The $500 billion distressed debt market in the U.S., which badly needs a break in the wake of the subprime mortgage credit crunch, caught one recently when U.S. District Judge Shira Scheindlin overturned a bankruptcy court decision in an Enron Chapter 11 case. The distressed market is one in which sophisticated investors, such as hedge funds, buy creditors’ claims at a discount in return for the right to pursue the claims on their own behalf.
In her Aug. 31 decision, Scheindlin warned that U.S. Bankruptcy Judge Arthur Gonzalez’s March 2006 decision “threatened to wreak havoc on the markets for distressed debt.” Gonzalez’s ruling suggested that innocent buyers of claims against a bankrupt company risked having courts wipe out their claims if they bought the claims from sellers that had engaged in misconduct.
Indeed, Merrill Lynch & Co. publicly stated its view that the ruling would “devastate” the market and also would “spill over into the regular capital markets.” Industry reaction was so strong that the Bond Market Association, the International Swaps and Derivatives Association and the Securities Industry Association all intervened in support of the appeal to the District Court.
“There’s a well-developed market for trading distressed debt, loans and securities,” says Evan Flaschen, chair of Bracewell & Giuliani’s financial restructuring group. “But the Bankruptcy Court’s decision threw a great deal of uncertainty into that market because it put buyers at risk of having their claims subordinated or denied, even though they had done nothing wrong.”
Fortunately, Scheindlin’s decision in Springfield Associates L.L.C. v. Enron Corp.–though not bereft of uncertainty–has gone a long way toward reducing that risk.
The case originated with a $1.7 billion syndicated loan that Citibank and other banks made to Enron before the energy trader went bankrupt in 2001 under a cloud of accounting fraud allegations. Soon after the collapse, Springfield Associates bought a $5 million claim from Citibank.
In 2003 Enron sued the lending syndicate for allegedly encouraging the fraud that led to the company’s demise. Two years later Enron sued Springfield, arguing its claim should be subordinated or disallowed because of Citibank’s alleged misconduct–even though Springfield had no knowledge of any alleged misconduct when it bought the Enron claim.
“This meant the real contest was between Springfield, an innocent third party, and other third-party creditors that would move up in priority if Springfield’s claim was subordinated or disallowed,” says Neal Rubenstein, a partner at Buchalter Nemer.
Springfield sought dismissal of Enron’s suit, arguing that innocent purchasers of claims shouldn’t suffer for the seller’s misconduct. But Gonzalez disagreed. “The bankruptcy judge took the position of ‘once a tainted claim, always a tainted claim’ and that Springfield’s claim was subject to subordination,” Flaschen says.
Springfield appealed to the District Court, which reversed–but did not entirely eliminate the uncertainty.
As Scheindlin saw it, misconduct was a “personal disability” of the seller that didn’t attach to the claim itself. If there was a “true sale” of the claim, the buyer did not take on that disability. But if the buyer acquired the claim by “assignment,” it took over the position of the seller and was subject to the subordination or disallowance to the same degree as the seller.
This distinction, Scheindlin said, was “particularly imperative in the distressed debt market context, where sellers are often anonymous, and purchasers have no way of ascertaining whether the seller (or a prior transferee) has acted inequitably or received a preference.”
Only with great effort and expense could buyers uncover that information, if at all.
“Parties to pure assignments, by contrast, can easily contract around the risk of equitable subordination or disallowance by entering into indemnity agreements to protect the assignee,” Scheindlin wrote.
What Scheindlin did not decide was whether Springfield had acquired the claim by assignment or sale. She left that to the bankruptcy court to decide on remand.
However, apart from a footnote that provided an example of a sale (purchase on the open market) and an assignment (acquisition by operation of law, such as subrogation), Scheindlin did not give the bankruptcy court any bright line on the principles dividing sales from assignments.
Although that still leaves some uncertainty–at least until the bankruptcy court decides the case again–stakeholders in the distressed market don’t appear too concerned.
“From the market’s point of view, the District Court’s ruling is a significant improvement on the bankruptcy court decision because parties will know how to structure transactions so as to avoid taking on any unknown disabilities the seller may have that could lead to subordination or disallowance,” says Karol Denniston, head of DLA Piper’s West Coast restructuring practice. “Knowledge of this kind restores pricing efficiency to the market.”
Denniston also points out that Scheindlin removed the uncertainty for a large part of the market when she stated that “claims on the open market are indisputably sales.”
And that’s good news. Because from all appearances, an influx of distressed product to the markets appears to be the order of the day in the current economy.