major issues that need to be diligenced from a legal perspective before purchasing a claim.

Equitable Subordination. If the seller of the claim aided and abetted fraud, insider trading or breach of fiduciary duty his claim may be equitably subordinated causing the priority of the claim to be moved to the end of the priority chain. This has the effect of the claim being treated as equity, not debt. This risk is heightened when a claim is purchased from an insider and one must have strong reps and warranties from an insider that he has not aided and or abetted any malfeasance. The purchaser must also have indemnification provisions covering such breaches. It can be several months post closing of a trade that these issues are discovered and even longer until they are adjudicated. In order to minimize this risk seek to avoid purchasing claims of company, insiders or those where the relationship could be potentially deemed as “insider”.

Avoidance Actions. When a company files for bankruptcy all payments made in the 90 days prior to bankruptcy (1 year for payments to insiders) are investigated as potential Preference Payments. A Preference Payment is the payment of a debt to one creditor rather than dividing the assets equally among all those to whom he/she/it owes money, often by making a payment to a favored creditor just before filing a petition to be declared bankrupt. The Bankruptcy Trustee has the power to Avoid (unwind) any payments that are deemed to be a Preference This is known as an Avoidance Action and the money is reclaimed by the bankruptcy estate . There are several criteria that are used to evaluate whether a payment was a Preference:

1. The transfer was "to or for the benefit of a creditor."
2. The transfer was made for or on account of an "antecedent debt"—that is, a debt owed prior to the time of the transfer.
3. The debtor was insolvent at the time of the transfer. (Fraudulent Conveyance which has 2-year look-back pursuant to 11 U.S.C. § 548)
4. The transfer was made within 90 days before the date of the filing of the bankruptcy petition or was made between 90 days and one year before the date of the filing of the petition to an insider who had reasonable cause to believe that the debtor was insolvent at the time of the transfer.
5. The transfer has the effect of increasing the amount that the transferee would receive in a liquidation proceeding under chapter 7 of the bankruptcy law (11 U.S.C.A. § 701 et seq.). 11 U.S.C.A. § 547

However, Section 547(c) of the Bankruptcy Code contains exceptions for payments made in the ordinary course of business. The prior course of dealings between the parties, including the amount and timing of payments, and circumstances surrounding the payments, should be analyzed. Additionally, inquiries may be made into the collection activities or practices between the parties, whether the payments were designed to give the transferee an advantage over other creditors in bankruptcy, or whether there was any change in the status of the transferee such as the ability to obtain security in the event of nonpayment. If there has been any unusual pressure or collection activity by the creditor resulting in the payment, the payment would not be ordinary course of business. The transfer at issue is not required to be the type that occurs in every transaction between the parties. It is necessary only that the type of payment be somewhat consistent with prior dealings and transactions

Closing the Trade

Once the due diligence and legal review is complete, the PSA is finalized and the trade is executed via Delivery vs Payment (“DVP”) format. ). DVP occurs when, to complete a trade, there is a simultaneous exchange of securities, in this case they are not securities but the format is the same, for cash that ensures that delivery occurs if, and only if, payment occurs. To be true DVP, there must be an element of finality in the process, whereby neither side of the trade can unwind the transaction after settlement. The funds are then wired within one day of execution. Closing can occur anywhere from 10-30 days post initial confirmation of the trade. The standard practice is that once the trade has closed, the Transferee files a Notice of Transfer and Evidence of Transfer (supporting documentation to evidence the transfer of claim) with the Bankruptcy Court pursuant to Bankruptcy Rule 3001(e). Rule 3001(e) reads as follows:

• Transferees trading on the “scheduled amount” prior to the filing of a POC must file a POC with court, although “evidence of transfer” is not required it recommend. Rule 3001(e) 1
• Assignment of a claim after a POC has been filed requires both a Notice of Transfer and an Evidence of Transfer to be filed with court. 3001(e)2

The clerk of the court or claims agent has the duty to notify the Transferor. The Transferor has 20 days to object to the transfer. Within 15-30 days post closing buyer follows up with claims agent to ensure claims register properly reflects the new owner of the claims.

Conclusion

Investing in trade claims provides a unique opportunity set for distressed investors who already understand the bankruptcy process, are familiar with analyzing complicated capital structures and understand inter-creditor issues. While trade claims are an illiquid market, they are also highly uncorrelated to the stock and equity markets making them attractive to distressed and special situation funds. Furthermore, it is possible in many cases to bid on claims at a discount to an established plan recovery for the reasons: stated earlier: that many trade creditors do not wish, or are unable, to wait for the exit from bankruptcy for payment. With that said the market has grown more competitive and sophisticated in the last several years, so do you due diligence and invest wisely.

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