Amended Rule 2019 community, citing the same concerns, Judge Drain - - PDF document

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44CanalCenterPlaza,Suite400Alexandria,VA22314(703)739-0800Fax(703)739-1060www.abiworld.org RichardCorbiisanassociateinthe

SLIDE 1 44฀Canal฀Center฀Plaza,฀Suite฀400฀฀•฀฀Alexandria,฀VA฀22314฀฀•฀฀(703)฀739-0800฀฀•฀฀Fax฀(703)฀739-1060฀฀•฀฀www.abiworld.org

JOURNAL

A M E R I C A N B A N K R U P T C Y I N S T I T U T E

The Essential Resource for Today’s Busy Insolvency Professional

Contributing Editors: Richard฀J.฀Corbi Proskauer;฀New฀York rcorbi@proskauer.com Billy฀Hildbold U.S.฀Bankruptcy฀Court฀(S.D.N.Y.);฀White฀Plains william_hildbold@nysb.uscourts.gov Jonathan฀M.฀Petts U.S.฀Bankruptcy฀Court฀(N.D.฀Ill.);฀Chicago jonathan_petts@ilnb.uscourts.gov Editor’s Note: For more information on this topic, please see the updated Rules

n page 10.

ver the past 10 years, hedge funds and other distressed investors have become increasingly frequent participants in chapter 11 pro-

ceedings. To maximize their influence,

distressed investors with similar interests in a bankruptcy case will often organize together in informal groups, known as “ad hoc committees.” Ad hoc committees’ participation has cre- ated certain proce- dural efficiencies and has also led to more competitive debtor- in-possession (DIP) financing terms because ad hoc committee members are

ften more willing to

lend to debtors than traditional banks, but ad hoc committee members’ aggressive pursuit of short-term returns and frequent use of derivatives and other “shorting” techniques can also give them different financial incentives from other creditors in their class and from the estate as a whole in some cases. Concern for the lack of transparency in ad hoc committees’ participation in bankruptcy proceedings has recently led to proposed amendments to Federal Rule

f Bankruptcy Procedure 2019, which

were approved by the Supreme Court on April 26, 2011. Ad hoc committees are required to broadly disclose their economic interests in the debtor, including debt and derivatives.

Current Rule 2019

Bankruptcy Rule 2019 currently requires, inter alia, that any “committee” representing more than one creditor

r equity securityholder in a bankruptcy

case to file a verified statement disclos- ing (1) the members it represents, (2) the amount and nature of each member’s claims, (3) the dates the members acquired their claims and (4) the amounts paid for the claims.1 The disclosure requirements of current Rule 2019 were conceived in the 1930s in response to the abuses of “protective committees” acting

n behalf of bondholders in railroad reor-

ganization cases.2 Protective committees, however, faded into obscurity soon after the Rule’s enactment.3 For many years, lit- igation arising out

f strict compliance

with Rule 2019 was

rare. Instead, ad

hoc committees customarily filed statements listing the group’s mem- bership and aggre- gate holdings, but not the individual holdings or trading histories of its members. Beginning in 2007, debtors sought to breathe new life into Rule 2019 by moving to enforce its plain terms with respect to ad hoc committees. The handful of decisions to consider whether an ad hoc committee is a “committee” under Rule 2019 are split,4 with each camp finding that Rule 2019’s plain language supports its view.5

Calls for Reform of Rule 2019

Northwest Airlines,6 Washington Mutual7 and other cases applying Rule 2019 to ad hoc committees led the distressed investment community to call for reforms to Rule 2019. Distressed investors’ push for change was met head

Feature

About the Authors

Richard฀Corbi฀is฀an฀associate฀in฀the฀ Bankruptcy฀and฀Restructuring฀Group฀ in฀the฀New฀York฀offjce฀of฀Proskauer.฀ Billy฀Hildbold฀is฀the฀law฀clerk฀for฀Hon.฀ Robert฀D.฀Drain฀of฀the฀U.S.฀Bankruptcy฀ Court฀for฀the฀Southern฀District฀of฀New฀ York.฀Jonathan฀Petts฀is฀the฀law฀clerk฀ to฀Hon.฀A.฀Benjamin฀Goldgar฀of฀the฀ U.S.฀Bankruptcy฀Court฀for฀the฀Northern฀ District฀of฀Illinois.

New Rule 2019: Distressed Investors, What Are You Holding?

1 Fed. R. Bankr. P. 2019. 2 In฀re฀Premier฀Int’l฀Holdings฀Inc., 423 B.R. 58, 65-66 (Bankr. D. Del. 2010) (discussing origin of Rule 2019’s predecessor rule under former Bankruptcy Act). 3 Id. at 73. 4 Compare฀In฀re฀Nw.฀Airlines฀Corp., 363 B.R. 701, 703 (Bankr. S.D.N.Y. 2007) (Gropper, J.) (ad฀hoc committee was “committee” under Rule 2019, requiring disclosure of individual holdings and trading histories

f members); In฀re฀Washington฀Mut., 419 B.R. 271 (Bankr. D. Del. 2009)

(Walrath, J.) (same) with฀In฀re฀Scotia฀Dev.฀LLC, 2007 WL 1192137 (Bankr. S.D. Tex. Apr. 20, 2007) (ad฀hoc group is not “committee” under Rule 2019 where group did not represent interests of anyone

ther than its members);฀In฀re฀Premier฀Int’l฀Holdings฀Inc., 423 B.R. 58

(Bankr. D. Del. 2010) (Sontchi, J.) (same);฀In฀re฀Phila.฀Newspapers฀LLC, 422 B.R. 553 (Bankr. E.D. Pa. 2010) (same). 5 Compare฀Washington฀Mut., 419 B.R. at 275 (ad฀hoc group of notehold- ers represented by shared counsel filing joint pleadings was committee representing more than one creditor under “the plain language of Rule 2019”), with฀Phila.฀Newspapers, 422 B.R. at 566 (steering group of pre- petition lenders was not “committee” under Rule 2019 because “ordi- nary meaning” of word “committee” is “a body appointed by a larger body for some specific purpose” and steering group did not represent any persons other than its members). 6 In฀re฀Nw.฀Airlines฀Corp., 363 B.R. 701 (Bankr. S.D.N.Y. 2007). Jonathan฀M.฀Petts Billy฀Hildbold

SLIDE 2 44฀Canal฀Center฀Plaza,฀Suite฀400฀฀•฀฀Alexandria,฀VA฀22314฀฀•฀฀(703)฀739-0800฀฀•฀฀Fax฀(703)฀739-1060฀฀•฀฀www.abiworld.org

n by a proposal from Hon. Robert E.

Gerber, in a letter to the Bankruptcy Rules Committee8 whose proposal Hon. Robert D. Drain adopted and expanded

n in his own letter to the Bankruptcy

Rules Committee.9 These countervail- ing views led to vigorous debate and testimony about the appropriate changes necessary to obviate the problems cre- ated by compliance with or failure to comply with Rule 2019. As expected, the sides had vastly different views about the reforms, but all parties agreed that Rule 2019, as then enacted, needed to change. Some in the distressed-investment community sought the outright repeal of Rule 2019,10 asserting that as written, it unfairly singled out ad hoc committees and reduced their bargaining position by requiring them to disclose the price paid for their investment, as well as by requiring them to potentially disclose proprietary investment strategies. For these reasons, they believed that creditors were less likely to create ad hoc committees and participate in the bankruptcy process, which may have been the most efficient, economically sound basis for their participation. Others in the distressed-investment community, citing the same concerns, sought a diametrically opposite approach for reform of Rule 2019. These distressed-investor groups believed that fairness should be achieved through expansion of Rule 2019’s reach to any party in interest who filed a pleading in the case. In addition, these members of the distressed-investment community suggested a tiered system of disclosure that would require increasing levels of disclosure based on a creditor, creditor group or committee’s participation level in the bankruptcy case, to include the

fficial unsecured creditors’ committee.

On the other hand, Judge Gerber argued for more directed disclosure so that parties in interest, as well as the bench, could consider and better under- stand the motivations of those coming before the court and asserting a position in the case.11 Although he recognized the benefits that distressed investing could play in a debtor’s recovery and the potential for cash infusion into distressed companies, he also feared that the pres- sure of high-stakes distressed investment had led to and might continue to lead to distressed investors’ nefariously advanc- ing personal agendas and gaming for a decline in the estate to maximize their returns over what was best for the estate and the creditor body as a whole.12 As examples, Judge Gerber expressed concerns over creditors holding “short” positions: selling the investment before actually purchasing it in hopes that its value will drop and the creditor can purchase it on the market at a later date for a lower price. Also, derivatives and credit- default swaps were a concern of Judge Gerber, who believed these now-common investments gave creditors an opportunity to participate in the case without “skin in the game.” As he put it, “[d]erivatives are securities or instruments whose value turns on the value of another security or instrument... Credit-default swaps will at least usually result in a situation where an alternative entity bears the economic risk, or will reap the rewards, that would

therwise be borne or enjoyed by the
riginal creditor.”13

Judge Drain added that the repeal of Rule 2019 could lead to confusion in the settlement process, which he referred to as the primary activity in bankruptcy cases.14 He articulated that it would make it much more difficult to know “who the other side is,” meaning that parties might think that they are nego- tiating with an entire body of creditors, resulting in the withdrawal of a pleading, only to have another creditor file a similar pleading, purporting not to have been represented by the settling group. Additionally, Judge Drain showed concern about the pressures put on counsel who represented distressed investors to seek positive results for their clients— results that may be attainable, in some cases, only by misleading the court and

ther creditors as to the distressed inves-

tor’s real intentions (a gain for the client that would come at the cost of violating ethical and professional duties). Judge Drain believed that Rule 2019 helped to alleviate some of those result-oriented influences by requiring the disclosure of an investor’s position, which would dis- suade parties from attempting to mislead the court when their standing as a creditor was already known. Judge Gerber’s proposed amendments sought to modernize Rule 2019 so that disclosure would provide a level

f transparency to not only the court,

but to all parties in interest, as well as, ultimately allow for the best interests of the estate to come through. He provided the committee with a thorough list of changes that would require the disclosure of the creditor’s position, whether short or long, as well as whether the creditor maintained any derivatives or default swaps. Essentially, he sought to require creditors to disclose any position that would result in their gain should the estate’s value diminish. Judge Gerber also argued that the rule was under-inclu- sive and sought to require disclosure by a much larger population of creditors, believing that his above-stated concerns were not limited to ad hoc committees alone but also applied to any creditors that possessed investments that profited from the demise of the estate. These suggestions, as well as testimony before the advisory committee, ultimately led to a compromise by the Federal Rules Committee, announcing a rule that incor- porated suggestions from both sides.

Amended Rule 2019

The amendments to Rule 2019 establish the “who, what, when and how” of disclosure by hedge funds and other distressed investors actively participating in chapter 11 and 9 proceedings.15 Amended Rule 2019 clarifies prior confusion among courts by making clear that Rule 2019’s disclosure requirements do apply to ad hoc

committees. Under subdivision (b)(1)
f the amended rule, a verified state-

ment must be filed by “every entity that represents multiple creditors or equity security holders that are (A) acting in concert to advance their common interests,” except for official committees of unsecured creditors or equityholders.16 Amended Rule 2019 also clarifies the scope of disclosure required of ad hoc committees. Under subdivision (c) (2), committees and groups subject to Rule 2019 must file a verified statement with the court, listing each member of the committee and any “disclosable economic interest” held by the member in relation to the debtor and acquired within a year of the petition date.17 The term “disclosable economic interest” 7 In฀re฀Washington฀Mut., 419 B.R. 271 (Bankr. D. Del. 2009). 8 Hon. Robert E. Gerber, Letter to the Federal Rules Advisory Committee, dated Jan. 9, 2009, www.uscourts.gov/uscourts/RulesAndPolicies/ rules/BK%20Suggestions%202008/08-BK-M-Suggestion-Gerber.pdf. 9 Hon. Robert D. Drain, Letter to the Federal Rules Advisory Committee, dated Jan. 13, 2009, www.uscourts.gov/uscourts/RulesAndPolicies/ rules/BK%20Suggestions%202008/08-BK-N-Suggestion-Drain.pdf. 10 Report of the Business Bankruptcy Committee Special Task Force on Bankruptcy Rule 2019, Dec. 12, 2008, www.uscourts.gov/uscourts/ RulesAndPolicies/rules/BK%20Suggestions%202008/08-BK-P- Suggestion-ABA%20Section%20of%20Business%20Law%20(Baxter).pdf. 11 National Bankruptcy Conference, Letter to the Bankruptcy Rules Advisory Committee, dated Dec. 10, 2008, www.uscourts.gov/uscourts/ RulesAndPolicies/rules/BK%20Suggestions%202008/08-BK-P- Suggestion-ABA%20Section%20of%20Business%20Law%20(Baxter).pdf. 12 Id. at 2-3. 13 Id. at 8. 14 Hon. Robert D. Drain, Letter to the Federal Rules Advisory Committee, dated Jan. 13, 2009, at 1. 15 A copy of Amended Rule 2019 is available at www.uscourts. gov/RulesAndPolicies/FederalRulemaking/PendingRules/ SupremeCourt042611.aspx. 16 Amended Rule 2019(b)(1). 17 Amended Rule 2019(c)(2)(B)-(C).

SLIDE 3 is defined broadly under subdivision (a)(1) to include any claim, option and derivative instrument or “other right or derivative right granting the holder an economic interest that is affected by the value, acquisition or disposition of a claim or interest.”18 Thus, under the amended Rule 2019, ad hoc committees will be required to disclose credit- default swap positions and other interests that formerly were not disclosed to courts under customary practice. Ad hoc committees’ duty to disclose these interests applies not only at the outset

f a bankruptcy case but throughout a

case in which it is actively participating, because subdivision (d) generally requires the filing of a supplemental verified statement whenever “any fact disclosed in its most recently filed statement has changed materially.”19 Significantly, amended Rule 2019 has softened the treatment of ad hoc committees from that under the initial proposed amendments to Rule 2019 in two important respects. First, amended Rule 2019 does not include language requiring ad hoc committees to disclose the purchase price of their members’

claims. The rules committee’s notes to

subsection (c)(1) do state that “nothing in this rule precludes either the discovery

f that information or its disclosure when
rdered by the court pursuant to author-

ity outside of this rule.”20 Thus, disclosure of the purchase prices and specific trading information of ad-hoc committee members may be still be ordered by a court pursuant to its inherent powers

r obtained by other discovery means

such as Rule 2004 in certain cases. Second, the amended Rule has deleted the enhanced sanctions provisions for failure to comply with Rule 2019 found in the initial proposed amendments.

Conclusion

The substance of amended Rule 2019 represents a compromise between the interests of advocates of greater transparency in claims trading and those of distressed-debt investors seeking to protect proprietary trading information. As such, the amendments may alleviate concerns for chilling the involvement of distressed investors in chapter 11 cases. n Reprinted฀with฀permission฀from฀the฀ABI฀ Journal,฀Vol.฀XXX,฀No.฀5,฀June฀2011. The฀ American฀ Bankruptcy฀ Institute฀ is฀ a฀ multi-disciplinary,฀nonpartisan฀organization฀ devoted฀ to฀ bankruptcy฀ issues.฀ ABI฀ has฀ more฀than฀13,000฀members,฀representing฀ all฀facets฀of฀the฀insolvency฀fjeld.฀For฀more฀ information,฀ visit฀ ABI฀ World฀ at฀ www. abiworld.org. 44฀Canal฀Center฀Plaza,฀Suite฀400฀฀•฀฀Alexandria,฀VA฀22314฀฀•฀฀(703)฀739-0800฀฀•฀฀Fax฀(703)฀739-1060฀฀•฀฀www.abiworld.org 18 Under subdivision (c)(2), a verified Rule 2019 statement must also list the date of acquisition of each member’s disclosable economic interests by quarter and year. 19 Amended Rule 2019(d). 20 Committee Note to Amended Rule 2019, Subdivision (b)(2).