The Wall Street Journal
In Six Flags Inc.'s bankruptcy case last fall, a hedge fund that owned senior bonds negotiated the theme-park company's reorganization plan, then dumped lower-ranking bonds it figured would lose value under the deal.
Other creditors cried foul. The hedge fund had used knowledge learned during its negotiations to gain an unfair edge, they suggested, accusing the fund of a "hijacking of the reorganization process."
So it goes in the rough-and-tumble new world of bankruptcy court. The bankruptcy process was created decades ago as a way to give ailing businesses a chance to heal and creditors a shot at repayment. Hedge funds and other big investors have transformed it into something else: a money-making venue where, after buying up distressed companies' debt at a deep discount, they can ply their sophisticated trading techniques in quest of profits. The "bankruptcy exchange," some call it.
This is perfectly legal, but is raising questions of transparency and fairness as the "distressed debt" investors joust with bankruptcy judges and others over what they must disclose as they trade in and out of a company's debt, even while trying to influence its reorganization.
To some in the bankruptcy bar, the investors' tactics are an affront to a tradition meant to nurse companies back to health and save jobs. At worst, say critics, the involvement of distressed-debt investors can turn a bankruptcy case into an insiders' game, putting at a disadvantage other creditors and even the judge who is trying to guide an outcome that best serves the company and the wide array of those it owes.
"Now what happens is you have very sophisticated people whose primary objective is material gain," says Harvey Miller, a veteran bankruptcy lawyer at Weil, Gotshal & Manges. "You've changed [bankruptcy] from at least the semblance of a rehabilitative approach to a casino approach of 'how do I make more money?'"
Distressed-debt investors say they play an important role in the bankruptcy process by buying claims from creditors who can't wait years for a resolution, and sometimes by providing loans that beleaguered companies need to keep operating.
They add that they honor all of the bankruptcy process's requirements, including bans on trading in company debt during periods when they have access to nonpublic knowledge.
In the Six Flags case, Marc Lasry, the founder of the hedge fund accused by other creditors of taking advantage of its negotiating position, said, "This vague aspersion was outrageous." Mr. Lasry, whose fund is called Avenue Capital Group, added: "We always follow every single rule."
But frictions such as these have led to an effort in the federal judiciary to revamp three-decade-old rules about what creditors in bankruptcy must reveal about their trading of company debt.
The distressed-debt market has grown rapidly. Edward Altman, a New York University finance professor, estimates it surpassed $1.6 trillion last year, up from roughly $250 billion two decades ago.
In a typical Chapter 11 filing, a company is protected from creditors while it develops a plan to repay as much as it can afford to and still remain viable. A trustee names an official committee of unsecured creditors, which watches over a reorganization and negotiates with the company. Committee members can't buy and sell the company's debt during this time because they often see nonpublic information.
But besides the official creditors' committee, ad hoc committees often form. Hedge funds and creditors that purchased debt in the secondary market frequently team up to influence the reorganization. A bankruptcy rule dating from 1978 requires creditors working together on informal committees to reveal what they bought and sold, on what date and at what price.
They sometimes resist, contending they aren't really "committees." Complicating matters, different bankruptcy judges facing the issue have reached different conclusions.
Before truck-parts supplier Accuride Corp. filed for Chapter 11 last October, six investment firms that owned a large chunk of its bonds negotiated a deal that would give them control of the company, in exchange for wiping out much of its debt.
At the start of the negotiations, the bonds traded at about 20 cents on the dollar. After five weeks of negotiations, they had soared to 61 cents, according to Thomson Reuters LPC.
Accuride shareholders, who stood to be wiped out, said the bondholders should be compelled to reveal what they had been doing in the Accuride-debt market during those five weeks and other times—what they bought and sold, when, and at what price.
The bondholders said they shouldn't have to, because they weren't a committee. They called themselves the "ad hoc noteholder group."
Other creditors cried foul. The hedge fund had used knowledge learned during its negotiations to gain an unfair edge, they suggested, accusing the fund of a "hijacking of the reorganization process."
So it goes in the rough-and-tumble new world of bankruptcy court. The bankruptcy process was created decades ago as a way to give ailing businesses a chance to heal and creditors a shot at repayment. Hedge funds and other big investors have transformed it into something else: a money-making venue where, after buying up distressed companies' debt at a deep discount, they can ply their sophisticated trading techniques in quest of profits. The "bankruptcy exchange," some call it.
This is perfectly legal, but is raising questions of transparency and fairness as the "distressed debt" investors joust with bankruptcy judges and others over what they must disclose as they trade in and out of a company's debt, even while trying to influence its reorganization.
To some in the bankruptcy bar, the investors' tactics are an affront to a tradition meant to nurse companies back to health and save jobs. At worst, say critics, the involvement of distressed-debt investors can turn a bankruptcy case into an insiders' game, putting at a disadvantage other creditors and even the judge who is trying to guide an outcome that best serves the company and the wide array of those it owes.
"Now what happens is you have very sophisticated people whose primary objective is material gain," says Harvey Miller, a veteran bankruptcy lawyer at Weil, Gotshal & Manges. "You've changed [bankruptcy] from at least the semblance of a rehabilitative approach to a casino approach of 'how do I make more money?'"
Distressed-debt investors say they play an important role in the bankruptcy process by buying claims from creditors who can't wait years for a resolution, and sometimes by providing loans that beleaguered companies need to keep operating.
They add that they honor all of the bankruptcy process's requirements, including bans on trading in company debt during periods when they have access to nonpublic knowledge.
In the Six Flags case, Marc Lasry, the founder of the hedge fund accused by other creditors of taking advantage of its negotiating position, said, "This vague aspersion was outrageous." Mr. Lasry, whose fund is called Avenue Capital Group, added: "We always follow every single rule."
But frictions such as these have led to an effort in the federal judiciary to revamp three-decade-old rules about what creditors in bankruptcy must reveal about their trading of company debt.
The distressed-debt market has grown rapidly. Edward Altman, a New York University finance professor, estimates it surpassed $1.6 trillion last year, up from roughly $250 billion two decades ago.
In a typical Chapter 11 filing, a company is protected from creditors while it develops a plan to repay as much as it can afford to and still remain viable. A trustee names an official committee of unsecured creditors, which watches over a reorganization and negotiates with the company. Committee members can't buy and sell the company's debt during this time because they often see nonpublic information.
But besides the official creditors' committee, ad hoc committees often form. Hedge funds and creditors that purchased debt in the secondary market frequently team up to influence the reorganization. A bankruptcy rule dating from 1978 requires creditors working together on informal committees to reveal what they bought and sold, on what date and at what price.
They sometimes resist, contending they aren't really "committees." Complicating matters, different bankruptcy judges facing the issue have reached different conclusions.
Before truck-parts supplier Accuride Corp. filed for Chapter 11 last October, six investment firms that owned a large chunk of its bonds negotiated a deal that would give them control of the company, in exchange for wiping out much of its debt.
At the start of the negotiations, the bonds traded at about 20 cents on the dollar. After five weeks of negotiations, they had soared to 61 cents, according to Thomson Reuters LPC.
Accuride shareholders, who stood to be wiped out, said the bondholders should be compelled to reveal what they had been doing in the Accuride-debt market during those five weeks and other times—what they bought and sold, when, and at what price.
The bondholders said they shouldn't have to, because they weren't a committee. They called themselves the "ad hoc noteholder group."
At a hearing in a federal bankruptcy court in Delaware, Judge Brendan Shannon challenged their argument, asking their lawyer, "Are you a committee?" The lawyer began to answer, "Well, actually, your honor, we are a group of—"
Interrupting, Judge Shannon said sarcastically: "A gaggle, a murder, a pod, a herd." (A flock of crows is sometimes called a "murder.")
The judge ordered the bondholders to file trading disclosures with the court, but kept them under seal. The Wall Street Journal has sought to unseal them, a move bondholders are resisting.
Members of the bondholders' group, who early in the process held 70% of the bonds, sold most of them sometime before Jan. 29, court filings show. By then, the bonds were going for 91 cents on the dollar, or 4 ½ times their value when the group first began negotiating a reorganization—suggesting fat profits for distressed-debt investors.
The investors either declined to comment or didn't respond to requests. They were Brigade Capital Management, Canyon Capital Advisors, Sankaty Advisors, BlackRock Financial Management, Tinicum Inc. and Principal Global Investors. Accuride emerged from bankruptcy in February.
Advocates of increased disclosure by debt investors say it will help bankruptcy judges better evaluate their proposals for shaping a reorganization. If, for instance, certain investors had placed a "short" bet—hoping to profit if the debt fell in value—their interest in a reorganization plan could be opposite that of other creditors.
In Adelphia Communications Corp.'s Chapter 11 proceedings, members of an ad hoc committee made disclosures of their holdings but didn't mention short positions held by two members, the bankruptcy judge wrote in a footnote in another case and in a letter to a judiciary panel drafting new rules.
Those investors, who weren't identified, stood to benefit if a restructuring was delayed or stymied. Sure enough, when a reorganization was proposed, they voted against it, according to the judge's account.
A motion to disqualify their votes was made, though it was withdrawn when it became clear they couldn't block the restructuring. If the motion in federal bankruptcy court in Manhattan hadn't been withdrawn, and "if the evidence the Court heard was not refuted, the Court would have [disqualified] their votes in a heartbeat," wrote the judge, Robert Gerber, in the footnote. Adelphia emerged from bankruptcy in early 2007.
Testifying this February before the judiciary panel rewriting disclosure rules, Judge Gerber urged strong regulation: "The notion that the transparency and integrity of the bankruptcy system upon which people have relied for decades can be abandoned or cut back to serve investors' desires is very troublesome to me. In fact, it's downright offensive."
The panel settled on a rule saying investors who band together in informal committees must always reveal their "economic interest" in a company, including stocks, debt and bearish bets. Hedge funds succeeded in watering down the proposal so in circumstances where they must disclose the timing of their trades, they need at most reveal only the quarter in which they bought, not specific dates or prices paid.
Thomas Lauria, a White & Case bankruptcy lawyer who often represents hedge funds, says if courts required too much disclosure, "there would be significant unintended consequences," including "shutting down the secondary debt markets."
The revamped rule will take effect by December 2011 if it is approved by one more panel and the Supreme Court, and isn't blocked by Congress.
Six Flags's Chapter 11 case in Delaware federal bankruptcy court last year intensified the disclosure debate, as hedge funds' tactics drew a protest from other creditors.
This was a case with many twists and turns. At one point, banks were poised to take ownership of the chain. At two other points, a group of senior bondholders sought to negotiate a reorganization that would hand them control. They stopped trading in Six Flags debt for temporary stretches so they could see nonpublic data.
The senior bondholders appeared to win on Nov. 6, when Six Flags filed a bankruptcy plan that handed them the bulk of new equity. As soon as private information they had seen was made public, the group, led by Mr. Lasry's Avenue Capital, became free to resume trading in the company's debt.
Sometime the following week, Avenue sold holdings of some lower-ranking bonds. This is what prompted the official creditors' committee to complain that the bondholder group had gained an unfair edge, in that its negotiations with Six Flags gave it insight into what was likely to happen to the value of those lower-ranking bonds.
Questioning when the divestitures occurred, the official committee asked the judge to force the Avenue group to reveal its trades in Six Flags debt and when they took place.
Mr. Lasry says the sales of lower-ranking bonds occurred only after any nonpublic information the Avenue group had seen was made public. "We try not to get restricted [from trading]," he said, but "if we do get restricted, then we follow the rules and end up waiting until the information is public to trade."
The Avenue group was allowed to keep its trading secret. Bankruptcy Judge Christopher Sontchi decided they didn't constitute a "committee."
As it happened, the decision to unload lower-ranking bonds proved not so smart. That's because, in yet another twist in the convoluted case, lower-ranking creditors then raised enough money to pay the senior bondholders and ultimately got control of the company.
Not that Avenue went home empty-handed. The senior bonds it held were repaid at par plus interest, netting the hedge fund a profit of about $100 million.
As for the lower-ranking bondholders who ended up in control, they, too, were hedge funds—a different set of distressed-debt investors.
Bankruptcy-court judges have sometimes expressed strong annoyance at the tactics of such investors.
ION Media Networks was on the cusp of emerging from bankruptcy last November when hedge fund Cyrus Capital Partners, which had proposed a different plan favoring itself, objected at a hearing in federal bankruptcy court in Manhattan.
Judge James Peck complained that this creditor had bought debt for "cents on the dollar" and then "decided to hijack the bankruptcy case." He wrote that the fund was "using aggressive bankruptcy litigation tactics as a means to gain negotiating leverage or obtain judicial rulings that will enable it to earn outsize returns on its bargain-basement debt purchases at the expense of" senior lenders.
After the reorganization plan was approved, Cyrus asked Judge Peck to delay ION's exit from bankruptcy while the fund appealed. This prompted another rebuke from the judge. "So you're looking at a free shot to continue your terrorism in this case at different levels of the federal system?" he asked, according to a transcript of the hearing.
Cyrus's lawyer responded: "Not at all, your honor, and from my client's perspective we object to the use of terrorism here."
A person close to Cyrus said the hedge fund had solid legal arguments for its position that some outside legal experts also found sound, and that the price it paid for its debt had "no legal relevance" to its rights.
"Cyrus is not a firm that makes senseless legal arguments, simply to hold up bankruptcy processes for gain," the person said, adding that Cyrus fights vigorously to defend investors' rights when it believes it is on the right side of the law.
ION emerged from bankruptcy in December owned by its senior lenders, which also were mainly hedge funds, among them Avenue Capital.
Jonathan Henes, a Kirkland & Ellis lawyer who represented ION, said that while there is "nothing wrong" with hedge funds placing bets on troubled companies' debt in pursuit of profits, that isn't the goal of the bankruptcy code. It "was established for companies to rehabilitate their operations, fix their capital structures, preserve jobs and treat creditors fairly," Mr. Henes said. "Bankruptcy isn't designed to make sure that investors make money."
Interrupting, Judge Shannon said sarcastically: "A gaggle, a murder, a pod, a herd." (A flock of crows is sometimes called a "murder.")
The judge ordered the bondholders to file trading disclosures with the court, but kept them under seal. The Wall Street Journal has sought to unseal them, a move bondholders are resisting.
Members of the bondholders' group, who early in the process held 70% of the bonds, sold most of them sometime before Jan. 29, court filings show. By then, the bonds were going for 91 cents on the dollar, or 4 ½ times their value when the group first began negotiating a reorganization—suggesting fat profits for distressed-debt investors.
The investors either declined to comment or didn't respond to requests. They were Brigade Capital Management, Canyon Capital Advisors, Sankaty Advisors, BlackRock Financial Management, Tinicum Inc. and Principal Global Investors. Accuride emerged from bankruptcy in February.
Advocates of increased disclosure by debt investors say it will help bankruptcy judges better evaluate their proposals for shaping a reorganization. If, for instance, certain investors had placed a "short" bet—hoping to profit if the debt fell in value—their interest in a reorganization plan could be opposite that of other creditors.
In Adelphia Communications Corp.'s Chapter 11 proceedings, members of an ad hoc committee made disclosures of their holdings but didn't mention short positions held by two members, the bankruptcy judge wrote in a footnote in another case and in a letter to a judiciary panel drafting new rules.
Those investors, who weren't identified, stood to benefit if a restructuring was delayed or stymied. Sure enough, when a reorganization was proposed, they voted against it, according to the judge's account.
A motion to disqualify their votes was made, though it was withdrawn when it became clear they couldn't block the restructuring. If the motion in federal bankruptcy court in Manhattan hadn't been withdrawn, and "if the evidence the Court heard was not refuted, the Court would have [disqualified] their votes in a heartbeat," wrote the judge, Robert Gerber, in the footnote. Adelphia emerged from bankruptcy in early 2007.
Testifying this February before the judiciary panel rewriting disclosure rules, Judge Gerber urged strong regulation: "The notion that the transparency and integrity of the bankruptcy system upon which people have relied for decades can be abandoned or cut back to serve investors' desires is very troublesome to me. In fact, it's downright offensive."
The panel settled on a rule saying investors who band together in informal committees must always reveal their "economic interest" in a company, including stocks, debt and bearish bets. Hedge funds succeeded in watering down the proposal so in circumstances where they must disclose the timing of their trades, they need at most reveal only the quarter in which they bought, not specific dates or prices paid.
Thomas Lauria, a White & Case bankruptcy lawyer who often represents hedge funds, says if courts required too much disclosure, "there would be significant unintended consequences," including "shutting down the secondary debt markets."
The revamped rule will take effect by December 2011 if it is approved by one more panel and the Supreme Court, and isn't blocked by Congress.
Six Flags's Chapter 11 case in Delaware federal bankruptcy court last year intensified the disclosure debate, as hedge funds' tactics drew a protest from other creditors.
This was a case with many twists and turns. At one point, banks were poised to take ownership of the chain. At two other points, a group of senior bondholders sought to negotiate a reorganization that would hand them control. They stopped trading in Six Flags debt for temporary stretches so they could see nonpublic data.
The senior bondholders appeared to win on Nov. 6, when Six Flags filed a bankruptcy plan that handed them the bulk of new equity. As soon as private information they had seen was made public, the group, led by Mr. Lasry's Avenue Capital, became free to resume trading in the company's debt.
Sometime the following week, Avenue sold holdings of some lower-ranking bonds. This is what prompted the official creditors' committee to complain that the bondholder group had gained an unfair edge, in that its negotiations with Six Flags gave it insight into what was likely to happen to the value of those lower-ranking bonds.
Questioning when the divestitures occurred, the official committee asked the judge to force the Avenue group to reveal its trades in Six Flags debt and when they took place.
Mr. Lasry says the sales of lower-ranking bonds occurred only after any nonpublic information the Avenue group had seen was made public. "We try not to get restricted [from trading]," he said, but "if we do get restricted, then we follow the rules and end up waiting until the information is public to trade."
The Avenue group was allowed to keep its trading secret. Bankruptcy Judge Christopher Sontchi decided they didn't constitute a "committee."
As it happened, the decision to unload lower-ranking bonds proved not so smart. That's because, in yet another twist in the convoluted case, lower-ranking creditors then raised enough money to pay the senior bondholders and ultimately got control of the company.
Not that Avenue went home empty-handed. The senior bonds it held were repaid at par plus interest, netting the hedge fund a profit of about $100 million.
As for the lower-ranking bondholders who ended up in control, they, too, were hedge funds—a different set of distressed-debt investors.
Bankruptcy-court judges have sometimes expressed strong annoyance at the tactics of such investors.
ION Media Networks was on the cusp of emerging from bankruptcy last November when hedge fund Cyrus Capital Partners, which had proposed a different plan favoring itself, objected at a hearing in federal bankruptcy court in Manhattan.
Judge James Peck complained that this creditor had bought debt for "cents on the dollar" and then "decided to hijack the bankruptcy case." He wrote that the fund was "using aggressive bankruptcy litigation tactics as a means to gain negotiating leverage or obtain judicial rulings that will enable it to earn outsize returns on its bargain-basement debt purchases at the expense of" senior lenders.
After the reorganization plan was approved, Cyrus asked Judge Peck to delay ION's exit from bankruptcy while the fund appealed. This prompted another rebuke from the judge. "So you're looking at a free shot to continue your terrorism in this case at different levels of the federal system?" he asked, according to a transcript of the hearing.
Cyrus's lawyer responded: "Not at all, your honor, and from my client's perspective we object to the use of terrorism here."
A person close to Cyrus said the hedge fund had solid legal arguments for its position that some outside legal experts also found sound, and that the price it paid for its debt had "no legal relevance" to its rights.
"Cyrus is not a firm that makes senseless legal arguments, simply to hold up bankruptcy processes for gain," the person said, adding that Cyrus fights vigorously to defend investors' rights when it believes it is on the right side of the law.
ION emerged from bankruptcy in December owned by its senior lenders, which also were mainly hedge funds, among them Avenue Capital.
Jonathan Henes, a Kirkland & Ellis lawyer who represented ION, said that while there is "nothing wrong" with hedge funds placing bets on troubled companies' debt in pursuit of profits, that isn't the goal of the bankruptcy code. It "was established for companies to rehabilitate their operations, fix their capital structures, preserve jobs and treat creditors fairly," Mr. Henes said. "Bankruptcy isn't designed to make sure that investors make money."
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