TIPPING THE SCALES IN CHAPTER 11: HOW …commission.abi.org/sites/default/files/Thomas.pdf · thomas galleysfinal 2/16/2011 12:05 pm tipping the scales in chapter 11: how distressed

THOMAS GALLEYSFINAL 2/16/2011 12:05 PM

TIPPING THE SCALES IN CHAPTER 11: HOW DISTRESSED DEBT INVESTORS DECREASE DEBTOR LEVERAGE AND

THE EFFICACY OF BUSINESS REORGANIZATION

INTRODUCTION

Congress drafted chapter 11 of the Bankruptcy Code to provide a forum where creditors and business debtors enter the reorganization process with the common interest of maximizing returns to all creditors through the debtor’s rehabilitation,1 while preserving the going-concern value2 of the debtor.3 Contravening this purpose, chapter 11 also allows nontraditional creditors4 to buy claims5 at a steep discount once a business files for bankruptcy and to demand full payment of these claims.6 These nontraditional creditors are known as distressed debt investors7 or vulture funds.8 For the purposes of this Comment, “DDI” will be used to describe all parties that invest in distressed

1 Chaim J. Fortgang & Thomas Moers Mayer, Trading Claims and Taking Control of Corporations in Chapter 11, 12 CARDOZO L. REV. 1, 12–13 (1990) [hereinafter Fortgang & Mayer, Trading Claims]. 2 “Going concern value” is defined as the positive difference between the debtor’s liquidation value and value of the business in continued operation. See H.R. REP. NO. 95-595, at 223 (1977) (“[G]oing-concern value . . . is usually higher than the liquidation value of the business, because assets in operation can usually earn more than assets sold for scrap.”). 3 Id. at 220 (“The purpose of a business reorganization case, unlike a liquidation case, is to restructure a business’s finances so that it may continue to operate, provide its employees with jobs, pay its creditors . . . . It is more economically efficient to reorganize than to liquidate . . . .”). 4 The term “traditional creditor” refers to institutional lenders envisioned by the drafters of chapter 11. Traditional creditors have relationships with the debtor long before the debtor files for bankruptcy and provide capital in expectation of a long-term relationship with the debtor and the successful operation of the debtor’s business. Non-traditional creditors are those creditors that have no prior relationship with the debtor and invest during bankruptcy to obtain a short-term return on their initial investment as well as on investments at other levels of the debtor. See Harvey R. Miller, Chapter 11 Reorganization Cases and the Delaware Myth, 55 VAND. L. REV. 1987, 2014 (2002). 5 Claims are debts accumulated by the debtor, such as trade debts, bank debts, tort claims, and other obligations that sophisticated investors treat like securities and trade for consideration. Daniel Sullivan, Big Boys and Chinese Walls, 75 U. CHI. L. REV. 533, 533 (2004). 6 Frederick Tung, Confirmation and Claims Trading, 90 NW. U. L. REV. 1684, 1699 (1996); see also Michelle M. Harner, Trends in Distressed Debt Investing: An Empirical Study of Investors’ Objectives, 16 AM. BANKR. INST. L. REV. 69, 76 (2008) (“The concept of ‘relationship lending,’ where a bank would work with a troubled company to develop a mutually-agreeable restructuring plan to foster repeat business with the company, is now the rare exception rather than the rule.”). 7 Hereinafter “DDI.” 8 Vulture Fund, INVESTOPEDIA, http://www.investopedia.com/terms/v/vulturefund.asp, (last visited Sept. 27, 2010) (“[T]hese funds are like circling vultures patiently waiting to pick over the remains of a rapidly weakening company. The goal is high returns at bargain prices.”).


214 EMORY BANKRUPTCY DEVELOPMENTS JOURNAL [Vol. 27

debt, while “vulture fund” will refer to a DDI that either seeks short-term returns through distressed debt investing, or attempts to take control of corporations when they exit chapter 11.9

Often, vulture funds have no interest in a successful reorganization,10 and they use their leverage to obtain short-term returns on investments at the expense of the debtor and other creditors.11 DDIs are not bad or malicious; however, like all participants in chapter 11 cases, DDIs are rational actors that attempt to maximize profits. Problematically, there is no individual entity present in a chapter 11 proceeding that represents the preservation of going-concern value or the rehabilitation of the debtor. It is easy to see why traditional creditors have interests inapposite to preserving going-concern value: they want their money.12 The individuals that comprise the debtor’s management may theoretically represent the preservation of going-concern value and the interests of the debtor; however, these individuals are impermanent and have concerns external to the debtor, such as personal well-being and continued employment.13 Instead, the rules of the game—the provisions of chapter 11—are present to protect going-concern value and promote rehabilitation. The rules are far from perfect. Congress enacted the basic structure of chapter 11 in the Bankruptcy Reform Act of 1978,14 which took effect on January 1, 1979, before claims-trading was a popular investment strategy.15 DDIs are currently able to pursue strategies that the drafters of

9 See, e.g., Michelle M. Harner, The Corporate Governance and Public Policy Implications of Activist Distressed Debt Investing, 77 FORDHAM L. REV. 703, 716–17 n.55 (2008). 10 Chapter 22: Are Vulture Investors to Blame?, 38 Bankr. Ct. Dec. (LRP) No. 4, at A1 (Aug. 21, 2001) (“[Vulture investors] are looking to buy at 40 and sell at 50. They’re only interested in their particular piece of paper. They couldn’t care less about the constructive process of developing a reasonable plan.”). 11 See Miller, supra note 4, at 2014; see also Steven Andersen, Distressed Debt; New Players, Global Sophistication Make Restructuring More Complex, INSIDE COUNSEL, May 2008, at 12 (“Nontraditional lenders often like the fact that debt is in default. If they do their homework right, they can buy-in at a discount and gain huge returns, but their primary concern is not necessarily that the borrower pay off the loan.”). 12 Indeed, a foundational premise of bankruptcy law, given creditors’ propensities to pursue their claims aggressively, is the need for a common collection procedure to prevent the individual state remedies available to creditors from being a detriment to creditors as a whole. Thomas H. Jackson, Of Liquidation, Continuation, and Delay: An Analysis of Bankruptcy Policy and Nonbankruptcy Rules, 60 AM. BANKR. L.J. 399, 399 (1986). 13 See Henry Hu & Jay Lawrence Westbrook, Abolition of the Corporate Duty to Creditors, 107 COLUM. L. REV. 1321, 1377 (2007). 14 Hereinafter “the ‘78 Act.” 15 Harner, supra note 9, at 710; Fortgang & Mayer, Trading Claims, supra note 1, at 13; see also Chaim J. Fortgang & Thomas Moers Mayer, Developments in Trading Claims: Participations and Disputed Claims, 15 CARDOZO L. REV. 733, 733 (1993).


2010] TIPPING THE SCALES IN CHAPTER 11 215

chapter 1116 did not contemplate and that contravene the policy choices made in creating the system.17

Specifically, claim flipping18 and betting against the success of reorganization19 are popular strategies used by vulture funds that tend to exacerbate the difficulties of complex business reorganizations. Furthermore, vulture fund involvement decreases a debtor’s leverage in negotiations by increasing confusion, thereby delaying productive negotiations.20 These delays diminish the value of the estate and prevent a debtor from investing in negotiations because the identities of creditors are not constant.21 Finally, vulture funds that actively seek control of the debtor through the reorganization process create disincentives for a debtor’s management to file a proactive plan for reorganization.22 The culminating effect of nontraditional creditor involvement is to decrease the debtor’s ability to preserve going-concern value, which is contrary to the purpose of business reorganization.23

While distressed debt trading is undoubtedly big business—estimates place the market in the hundreds of billions of dollars24—its consequences for the

16 See Jonathan C. Lipson, The Shadow Bankruptcy System, 89 B.U. L. REV. 1609, 1614–15 (2009) (arguing that chapter 11 creates a “shadow bankruptcy” system where “[s]ophisticated and aggressive private investors exploit interstices in [c]hapter 11, and between [c]hapter 11 and other laws—in particular federal securities laws—that might check their behavior”). 17 These policy choices include the premise that rehabilitation may benefit creditors more than a piecemeal liquidation of the debtor’s assets. See Fla. Dep’t of Revenue v. Piccadilly Cafeterias, Inc., 554 U.S. 33, 50 (2008) (noting that chapter 11 has “twin objectives of ‘preserving going concerns and maximizing property available to satisfy creditors” (quoting Bank of Am. Nat’l. Trust and Sav. Ass’n. v. 203 N. LaSalle St. P’ship, 526 U.S. 434, 453 (1999))); H.R. REP. NO. 95-595, at 220 (1977) (“The purpose of a business reorganization case, unlike a liquidation case, is to restructure a business’s finances so that it may continue to operate, provide its employees with jobs, pay its creditors . . . . It is more economically efficient to reorganize than to liquidate . . . .”). Reorganization may also preserve jobs and tax bases in the communities where the debtor operates while preventing the general upheaval caused by liquidation. 7 COLLIER ON BANKRUPTCY ¶ 1100.01 (Alan N. Resnick & Henry J. Sommer eds., 16th ed. 2010). 18 Purchasing and selling claims for a profit before plan confirmation. See infra text accompanying notes 120–26. 19 See infra text accompanying notes 127–45. 20 See infra text accompanying notes 163–71. 21 See infra text accompanying notes 163–71. 22 See infra text accompanying notes 212–31. 23 See H.R. REP. NO. 95-595, at 220 (1977). 24 Adam J. Levitin, Finding Nemo: Rediscovering the Virtues of Negotiability in the Wake of Enron, 2007 COLUM. BUS. L. REV. 83, 86 (2007); Tung, supra note 6, at 1685 (“The size of the [distressed debt] market was estimated to run as high as $300 billion.”); see also Robert D. Drain & Elizabeth J. Schwartz, Are Bankruptcy Claims Subject to the Federal Securities Laws?, 10 AM. BANKR. INST. L. REV. 569, 569–70 (2002) (“[T]rading in distressed debt continued to increase, with the formation of numerous distressed debt funds with assets in excess of $1 billion.”).



restructuring process remain recondite outside the bankruptcy community. The negative externalities attributable to vulture funds may have gone unnoticed due to the decrease in reorganization filings experienced in the United States between 2003 and 2007.25 However, the recession that began in 2007 with the subprime mortgage collapse created a boom in reorganization filings that will continue into the foreseeable future,26 causing distressed debt trading and other detrimental actions of vulture funds to become more prominent across business and legal communities.27 Therefore, distressed debt trading will serve as a major obstacle in reorganizations, which stand to be more commonplace in the wake of the subprime mortgage collapse.

This Comment argues that the Bankruptcy Code28 should be revised to promote traditional reorganization—as envisioned under the ‘78 Act—while taking into account the realities of today’s market and preserving the positive attributes of claims trading. Specifically, it argues that the Code should be revised in a pro-debtor fashion to restore the balance between debtor- and creditor-leverage. To solve the issues that distressed debt trading creates during reorganization, the Code should be revised to: (1) require disclosure of all holdings that a DDI has in the debtor, and a determination by the court of whether the DDI’s interests are adverse to, or in line with, a reorganization; (2) create restrictions on the resale of claims once a creditor has sold a claim to a DDI or other creditor; and (3) allow for a bankruptcy payment to corporate management that files for chapter 11 proactively, but eliminate the payment if creditors successfully argue that management delayed filing a plan and engaged in behavior that increased corporate debt––similar to the tort theory of deepening insolvency.29

25 See generally Harvey R. Miller, Chapter 11 in Transition—From Boom to Bust and Into the Future, 81 AM. BANKR. L.J. 375, 376–77 (2007). 26 Id. 27 Some commentators, including the bankruptcy-data firm New Generation Research, Inc., predicted that the number of prearranged bankruptcy plans approved in 2009 would double from 2008 due to the economic crisis and frozen credit markets. Mike Specter & Jeffrey McCracken, Barbarians in Bankruptcy Court—Merger Financiers Find Action Now in Chapter 11; ‘Debt Is the New Equity’, WALL ST. J., June 18, 2009, at C1. 28 11 U.S.C. § 101 et seq. (2006). Hereinafter “the Code.” 29 This approach attempts to reach a middle ground between those arguments that state that chapter 11 is obsolete in a modern economy and those that state that traditional reorganizations remain relevant. Compare Douglas G. Baird & Robert K. Rasmussen, Chapter 11 at Twilight, 56 STAN. L. REV. 673 (2003), and Michael Bradley & Michael Rosenzweig, The Untenable Case for Chapter 11, 101 YALE L. J. 1043 (1992), with Harvey R. Miller & Shai Y. Waisman, Is Chapter 11 Bankrupt?, 47 B.C. L. REV. 129 (2005).



This Comment progresses in three parts. Part I provides background concerning distressed debt trading. Part II briefly presents the traditional goals of chapter 11 and argues that predatory distressed debt trading undermines the traditional purposes of chapter 11 reorganization by: (1) draining value from the estate through claim flipping;30 (2) providing a forum for predatory DDIs to use leverage through acquired debt to sink negotiations and profit on non-debt investments in the debtor; (3) creating an asymmetry of information in favor of creditors during negotiations, which in turn creates a Lemon’s Problem for the Debtor in Possession; (4) creating coercive markets for claims, which drive down the prices of distressed debt; (5) increasing the rates of chapter 11 recidivism by decreasing the leverage that the debtor derives from exclusivity; and (6) decreasing the incentives for management of public corporations to file for chapter 11 protection proactively in an effort to preserve assets for creditors. Finally, Part III posits possible solutions to the problems that distressed debt investing creates for business reorganizations.

I. VULTURE FUNDS: WHAT IS DISTRESSED DEBT TRADING?

“If we were asked—Who made the discovery which has most deeply affected the fortunes of the human race? We think, after full consideration, we might safely answer - The man who first discovered that a Debt is a Saleable Commodity.”31

The distressed-debt market consists of nontraditional investors purchasing “debt, equity or trade claims of companies in financial distress or already in default.”32 Claims-trading offers a beneficial opportunity for two distinct groups: willing sellers and willing buyers.33 Creditors can avoid the cost and hassle of extended chapter 11 negotiations and cut their losses by selling their claims, often at a discount in order to attract buyers.34 Conversely, distressed-debt investors have an opportunity “to arbitrage the bankruptcy payment risk

30 For a definition of claim flipping, see infra notes 120–26 and accompanying text. 31 Miller, supra note 25, at 377 (quoting HENRY DUNNING MACLEOD, 31 THE PRINCIPLES OF ECONOMIC

PHILOSOPHY 481 (Longmans, Green, Reader, and Dyer, 2d ed. 1872)). 32 HEDGE FUNDS CONSISTENCY INDEX, http://www.hedgefund-index.com/SectorDefinitions.asp# DistressedSecurities (last visited Sep. 7, 2010). 33 Tung, supra note 6, at 1688. 34 See Harner, supra note 6, at 75 (“The amount of the discount varies by situation, but can range from a low discount of 20% to a high discount of 60% or perhaps even 80%.”); see also Michelle Campbell, Savvy Claims Purchasers Must Avoid Pitfalls, 25-5 AM. BANKR. INST. J. 26, 26 (2006); see also Tung, supra note 6, at 1686.



for a profit, buying the claims at a lower price than the expected payout.”35 Crucial to the distressed-debt trader is the ability to assert leverage in the reorganization process based on the face value of the claim, despite the discount price.36 The ultimate goal of the DDI is “to purchase a good seat at the negotiating table in order to influence the terms of reorganization”37 to achieve optimal returns on its investment.

The distressed-debt market is significant. Some commentators estimate that $500 billion changes hands each year within the market for distressed debt.38 In large bankruptcy proceedings, DDIs are commonly among the largest claimholders. When Adelphia Communications filed for bankruptcy in June 2002, three of the largest bondholders were DDIs.39 Similarly, when Enron filed under chapter 11, two DDIs acquired $2 billion worth of corporate notes to become two of the three largest claimants in the bankruptcy.40

Despite the size and liquidity of the distressed-debt market, it is largely unregulated.41 Many participants are hedge funds that are generally exempt from the Securities and Exchange Commission’s disclosure requirements.42

35 Levitin, supra note 24, at 87. Distressed-debt traders have motives beyond arbitraging claims such as purchasing claims to facilitate standing as a party in interest in particular proceedings, as well as acquiring claims in order to obtain equity in the reorganized business. Campbell, supra note 34, at 26. 36 W. Andrew P. Logan III, Note, Claims Trading: The Need for Further Amending Federal Rule of Bankruptcy Procedure 3001(e)(2), 2 AM. BANKR. INST. L. REV. 495, 495 (1994); see also Tung, supra note 6, at 1686; HEDGE FUNDS CONSISTENCY INDEX, supra note 32 (“The securities of companies in distressed or defaulted situations typically trade at substantial discounts to par value due to difficulties in analyzing a proper value for such securities, lack of street coverage, or simply an inability on behalf of traditional investors to accurately value such claims . . . .”) (emphasis added). 37 Tung, supra note 6, at 1686. 38 Julius Melnitzer, Judge Scheindlin Mollifies Distressed Debt Market, INSIDE COUNSEL, Nov. 1, 2007, at 75. 39 Paul M. Goldschmid, Note, More Phoenix than Vulture: The Case for Distressed Investor Presence in the Bankruptcy Reorganization Process, 2005 COLUM. BUS. L. REV. 191, 200–01 (2005) (citing Peter Lauria, Adelphia off to Chapter 11, DAILY DEAL, June 22, 2002). 40 Id. at 201 (citing Henny Sender, Enron Bets May Bite ‘Vulture’ Firms, WALL ST. J., May 23, 2002, at C1). 41 The sole limitation for unregulated hedge funds is Federal Rule of Bankruptcy Procedure 3001(e). See generally Drain & Schwartz, supra note 24, at 571–72 (describing application of U.S. securities laws to claims trading). 42 See Peter M. Gilhuly et. al, Living on the [H]edge: New Ethical Challenges, 2007 NATIONAL

CONFERENCE OF BANKRUPTCY JUDGES (2007) (stating that the inapplicability of securities regulations is one of the reasons why the precise size of the market is unknown, leading commentators to speculate as to the size of the distressed debt market); see also $8 Billion in Unsecured Claims Traded in 2009, 52 Bankr. Ct. Dec. (LRP) No. 21 (Mar. 16, 2010) (“Given the fact that 3001(e) of the Federal Rules of Bankruptcy Procedure only requires notice be filed with the court when the legal title of a bankruptcy claim is transferred—not the beneficial interest—a handle on the universe of trading in bankruptcy claims is out of reach.”).



Furthermore, pertinent provisions of the Federal Rules of Bankruptcy Procedure have been hamstrung by congressional amendments and judicial applications that are detrimental to debtors but beneficial to DDIs.

The 1991 amendment to Federal Rule of Bankruptcy Procedure 3001(e)43 increased the frequency of claims-trading by eliminating the disclosure requirement for the terms and consideration upon transfer of the claim.44 The prior version of FRBP 3001(e) contemplated “that the court [would] enter the order of substitution only after a hearing on notice and further [permitted] the court to enter such an order as [was] appropriate.”45 Congress increased the liquidity of the claims through the 1991 amendments to FRBP 3001(e), by limiting the role of the court only to situations when a dispute arises between a transferor and transferee of the claim.46 Congress states in the advisory committee notes that the purpose of the amendments is “to limit the court’s role to the adjudication of disputes regarding transfers of claims.”47

Before the revision, the court’s power in determining the propriety of a transfer stemmed from § 1126(e).48 Section 1126(e) remains in effect and allows the court to exclude transferred claims from class acceptance49 by designating those claims as solicited or procured in bad faith pursuant to § 1126(c).50 However, the revision of FRBP 3001(e) seriously limits the court’s ability to police claims-trading and determine bad faith transfers. The previous version of FRBP 3001(e) required the post-petition transferee to provide the terms and consideration for the transfer to allow the court to deal “with evils that may arise out of post-bankruptcy traffic in claims against an estate.”51 These evils included the transfer of claims to manipulate other creditors’ interests,52 to prevent confirmation and destroy an enterprise in order to advance a competing interest,53 to aid an interest other than an interest as a

43 FED. R. BANKR. P. 3001(e). Hereinafter “FRBP 3001(e). 44 Miller, supra note 4, at 2016. 45 In re Revere Copper & Brass, Inc., 58 B.R. 1, 2 (Bankr. S.D.N.Y. 1985). 46 Michael H. Whitaker, Note, Regulating Claims Trading in Chapter 11 Bankruptcies: A Proposal for Mandatory Disclosure, 3 CORNELL J.L. & PUB. POL’Y 303, 320 (1994). 47 FED. R. BANKR. P. 3001(e) advisory committee’s note. 48 11 U.S.C. § 1126(e) (2006) (“[T]he court may designate any entity whose acceptance of such plan was not in good faith . . . .”). 49 Id. § 1126(c) (excluding entities designated under § 1126(e) from participating in class acceptance). 50 Id. 51 See In re Revere Copper & Brass, Inc., 58 B.R. 1, 2 (Bankr. S.D.N.Y. 1985) (quoting FED. R. BANKR. P. 3001(e) advisory committee’s note (occurring prior to the 1991 revision to the rule)). 52 See In re Kuhns, 101 B.R. 243, 247 (Bankr. D. Mont. 1989). 53 In re Pine Hill Collieries Co., 46 F.Supp. 669, 671 (E.D. Pa. 1942).



creditor,54 and to harm an unsophisticated creditor.55 After the revision, the transferee need only provide evidence of the transfer to the court,56 which makes the determination of bad faith difficult; the congressional intent to remove the purview of claims-trading from the courts has been a success, as indicated by the lack of case law on FRBP 3001(e), post-amendment.57

Furthermore, Federal Rule of Bankruptcy Procedure 2019’s58 disclosure requirement serves as a possible limitation on claims-trading but there is disagreement between—and among courts within—some of the most respected districts concerning its meaning.59 The relevant section of FRBP 2019 reads:

In a . . . chapter 11 reorganization . . . every entity or committee representing more than one creditor or equity security holder . . . shall file a verified statement setting forth . . .

(2) the nature and amount of the claim or interest and the time of acquisition thereof unless it is alleged to have been acquired more than one year prior to the filing of the petition . . .

(4) with reference to the time of . . . the organization or formation of the committee . . . the amounts of claims or interests owned by . . . the members of the committee . . . the times when acquired, the amounts paid therefor, and any sales or other disposition thereof.60

In 2007, Judge Allan Gropper of the Bankruptcy Court for the Southern District of New York held in In re Northwest Airlines61 that DDIs that wish to serve on a committee, whether official or unofficial, must disclose the entirety of their holdings in the debtor.62 In January 2010, Judge Christopher Sontchi of

54 In re P-R Holding Corp., 147 F.2d 895, 897 (2d Cir. 1945); In re MacLeod Co., Inc., 63 B.R. 654, 655 (Bankr. S.D. Ohio 1986); see also In re Featherworks Corp., 36 B.R. 460, 463 (E.D.N.Y. 1984). 55 See In re Revere Copper & Brass, Inc., 58 B.R. at 2. 56 FED. R. BANKR. P. 3001(e). 57 See Whitaker, supra note 46, at 329. 58 FED. R. BANKR. P. 2019. Hereinafter “FRBP 2019.” 59 See generally Lawrence V. Gelber & Jonathan D. Blattmachr, Delaware Bankruptcy Court Decisions Highlight Split on Rule 2019 Disclosure, LEXOLOGY (Feb. 15, 2010), http://www.lexology.com/library/detail. aspx?g=587983c2-8da9-4e9a-8c2e-d22fd9601994. 60 FED. R. BANKR. P. 2019 (emphasis added). 61 In re Nw. Airlines Corp., 363 B.R. 701 (Bankr. S.D.N.Y. 2007). 62 Id. at 702–03; see also In re Wash. Mut., Inc., 419 B.R. 271 (Bankr. D. Del. 2009) (agreeing with the Northwest holding); In re Keene Corp., 205 B.R. 690 (Bankr. S.D.N.Y. 1997); Baron & Budd P.C. v. Unsecured Asbestos Claimants Comm., 321 B.R. 147, 166 (D.N.J. 2005); Certain Underwriters at Lloyds v. Future Asbestos Claim Representative (In re Kaiser Aluminum Corp.), 327 B.R. 554, 558 (D. Del. 2005); In re Ionosphere Clubs, Inc., 101 B.R. 844, 852 (Bankr. S.D.N.Y. 1989). But see In re Scotia Dev. LLC, No. 07-



the Bankruptcy Court for the District of Delaware expressly disagreed with the Northwest holding in In re Premier International Holdings and decided that a group of investors need not comply with FRBP 2019’s disclosure requirement.63 Two days later, Judge Brendan Shannon, who also presides over the Bankruptcy Court for the District of Delaware, handed down In re Accuride,64 in which he disagreed with Judge Sontchi.65 The piecemeal application of FRBP 2019, demonstrated by the split in Delaware, as well as the ability of DDIs to participate individually without any disclosure, prevents FRBP 2019’s deterrent effect66 and supports the thesis of this Comment that distressed-debt trading reduces debtors’ leverage to the detriment of chapter 11’s efficacy.

II. PREDATORY DISTRESSED-DEBT TRADERS UNDERMINE THE TRADITIONAL

PURPOSE OF CHAPTER 11 REORGANIZATION

Claims-trading has two distinct consequences. First, the identities of claimholders are not static. The ease with which creditors can sell their claims to a party that has no preexisting relationship with the debtor has the following consequences: (1) draining value from the estate; (2) allowing DDIs to engage in bad faith negotiations to profit from holdings outside of bankruptcy; (3) increasing confusion at the negotiating table; (4) creating coercive markets for claims; and (5) reducing the DIP’s leverage derived from exclusivity, and thereby increasing chapter 11 recidivism. Second, the decrease in the DIP’s leverage in negotiations has been accompanied by an increase in creditors’ leverage, which ultimately defeats the Code’s goal of providing an incentive for the debtor’s management to file proactive and feasible plans.67 These combined factors decrease the efficacy of chapter 11 and hinder the preservation of going-concern value. Prior to discussing the detriments of

20027, 2007 WL 2726902 (Bankr. S.D. Tex. May 27, 2007) (reaching the opposite result of Northwest). For a discussion detailing the difference between Northwest and Scotia, see James M. Shea, Jr., Who is at the Table? Interpreting Disclosure Requirements for Ad Hoc Groups of Institutional Investors Under Federal Rule of Bankruptcy Procedure 2019, 76 FORDHAM L. REV. 2561 (2008) (arguing for the “practical approach” in Scotia over the “plain meaning” approach used in Northwest). 63 In re Premier Int’l Holdings, Inc., 423 B.R. 58, 76 (Bankr. D. Del. 2010) (“The existence of a proposed rule expanding the disclosures required of those already subject to the rule is of no moment with regard to whether the rule applies in the first place . . . [T]his Court disagrees with the holdings in Northwest and WaMu.”). 64 In re Accuride Corp., No. 09-13449 (Bankr. D. Del. Jan. 22, 2010). 65 Id. 66 See infra text accompanying notes 154–58. 67 See infra text accompanying notes 75–88.



certain distressed-debt investing strategies, however, it is necessary to understand the traditional underpinnings of chapter 11 reorganization.

A. Chapter 11 Reorganization: Traditional Themes in Business Reorganization

Chapter 11 reorganization is “premised upon a symbiotic relationship between debtor and creditor.”68 It is founded on the belief that reorganizing the debtor may benefit interested parties more than a liquidation of the debtor’s assets.69 Economically, reorganization allows a debtor to preserve the positive difference between its going-concern value and its liquidation value.70 On a policy level, reorganization may preserve jobs and tax bases in the communities where the debtor operates while preventing the general upheaval caused by liquidation.71 The ‘78 Act was very much a balancing act.72 Congress was forced to balance the interests of disparate parties.73 It was imperative to consider the need for creditors to protect their investment in the debtor while simultaneously protecting the debtor from overly aggressive creditors.74 Some of the most pertinent protections and incentives granted by the Code are discussed below.

1. Chapter 11 Is Both Voluntary and Involuntary: 11 U.S.C. § 303

A debtor may seek protection from chapter 11,75 or creditors can force the debtor into bankruptcy.76 Section 303 of the Code governs involuntary

68 Miller, supra note 4, at 2015. 69 See Fla. Dep’t of Revenue v. Piccadilly Cafeterias, Inc., 128 S. Ct. 2326, 2338 (2008) (“Chapter 11’s twin objectives [are] ‘preserving going concerns and maximizing property available to satisfy creditors.’” (quoting Bank of Am. Nat’l. Trust and Sav. Ass’n. v. 203 N. LaSalle St. P’ship., 526 U.S. 434, 453 (1999))); H.R. REP. NO. 95-595, at 220 (1977) (“The purpose of a business reorganization case, unlike a liquidation case, is to restructure a business’s finances so that it may continue to operate, provide its employees with jobs, pay its creditors . . . . It is more economically efficient to reorganize than to liquidate . . . .”). 70 7 COLLIER ON BANKRUPTCY, supra note 17, ¶ 1100.01. 71 Id. 72 See Rhett G. Campbell, Financial Markets Contracts and BAPCPA, 79 AM. BANKR. L.J. 697, 711–12 (2005) (“Many of [Chapter 11’s] goals are mutually inconsistent, of course, and thus . . . require[] a weighing of interests. Congress . . . set the outer boundaries . . . .”). 73 Id. 74 2 COLLIER ON BANKRUPTCY, supra note 17, ¶ 303.14 (noting that § 303’s involuntary filing requirements were founded on a “fear that one or two recalcitrant creditors might file an involuntary case to harass a debtor”). 75 11 U.S.C. § 301 (2006). 76 Id. § 303(a) (“An involuntary case may be commenced only under chapter 7 or 11 of [Title 11] . . . .”). The debtor will most frequently be forced into chapter 7 liquidation, but the debtor has the right to convert to



bankruptcy filings. It attempts to balance the concern that debtors will delay filing and thus waste assets that can be used to satisfy creditors,77 against the fear of giving overly aggressive creditors too much leverage if they are able to force a debtor into bankruptcy.78 Learning a lesson from the past practices of corporate managements that faced reorganization under chapter X, Congress understood that it was imperative for the Code to provide enough incentives to a debtor’s management to prevent delays in filing that might result in unabated deterioration of the debtor’s business.79 The Code sought to reach a middle ground by providing incentives for debtors to file, such as leverage in future negotiations,80 while limiting a creditor’s ability to force the debtor into bankruptcy.81

Importantly, the restrictions placed on creditors’ abilities to file an involuntary petition are more concrete than the incentives provided to the debtor to file a plan.82 To file a petition, the creditor must be joined by two other creditors in most circumstances,83 in addition to showing that the debtor is “equitably insolvent”84 if the debtor files an answer to the involuntary petition.85 A creditor may also be forced to provide a bond and pay damages if a case is filed in bad faith to “discourage frivolous petitions as well as spiteful petitions based on a desire to embarrass the debtor.”86 While the hurdles that

chapter 11. Id. § 706(a) (“The debtor may convert a case under this chapter to a case under chapter 11, 12, or 13 of this title at any time, if the case has not been converted under section 1112, 1208, or 1307 of [ Title 11] . . . .”) (emphasis added). 77 2 COLLIER ON BANKRUPTCY, supra note 17, ¶ 303.01. 78 Id.; see also In re Tichy Elec. Co., 332 B.R. 364, 377 (Bankr. N.D. Iowa 2005) (“[T]he [use of the] bankruptcy process for the improper purpose of obtaining a disproportionate advantage over all other creditors . . . establish[es] bad faith warranting sanctions.”). 79 Miller, supra note 29, at 140. 80 See infra text accompanying notes 89–96 (discussing the debtor in possession) and 97–107 (discussing exclusivity). 81 See generally 11 U.S.C. § 303. 82 See In re Faberge Rest. of Fla., Inc., 222 B.R. 385, 387 (Bankr. S.D. Fla. 1997) (“Section 303 of the Bankruptcy Code governs the filing of involuntary petitions and provides stringent tests which must be satisfied before a debtor may be adjudicated and an order for relief be entered by the Court.”) (emphasis added). This Comment argues that debtor leverage has been eroded by distressed-debt trading while the statutory barriers for creditors to file involuntary petitions have been interpreted strictly, preventing proactive filings. 83 11 U.S.C. § 303(b)(1). 84 Equitable insolvency is the inability to pay debts as they mature, whereas balance sheet insolvency is when liabilities exceed assets. 85 11 U.S.C. § 303(h)(1). 86 S. REP. NO. 95-989, at 5819 (1978). Creditors that file an involuntary petition in bad faith may also be held liable for reasonable costs including attorney’s fees, actual damages, as well as punitive damages. See 11 U.S.C. § 303(i); see also Miles v. Okun (In re Miles), 430 F.3d 1083 (9th Cir. B.A.P. 2005) (“Congress



creditors face to force a debtor into bankruptcy remain significant,87 the incentives provided to debtors to file have significantly decreased since the ‘78 Act came into effect on January 1, 1979. The thesis of this Comment is that distressed-debt investing is the cause of this decrease, and as a result, chapter 11 has become inefficient as a tool to restructure failing businesses.88

2. The Debtor in Possession: 11 U.S.C. § 363

One of the most attractive incentives for debtors provided by the Code was the creation of the Debtor in Possession,89 which allows existing management to control business operations after filing.90 Section 363 outlines the powers of the DIP in managing its business as a going concern.91 Specifically, the DIP “may enter into transactions, including the sale or lease of property of the estate, in the ordinary course of business, without notice or a hearing.”92 Allowing the DIP to retain control of the business serves two functions. First, it provides the debtor with leverage over creditors. For example, the DIP can obtain post-petition financing by “priming”93 senior claimants in giving the providers of post-petition financing senior or priority liens on secured property of the estate under § 364(d)(1).94 Second, the DIP’s management theoretically will provide a greater return for creditors due to the DIP’s expertise in the operation of its business.95 Despite the Code’s attempt to provide management

determined that bankruptcy courts could award damages predicated on the bad faith filing of involuntary petitions only to the debtors . . . who suffer most directly the harm from frivolous or spiteful filings.”); In re Silverman, 230 B.R. 46, 50–51 (Bankr. D.N.J. 1998). 87 See, e.g., Liberty Tool, & Mfg. v. Vortex Fishing Sys., Inc. (In re Vortex Fishing Sys.), 277 F.3d 1057, 1064 (9th Cir. 2001) (“Where there are twelve or more creditors, as here, three or more creditors without a bona fide dispute must file a petition, and the claims must aggregate at least $10,775.”) (emphasis added); In re Faberge Rest. of Fla., Inc., 222 B.R. at 387 (Bankr. S.D. Fla. 1997) (discussing § 303’s “stringent tests” for filing an involuntary petition against a debtor). 88 See infra text accompanying notes 127–41. 89 Hereinafter “DIP.” 90 Harvey R. Miller & Shai Y. Waisman, Does Chapter 11 Reorganization Remain a Viable Option for Distressed Businesses for the Twenty-First Century?, 78 AM. BANKR. L.J. 153, 176 (2004). 91 See generally 11 U.S.C. § 363. See also id. § 1107(a) (granting a debtor in possession the rights, powers, and duties of a trustee). 92 Id. § 363(c)(1). 93 3 COLLIER ON BANKRUPTCY, supra note 17, ¶ 364.01 (“[I]f the trustee cannot obtain credit otherwise, the court may authorize ‘priming’ an existing lien, i.e., borrowing secured by a lien senior to or equal to an existing lien, provided that the existing lienor is adequately protected.”). 94 11 U.S.C. § 364(d)(1) (“The court, after notice and a hearing, may authorize the obtaining of credit or the incurring of debt secured by a senior or equal lien on property of the estate that is subject to a lien . . . .”) (emphasis added). 95 See Raymond T. Nimmer & Richard B. Feinberg, Chapter 11 Business Governance: Fiduciary Duties, Business Judgment, Trustees and Exclusivity, 6 EMORY BANKR. DEV. J. 1, 51 (1989). To some it may seem



with incentives to file, vulture funds have reduced the incentive that § 363 provides by using chapter 11 as a market for corporate control.96

3. The DIP’s Right of Exclusivity: 11 U.S.C. § 1121

Another incentive for the debtor to file is the privilege of exclusivity under § 1121.97 Exclusivity grants the DIP an initial sole right to present a plan for confirmation.98 By providing the DIP with the exclusive right to file a plan, Congress granted the debtor an enormous degree of leverage. The DIP’s exclusive control in drafting the plan allows the DIP to: (1) propose the consideration creditors will receive if the plan is confirmed; (2) gerrymander classes of creditors to minimize the voting strength of adversaries while maximizing the influence of allies’ votes; and (3) set the pace of negotiations, usually through delay, which is a powerful strategy because time is money––in the form of attorneys’ and other professionals’ fees.99

Delay is the most powerful tool at the DIP’s disposal.100 The purpose of reorganization is to pay creditors, and less money is available with each passing minute.101 Exclusivity allows the DIP to withhold a plan, which is subject to numerous requirements before confirmation.102 Until confirmation, unsecured creditors neither receive payments nor accrue post-petition interest, and the DIP may withhold payments to a secured creditor until the secured creditor receives a judgment requiring adequate protection.103 In this sense, delay equates to leverage for the DIP because delay is a cost to the estate and, thus, to the estate’s creditors.

strange to retain the management that put the corporation in bankruptcy, but the logic is that existing management, even poor management, is better than a court-appointed trustee. There is also an argument that a DDI that takes control of the business will place a better person in control than a trustee would, similar to a restructuring consultant that has the required expertise and ability to comprehend the debtor’s finances. 96 See infra text accompanying notes 212–29 (discussing the distressed-debt investor in possession). 97 11 U.S.C. § 1121(a)-(d). 98 Id. 99 See Tung, supra note 6, at 1695. 100 Delay is also a contentious issue, with critics of chapter 11 arguing that delay gives the DIP too much leverage. See, e.g., David A. Skeel, Jr., Doctrines and Markets: Creditors’ Ball: The “New” New Corporate Governance in Chapter 11, 152 U. PA. L. REV. 917, 920–21 (2003). 101 If taking account of professional fees, like attorney’s fees, it may be more appropriate to say “with each six minutes that pass” or whatever other increment the attorneys, bankers, and analysts use to bill clients. 102 See 11 U.S.C. § 1129. 103 J. Bradley Johnston, The Bankruptcy Bargain, 65 AM. BANKR. L.J. 213, 294 (1993); see also 11 U.S.C. §§ 361–64.



Currently, the DIP has the exclusive right to file a plan during the 120 days following the order for relief.104 Prior to the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005,105 judges had broad discretion to grant extensions to the 120-day exclusivity period. In fact, it was almost unheard of for judges to deny the DIP’s request for an extension due to fears that negotiations would unravel.106 BAPCPA, however, amended § 1121 and provided a cap of eighteen months from the order for relief, after which the court is prohibited from granting an extension of exclusivity.107 The cap on extensions, combined with confusion and delays in negotiations due to distressed-debt trading, significantly reduces the DIP’s leverage derived from exclusivity. This tips the scales in favor of creditors and decreases the chances for successful reorganization in chapter 11.108

B. A Revolving Door for Claimants: Value Drains, Ulterior Motives, Increased Confusion, Coercive Markets, Limits on Exclusivity, and the Rise in Chapter 22 Filings

Much of the harm to reorganization caused by vulture funds can be tied directly to the ability of creditors and distressed-debt investors to leave and enter negotiations, almost capriciously. The interchangeability of creditors harms the reorganization process in five ways. First, claim flipping109 diminishes the value of the estate. Second, claims-trading allows creditors with ulterior motives to profit from holdings outside of bankruptcy by sinking negotiations. Third, claims-trading eliminates the incentive for negotiations when the DIP knows that the holders of claims are unlikely to remain constant. Fourth, claims-trading can create coercive markets for claims when a vulture fund is betting against the success of reorganization. Finally, the convergence of these harms delays the negotiation process, which decreases the DIP’s leverage derived from exclusivity and may lead to recidivism among debtors, often known as a chapter 22 reorganization.110

104 11 U.S.C. § 1121(b). 105 Hereinafter “BAPCPA.” 106 An illustrative and extreme example is that of Eastern Airlines and the delay tactics of its CEO Frank Lorenzo, which kept the corporation in bankruptcy for several years. See, e.g., Skeel, supra note 100, at 920–21. See generally Claudia MacLachlan, Blame Flies in Demise of Airline, NAT’L L.J., May 27, 1991, at 1. 107 11 U.S.C. § 1121(d)(2); see also H.R. REP. No. 109-31, pt. 1, at 88 (2005). 108 See infra text accompanying notes 190–94. 109 See infra text accompanying notes 120–26 (discussing claim flipping). 110 E.g., Brett Goldblatt, Getting Out After It’s Too Late: Exit Strategies in Chapter 11 Bankruptcies, AM. BANKR. INST. J., Oct. 2004, at 26, 26.



1. The Detriments of Claim Flipping

With the ‘78 Act, Congress intended to create a forum for negotiation between debtors and creditors in chapter 11.111 Distressed-debt investors, however, pose a threat to the environment of negotiation envisioned under the ‘78 Act.112 Chapter 11 attempts to create an environment for negotiation by providing a framework that encourages cooperation.113 The relationships between the debtor and its creditors, as well as the relationships between the creditors themselves, are founded on the belief that negotiations will foster constant interaction throughout the reorganization process.114

While the Code provides incentives for interested groups to cooperate, it does not protect the relationships that the groups forge during the “initial skirmishes” in reorganization.115 Distressed-debt trading provides a revolving door to and from the negotiation forum, which is a drain on the estate. The knowledge and familiarity that the selling creditor acquires in negotiation is debtor-specific.116 Consequently, when the selling creditor exits the chapter 11 negotiation forum, that creditor leaves with its debtor-specific relationship. Simultaneous with the creditor’s exit is the DDI’s entrance through the other side of the revolving door. The DDI, however, is a stranger to the DIP and provides no relationship-value (though it is possible to develop relationship-value over time). The relationship-value leaves with the creditor that sold its claim,117 resulting in a net loss in value within the forum. Some argue that DDIs have a salutary effect on reorganization by bringing expertise to the negotiation forum while simultaneously consolidating claims that may represent disparate interests.118 This argument is meritorious. These values, however, only exist if such a creditor remains within the forum for negotiation

111 Fortgang & Mayer, supra note 1, at 13. 112 Miller, supra note 4, at 2014 (“Distressed debt trading and changes in bankruptcy relationships have destroyed the symbiotic relationship of debtor and creditor.”); Tung, supra note 6, at 1718 (“Claims trading may destroy . . . valuable relationships.”). 113 Tung, supra note 6, at 1718. 114 Id.; cf. Miller, supra note 4, at 2014. 115 Tung, supra note 6, at 1719. 116 Id. at 1718. 117 See id. at 1719 (describing the value in a bankruptcy relationship as an “idiosyncratic investment–highly specialized and not transferable”). 118 Goldschmid, supra note 39, at 191 (“[D]istressed-debt investors have driven . . . important and desirable bankruptcy trends: faster reorganizations, increased liquidity in the markets for debtor assets, greater flexibility in creditor-debtor negotiations under Delaware law, and improved focus on enterprise strategies that maximize long-term enterprise value . . . .”); Whitaker, supra note 46, at 303 (“Claims trading benefits everyone involved. It provides . . . debtors with interested and motivated parties to help them through the reorganization process.”).



as a long-term residual owner; however, this is not the sole, or even the dominant, strategy for DDIs, which often seek short-term returns in order to remain liquid.119

For example, a popular strategy for DDIs is to flip claims.120 Claim flipping should be contrasted with purchasing claims with the anticipation of profiting under the confirmed plan’s payout. To profit from a payout, a DDI buys claims at a discount in anticipation of a payment under the confirmed plan that is greater than the discounted price.121 Alternatively, to flip a claim, a DDI buys low and sells high, taking advantage of fortuitous market fluctuations prior to plan confirmation.122

A simplified hypothetical demonstrating the difference between profiting from a payout and profiting by claim flipping may be helpful. For example, suppose a DDI looking to benefit from the plan payment buys a claim at a discount (20% of the claim’s face value) in anticipation of a payout that is greater than that price under the confirmed plan (perhaps, 60% of the claim’s face value). As long as the cost of the DDI participating in the reorganization does not exceed the difference between the price the DDI paid for the claim and the payout provided in the plan (40% of the face value) then the DDI profits. Typically, the DDI’s long-term involvement requires a rather high increase in the claim’s value because the costs to the DDI become greater the longer it is involved in negotiations.123 An investor looking to flip a claim, however, buys the claim for 20% of its face value and sells the claim to another DDI or creditor for any price greater than 20% of the face value. Because the claim-flipper is involved for a shorter time period, its negotiation costs are less, and it can profit despite just a moderate increase in the price.

Returning to the revolving-door analogy, every time a creditor exits the forum, there is a loss in relationship-value. Thus, continuous claim flipping results in a net loss to the forum every time a DDI without an existing relationship enters. Most important, it is necessary to understand what creates

119 See Eric B. Fisher & Andrew L. Buck, Hedge Funds and the Changing Face of Corporate Bankruptcy Practice, AM. BANKR. INST. J., Dec./Jan. 2007, at 24, 86 (“[T]he liberal redemption policies offered by most hedge funds require more short term strategies in order to maintain sufficient fund liquidity.”). 120 Harner, supra note 9, at 716. 121 Another strategy for investors is to hold onto claims until confirmation in anticipation of a debt-for-equity exchange, which this Comment argues is beneficial for business reorganization. See, e.g., id. at 718. 122 Id. at 716. 123 This fact leads to DDIs pushing debtors for quick exits from chapter 11, something that may lead to increased recidivism. See infra text accompanying notes 207–11.



relationship-value. Relationships in chapter 11 are built over time, and due to the nature of professional fees during reorganization, time is money.124 During a reorganization, the money belongs to the creditors, either in the form of the estate that will be distributed to creditors or from the creditors’ own pockets.125 In chapter 11, it is presumed that the cost of building these relationships will benefit the creditors in the long-run by preserving the going-concern value of the business.126 Every time relationship-value leaves the estate, however, it decreases the difference between the going-concern value and the cost of negotiation.

Of equal importance, claim-flippers do not derive their profits from the estate. When a claim-flipper sells, it leaves the forum with a profit derived from the sale price of the claim. The parties adversely affected by the revolving-value drain are those parties that are committed to reorganization because their payout is directly tied to the value of the estate when the plan is confirmed. Thus, claim flipping, when done as intended, is profitable for those that sell their interests, but it shifts negative externalities onto those groups interested and engaged in reorganization.

The term “vulture fund” may be a misnomer when applied to DDIs that flip claims. Vultures mainly scavenge, surviving on the remains of deceased fauna, while rarely resorting to predation. Vulture funds operate in a different manner. Vulture investors do not wait. Instead, vulture investors that flip claims are more akin to predators that actively participate in and contribute to the downfall of the debtor.

2. Net Adverse Creditors: DDIs May Have Ulterior Motives that Hinder Reorganization

Perhaps even more troublesome, some vulture funds have interests disparate from creditors holding identical or similar claims. Vulture funds are frequently invested in the debtor across several levels, presenting strategic alternatives that may be contrary to the goals of other creditors within the same

124 Harner, supra note 6, at 102. 125 The Code authorizes committee members to retain professionals for use by the estate. 11 U.S.C. § 1103(a) (2006). The Code also authorizes the DIP to retain professionals for use by the estate. Id. § 327(a). 126 H.R. REP. NO. 95-595, at 220 (1977) (“The purpose of a business reorganization case, unlike a liquidation case, is to restructure a business’s finances so that it may continue to operate, provide its employees with jobs, pay its creditors . . . . It is more economically efficient to reorganize than to liquidate . . . .”).



class.127 Indeed, certain holdings, such as short positions and credit derivatives, pay significant returns when reorganization fails. A creditor with such holdings in excess of the value of its claims is known as a net adverse creditor, since its economic interests oppose a beneficial return to traditional creditors.128

For example, a vulture fund can invest in short positions in the debtor’s stock and simultaneously buy debt; business commentators describe this as betting on the failure, or against the success, of a chapter 11 reorganization.129 In such situations, the vulture fund buys the debt at a steep discount from a willing130 creditor wishing to exit the negotiation forum. The newly acquired claim allows the vulture fund to exert leverage in the reorganization.131 The vulture fund’s profit, however, does not stem from a return on the claim it purchased. Instead, the vulture fund benefits from poor returns to equity holders because of the short positions it acquired. The vulture fund in this case has no incentive to preserve the debtor’s going-concern value and can use leverage to force a sale of the underlying assets, often at below-market prices.132 A traditional creditor involved in the negotiation process, on the other hand, has an incentive to preserve the debtor’s going-concern value133 in order to maintain its source of income through a steady stream of interest payments.

127 Fisher & Buck, supra note 119, at 86 (“Such varied holdings present different strategic alternatives that may put [hedge funds] at odds with the interests of more conventional creditors.”); Andersen, supra note 11, at 12 (“The bottom line is that where borrowers used to go into a restructuring knowing that their creditors’ main objective was getting their money back, today some of them might have a vested interest in default.”). 128 See generally Patrick D. Fleming, Credit Derivatives Can Create a Financial Incentive for Creditors to Destroy a Chapter 11 Debtor: Section 1126(e) and Section 105(a) Provide a Solution, 17 AM. BANKR. INST. L. REV. 189 (2009). 129 Tiffany Kay, Federal Judge Says Rules Needed to Bar Bankruptcy Failure Bets, BLOOMBERG BUSINESSWEEK, Feb. 5, 2010, http://www.businessweek.com/news/2010-02-05/bankruptcy-rule-may-chill-investing-lawyer-says-update1-.html. 130 “Willing” may be the wrong word, for an argument can be made that distressed-debt trading actually creates a coercive market for claims, similar to a two-tiered tender offer during a hostile takeover. See infra text accompanying notes 175–86. 131 See In re Pittsburgh Rys. Co., 159 F.2d 630, 632–33 (3d Cir. 1946), cert. denied, 331 U.S. 819 (1947): Security-First Nat’l Bank of L.A. v. Rindge Land & Navigation Co., 85 F.2d 557, 563 (9th Cir. 1936), cert. denied, 299 U.S. 613 (1937); In re Exec. Office Ctrs., Inc., 96 B.R. 642, 649 (Bankr. E.D. La. 1988). 132 See Fisher & Buck, supra note 119, at 87 (“[A vulture fund] hits a grand slam on its investment if [the debtor] recovers enough value to pay off its bank, unsecured and trade debt, but does not recover enough money to provide a return to equityholders [sic].”). 133 The traditional creditor does so by providing post-petition financing and long-term workout solutions. Id. at 86.



Short positions are not the only tools at a DDI’s disposal. Other credit derivatives, such as total return swaps,134 create an incentive for creditors to sabotage a plan for reorganization in order to profit on the derivatives.135 A total return swap functions like insurance: it will pay when there is a default.136 The pernicious aspect of a total return swap is that payment does not occur when the asset holder files for bankruptcy, as in the case of a credit default swap.137 In other words, a DDI that owns total return swaps based on the assets of a chapter 11 debtor can buy debt after chapter 11 is filed, and then it can influence the return on the swap with its purchased leverage.138 But unlike insurance, the derivative is not a hedging device in this circumstance; rather, it is a speculative instrument.139 A rational DDI can invest in total return swaps, buy debt at a discount to acquire leverage in negotiations, and, finally, profit by using this leverage to sink negotiations.140 By voting against a plan confirmation, a creditor holding such derivatives maximizes its total return by minimizing its return on the bankruptcy claims.141

Chapter 11, as it currently stands, is ineffective in limiting the above profit-seeking strategies employed by vulture funds. The Code was not crafted with DDIs in mind; as such, it is an inefficient tool for preserving going-concern value in the face of activist claims-trading. Section 1126(e) specifically allows the court to “designate any entity whose acceptance or rejection of such plan was not in good faith.”142 Courts have identified voting against plan confirmation to “aid . . . an interest other than an interest as a creditor” as a specific instance that may constitute bad faith under § 1126(e).143 Cases that

134 Fleming, supra note 128, at 194–96. 135 Id. at 189. 136 Scouting Junk: Emerging-Market Debt Pays Off in Double Digits for Fund Manager, BARRON’S, Dec. 4, 2000, at 40. 137 The key difference (in the context of chapter 11) between a credit default swap and a total return swap, is that a total return swap survives through bankruptcy because settlement is not triggered by a “credit event” that includes bankruptcy, as under a credit default swap. Fleming, supra note 128, at 194–96. 138 Id. at 195–97. 139 See id. at 195. 140 Id. at 197 (“[A] protection buyer in a credit derivative who does not own the reference asset can only profit if the value of the reference asset decreases. Outside of bankruptcy this situation is relatively without problem, because the protection buyer has little influence over the performance of the reference asset. However, once the reference debtor enters bankruptcy, the protection buyer can acquire influence over the direction of the reference debtor by purchasing claims against the debtor and thus becoming a creditor.”). 141 Id. 142 11 U.S.C. § 1126(e) (2006). 143 In re P-R Holding Corp., 147 F.2d 895, 897 (2d Cir. 1945); see also In re MacLeod Co., Inc., 63 B.R. 654, 655 (Bankr. S.D. Ohio 1986); In re Featherworks Corp., 36 B.R. 460, 463 (E.D.N.Y. 1984).



consider this issue in the context of credit derivatives and other exotic investment instruments are exceedingly rare.

The problem is that courts have no ability to determine good faith without complete disclosure of a DDI’s holdings, and the current disclosure provisions do little to help. The amendment to FRBP 3001(e) eliminates a court’s ability to review the propriety of transfers by simply requiring evidence that the transfer was made.144 Furthermore, it is possible, but doubtful, that a DDI’s disqualification from sitting on an official committee may limit such behavior. The Code requires the United States trustee to create an official committee145 comprised of the seven largest and willing holders of unsecured claims146 to act as fiduciaries of the case.147 The downside for a vulture fund is that in order to fulfill its fiduciary responsibility it must receive material inside information and cease trading in the debtor’s equity148 to avoid the danger of engaging in insider trading.149 However, it remains to be seen whether this danger is an adequate deterrent. Indicative of vulture funds’ disregard for the protective measures constructed by bankruptcy law, the Securities and Exchange Commission has begun investigations into whether hedge funds have been deliberately misstating their bond holdings to gain access to official committees in order to obtain material inside information and trade on that information.150

Furthermore, vulture funds seeking to avoid the limitations required for official committee membership can form an unofficial committee with other creditors:151 “Ad hoc committees are popular with distressed investors . . . because they permit their members to share costs and to exert

144 FED. R. BANKR. P. 3001(e). 145 11 U.S.C. § 1102(a)(1) (“[T[he United States trustee shall appoint a committee of creditors holding unsecured claims . . . .”) (emphasis added). The U.S. trustee may create additional committees of creditors as well as equity holders, with the court having the authority upon a motion by a party in interest to order the trustee to appoint such a committee. Id. §§ 1102(a)(1)-(2). 146 Id. § 1102(b)(1). 147 Id. 11 U.S.C § 1102. 148 Fisher & Buck, supra note 119, at 87–88. 149 See More Heat on Hedge Funds, BLOOMBERG BUSINESSWEEK, Feb. 6, 2006, www.businessweek.com/ magazine/content/06_06/b3970066.htm. (referring to a situation in which the manager of the hedge fund Blue River Capital, LLC “paid the SEC $150,000 to settle charges that he failed to guard sufficiently against the potential for misuse of insider information he obtained while serving on the bankruptcy committees of WorldCom, Adelphia Communications, and Globalstar Telecommunications”). 150 Otis Bilodeau, SEC Probes Bankruptcy Committees for Hedge Fund Fraud, BLOOMBERG, Nov. 29, 2005, http://www.bloomberg.com/apps/news?pid=10000103&sid=a1yyTgCjH.qM&refer=us. 151 See 11 U.S.C § 1102(a) (permitting the appointment of ad hoc committees of creditors and equity-holders as the U.S. trustee deems appropriate).



greater influence as a group without the statutory duties and some of the trading restrictions and disclosure obligations imposed on an official [§] 1102 committee.”152 The unofficial committee’s expenses will not be paid by the estate, but professional fees will be divided among the members. The committee can exert more leverage as a group, thus giving a vulture fund that desires to trade in the debtor’s equity and avoid disclosure a viable alternative to sitting on an official committee.153

The attractive nature of an ad hoc committee is currently in a state of flux, with some courts requiring full disclosure of a DDI’s interests in the debtor,154 while other courts155 limit the reach of FRBP 2019.156 The disclosure requirements for ad hoc or unofficial committees are a contentious issue. Hedge funds and other private investment groups argue that regulation will discourage DDI involvement in reorganization, which will decrease the available liquidity for struggling businesses.157 The proponents of added disclosure requirements argue that short positions and exotic investment vehicles, such as credit default swaps and total return swaps, need to be disclosed to increase the transparency of interests in reorganization;158 indeed, this Comment supports this argument. Even under an aggressive use of FRBP 2019, however, the disclosure rule only applies to vulture funds that voluntarily join committees. While using FRBP 2019 to force vulture funds that joing unofficial committees to disclose their holdings will increase transparency, it does nothing to prevent the lone vulture from muddying the waters.

The vulture fund’s late entrance into the game gives it the advantage of being able to assert more leverage for its investment than other creditors.159 The vulture fund is able to assert leverage based on the par value of the claim and thus profit from investments at other levels of the debtor, even though it may suffer a loss on the claim purchased. This behavior goes beyond

152 Bankruptcy Rule 2019: A New Battleground, 48 Bankr. Ct. Dec. (LRP) No. 10 (Jul. 3, 2007). 153 Fisher & Buck, supra note 119, at 87. 154 See, e.g., In re Nw. Airlines Corp, 363 B.R. 701, 702 (Bankr. S.D.N.Y. 2007). 155 See, e.g., In re Premier Int’l Holdings, Inc., 423 B.R. 58 (Bankr. D. Del. 2010). 156 See supra notes 58–65 and accompanying text. 157 Tom Hals, Hedge Funds, Bankruptcy Judges Spar Over Disclosure, REUTERS (Feb. 4, 2010), http://www.reuters.com/article/idUSTRE61362Y20100204. 158 See generally In re Accuride Corp., No. 09-13449 (Bankr. D. Del. Jan. 22, 2010); In re Nw. Airlines Corp., 363 B.R. at 701; In re CF Holding Corp. 145 B.R. 124, 126 (Bankr. D. Conn. 1992) (ordering a more complete 2019 disclosure); see also Hals, supra note 157. 159 Hals, supra note 157 (“It’s a bedrock principle of bankruptcy law that the price a creditor paid for a claim is legally irrelevant to that creditor’s rights . . . .”).



hedging160 the distressed-debt transaction. Hedging is a passive risk management tool.161 A vulture fund that bets against the success of the reorganization, or uses leverage to sink negotiations and profit on credit derivatives, actively participates in a reorganization to decrease the price of the debtor’s equity and the return to creditors. Rather than the short positions and credit derivatives being a safety net for the vulture fund if there is no beneficial payment under the plan, the claims purchased are a tool to be wielded in negotiations to realize a profit on the short positions and derivatives. Vulture funds shift the externalities of such actions to long-term claimholders that are unable to profit from short positions and derivatives because they acquired their claims for par value rather than the discounted price the vulture fund paid.

In addition to the costs of such actions to the debtor and traditional creditors, classes of claims may also be inappropriately classified because the DIP has no method for determining the interests of each claimholder.162 The interchangeability of claimants and the inability to determine the ulterior motives that some claimholders may possess, such as profiting on a bet against the reorganization’s success, severely undermine the leverage that the DIP derives from being able to gerrymander classes of creditors.

Furthermore, even if the debtor is aware of the claimholder’s motive, the identity of the claimholder is likely to change if the DIP takes a stance that is contrary enough to the original holder’s interest. In addition, traditional creditors within the vulture fund’s class stand to lose the most because the dominant bargainer within their class stands to profit from a strategy inapposite to one that would maximize the return to traditional creditors. The likely result is that the traditional creditors in these classes, who may have retained their claims through negotiations, have an incentive to sell to a vulture fund that can profit from the leverage accompanying those claims, exacerbating the problems that vulture funds bring to business reorganizations.

160 “‘[H]edging’ involves buying or selling futures contract [sic] opposite to position [sic] held in a cash market to minimize risk of adverse price move [sic] or buying a sale of futures contract [sic] as substitute for cash transaction [sic] to take place at later date.” John Buchovecky, The Future of Leverage Contract Trading Under the Futures Trading Act of 1986, 37 AM. U. L. REV. 157, 171 n.81 (1987). 161 Compare In re Adelphia Commc’ns Corp., 359 B.R. 54, 63 (Bankr. S.D.N.Y. 2006) (finding that hedging was not in bad faith when the creditor was not net adverse), with In re MacLeod Co., 63 B.R. 654, 655–56 (Bankr. S.D. Ohio 1986) (finding bad faith under § 1126(e) when a vote was cast to profit other than as a creditor). 162 See supra notes 109–26 and accompanying text.



3. The Vulture Fund Problem: A Negotiation “Lemons Problem”?

The interchangeability of claimants in a chapter 11 case creates problems beyond draining value from the estate and allowing for bets against the success of reorganization. The interchangeability of claimants also creates an environment with informational asymmetries that disfavor the DIP, which may in turn cause it to retract from negotiations. The situation is analogous to the Lemons Problem, in which hypothetical used-car buyers retract from a market with both good and bad cars, because an asymmetry of information prevents the buyer from being able to differentiate a non-lemon from a lemon.163

At the heart of the dilemma for the DIP that is deciding whether to participate in negotiations, is the confusion created by claim flipping and the strategy of betting against the success of reorganization. If a DDI purchases a claim with the expectation of a higher payout at confirmation or an interest in converting debt to equity, that single DDI will be at the negotiating table for the length of the bankruptcy.164 While the debtor may not have an existing relationship with the investor, at least the debtor interacts with the same party consistently and both parties have an incentive to engage in future and prolonged negotiations. On the other hand, the DIP has no incentive to negotiate with an investor looking to flip its claim because the DIP has no confidence that the claimholders on day one will be the same parties the DIP speaks to on days three, five, twenty, and so on; indeed “[e]ven the potential for trading deters parties from investing in relationships and from cooperating.”165 Furthermore, negotiation with a vulture fund that is betting against the success or reorganization is futile since that creditor will work to prevent confirmation.

The DIP—fully aware of the value drain—may retire from negotiations with creditors because the DIP knows that the value derived from such negotiations will disappear if that party sells its claim. Furthermore, the DIP has no incentive to negotiate with a vulture fund that is net adverse. The situation is analogous to the Lemons Problem166 in that the DIP is unable to

163 George A. Akerlof, The Market for “Lemons”: Quality Uncertainty and the Market Mechanism, 84 Q. J. ECON., 488–500 (1970). 164 See Goldschmid, supra note 39, at 273 (applauding DDIs for aggregating claims and promoting a negotiation community). 165 Tung, supra note 6, at 1718. 166 Akerlof, supra note 163, at 488–500. To simplify, the Lemons Problem attempts to determine the economic costs of dishonesty. It concludes that when an asymmetry of information exists in favor of sellers, buyers will retract from the market if there is dishonesty concerning quality of the product provided. Id.



determine the strategies of each creditor. It is impossible for the DIP to determine which creditors intend to remain in the negotiation forum because there is an open market for claims. Additionally, due to lax disclosure requirements—FRBP 2019 and 3001(e)—the DIP is likely unaware of the totality of a creditor’s holdings167 and whether such holdings may incentivize a creditor to sink negotiations.168 In this light, claims-trading creates an asymmetry of information in favor of creditors, as they are the only parties with actual knowledge of their intentions either to participate in claim flipping or to sink negotiations. So, like the market for used cars, where the existence of the occasional lemon drives buyers from the entire market,169 vulture funds drive the DIP from the market for negotiation despite the presence of creditors without such intentions. This is detrimental to the efficacy of business reorganizations that hinge on negotiation.

These combined factors undoubtedly contribute to delays in productive negotiations.170 When parties are free to exit the negotiation forum, there is no need to make concessions or play by the rules because there will be no repeat interaction if the claimholder so chooses. Concomitant to the DIP and claimholders struggling to negotiate productively, the DIP faces pressure from hedge funds that buy claims as long-term residual owners for an expedited exit from chapter 11. This is because hedge funds frequently have liberal redemption policies for investors, which require the fund to maintain high levels of liquidity, so the DDI cannot afford to have its funds tied up in bankruptcy.171 The possibility of a successful reorganization takes a hit on two fronts. First, productive negotiations take more time due to the interchangeability of claimants.172 Second, negotiations must take place over a shorter period of time due to pressure from DDIs acting as long-term residual owners of the claims.173 The delay in productive negotiations has serious cost consequences, such as causing the debtor to languish in bankruptcy longer than necessary or increasing the probability of a sub-optimal plan being confirmed.174

167 See supra text accompanying notes 58–65. 168 A net adverse creditor may desire to sink negotiations to profit on swaps or short positions in the debtor. See infra text accompanying notes 127–41. 169 Akerlof, supra note 163, at 489–92. 170 See Tung supra note 6, at 1722. 171 Fisher & Buck, supra note 119, at 86. 172 See supra text accompanying notes 109–26. 173 See generally Goldschmid, supra note 39. 174 See infra text accompanying notes 190–211.



4. Claims Trading Can Parallel Coercive Corporate Takeovers

DDIs that use leverage to pursue profits from short positions or credit derivatives may also create coercive markets for claims. If creditors’ claims have been classified by the DIP, then each class contains a controlling block consisting of two majorities.175 To control the class in a vote for plan confirmation, the class must vote with more than half the number of claims and at least two-thirds the dollar-value of all claims within the class.176 A sophisticated DDI understands that it can control a class of claims by purchasing fewer than 100% of the claims within the class. Instead, the cost of 100% of the leverage within a class is the cost of acquiring the two majorities required for plan acceptance under § 1126(c).177 A sophisticated DDI wishing to control the class will make an offer to all class members similar to a two-tier, front-loaded offer178 that is employed by corporate raiders outside of bankruptcy.179

In a two-tier, front-loaded offer, shareholders face a prisoner’s dilemma.180 The dilemma occurs because shareholders would make a different decision collectively than they would individually.181 The offeror presents shareholders with a bid for only those shares necessary for control, buying shares on a first-come-first-served basis.182 Thus, the nature of the bid penalizes those that fail to tender their shares up front, creating a coercive market based on the inability of shareholders to act collectively.183 Theoretically, the shareholder is more

175 See 11 U.S.C. § 1126(c) (2006). 176 Id. (“A class of claims has accepted a plan if such plan has been accepted by creditors . . . that hold at least two-thirds in amount and more than one-half in number of the allowed claims of such class held by creditors . . . .”). 177 Id. 178 Neil C. Rifkind, Should Uninformed Shareholders Be a Threat Justifying Defensive Action by Target Directors in Delaware?: “Just Say No” After Moore v. Wallace, 78 B.U. L. REV. 105, 122–23 (1998). 179 See, e.g., Sunbeam Corp. v. Allegheny Int’l, Inc. (In re Allegheny Int’l.), 118 B.R. 282, 295–96 (Bankr. W.D. Pa. 1990) (noting that the manner in which the DDI acquired claims was discriminatory because members of a class that accepted the offer received cash up front while those that rejected the offer needed to wait for plan confirmation). 180 Rifkind, supra note 178, at 122–23. 181 Id. 182 See, e.g., Paramount Commc’ns, Inc. v. QVC Network, Inc., 637 A.2d 34, 48 n.18 (Del. 1994) (“[T]ender offers were for 51 percent cash and a ‘back-end’ of various securities, the value of each of which depended on the fluctuating value of . . . stock at any given time. Thus, both tender offers were two-tiered, front-end loaded, and coercive.”); Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 956 (Del. 1985). 183 Rifkind, supra note 178, at 122–23.



willing to accept a low initial bid out of fear that it will be penalized for failing to tender its shares on the front-end of the offer.184

The conditions that make a two-tier, front-loaded offer coercive outside of bankruptcy are also present within bankruptcy once claims are classified.185 The prisoner’s dilemma that shareholders face is nearly identical to that faced by claimholders considering offers from a DDI. There is one possible difference, however. Outside of bankruptcy, the acquiring party uses the two-tier, front-loaded offer to freeze out minority shareholders through a short-186 or long-form merger187 under state corporate law. Under bankruptcy law, on the other hand, the minority claimholders within each class retain their claims and receive a payment through the plan if it is confirmed. The only protection for the minority claimholders within the class is the ability of the DDI that controls the class to negotiate on behalf of the entire class. The problem stems from vulture funds that use leverage derived from class control to profit on their bets against the success of reorganization. Under these circumstances, the minority claimholders within the class have disparate interests from the vulture fund, since the traditional creditors stand to benefit from a plan payment. The result is that creditors may tender claims for lower prices due to the coercive nature of an offer; the controlling block of shares will ultimately be sold at an even greater discount. Additionally, the DDI uses the leverage obtained from controlling the class for its own benefit while shifting negative externalities to the minority block of claims that are left with little leverage in negotiations once the DDI has purchased the controlling block of claims.188 While the foundational premise of chapter 11 is to maximize returns to all creditors,189 vulture funds that implement the above strategy use their unique positions to maximize their own returns at the expense of other creditors. This result is

184 See, e.g., Unocal Corp., 493 A.2d at 949 (describing two-tier, front loaded tender offers as coercive when a 13% owner of the target’s stock offered $54 for 37% of the remaining shares and only “junk bonds” for those on the back-end). 185 See, e.g., In re Allegheny Int’l, Inc., 118 B.R. 282, 295–96 (Bankr. W.D. Pa. 1990) (noting that the manner the DDI acquired claims was discriminatory because members of a class that accepted the offer received cash up front while those that rejected the offer needed to wait for plan confirmation). 186 DEL. CODE ANN. tit. 8, § 253 (2010). A short-form merger employs a statutory summary process to eliminate minority shares when the majority shareholder owns at least 90% of each class of stock. Id. § 253. 187 Id. § 262. A long-form merger is employed when the raider has 50.1% of the target’s stock and requires the Board of Directors of the target to consider the merger agreement and submit it to stockholders for approval. Id. 188 Creditors in the minority block of claims only have leverage derived from their ability to argue that the plan is not feasible under 11 U.S.C. § 1129(a)(11), and that they are receiving less than under a liquidation of the debtor under 11 U.S.C. § 1129(a)(7)(A)(ii). 189 H.R. REP. NO. 95-595, at 220 (1977).



detrimental to business reorganizations and is contrary to the intent of Congress when it drafted the ‘78 Act.

5. Reduced Exclusivity Leverage and the Rise of Chapter 22

Prior to BAPCPA, a DIP’s right to exclusivity was infrequently, if ever, questioned due to judicial fears that the negotiation process would unravel.190 BAPCPA changed this. BAPCPA established firm limits on judicial extensions to exclusivity.191 The combined effect of delays in productive negotiation due to distressed-debt trading and BAPCPA’s time limitation for exclusivity is a significant decrease in the DIP’s leverage in the negotiation process. The DIP stands to lose control after eighteen months,192 which is now more likely due to delays in productive negotiations.193 A likely result is that the creditors’ leverage increases as the end of exclusivity nears, allowing creditors to force the DIP to make concessions in its plan as the DIP becomes more worried about losing control.194 Again, distressed-debt trading tips leverage in favor of creditors despite the Code’s attempt to balance leverage among interested groups.

The DIP’s reduction in leverage has been accompanied by increased participation of predatory vulture funds.195 While chapter 11’s success was premised “upon a symbiotic relationship between debtor and creditor, it is becoming less effective in the context of distressed debt trading.”196 The fundamental relationships have changed within the reorganization forum. When chapter 11 was drafted there were two players: (1) the DIP and (2) creditors with a stake in the debtor’s recovery.197 With the advent of distressed-debt investing, three different players occupy the forum: (1) the DIP; (2) creditors that have an interest in reorganization and an ongoing relationship;198

190 See supra text accompanying notes 97–107. 191 See 11 U.S.C. § 1121(d)(2) (2006). 192 Id. 11 U.S.C. § 1121(b). 193 See supra text accompanying notes 97–107. 194 See Michelle M. Harner, A Chapter 11 Debtor’s Life After Oct. 17: Not So Bad If You Effectively Plan, 24-9 AM. BANKR. INST. J. 36, 76 (2005) (“[Section 1121(d) as amended by BAPCPA] potentially gives creditors significantly more leverage in negotiating a plan.”). 195 See infra text accompanying note 206. 196 Miller, supra note 4, at 2015. 197 See id. at 2014; see also Andersen, supra note 11, at 12. 198 DDIs that buy claims in order to profit from a payout, rather than flipping a claim, belong in this category because they are long-term residual owners that intend to participate and remain in negotiations.



and (3) vulture funds that grab value and flee or assert leverage to profit from bets against reorganization.199 This last category is problematic.

Not every DDI falls into this third category. DDIs that purchase claims with the intent of being long-term residual owners are of the second class because they intend to participate in negotiations, bring expertise to the table, and consolidate claims within a class.200 The third category does not provide these benefits and instead drains value from the estate. Most hedge funds have liberal redemption policies for investors, which require the funds to maintain high levels of liquidity and cause the fund to seek short-term returns when investing in distressed debt.201 Unfortunately, the DDI’s needs for liquidity make claim flipping and betting against the success of reorganization more attractive options than acting as a long-term residual owner. This is detrimental to reorganization.

Rather than encouraging negotiations to place the debtor on its best footing when it emerges from bankruptcy, chapter 11 currently exposes the debtor to opportunistic debt traders. Unfortunately, the participation of vulture funds causes reorganization to be more of a zero-sum game.202 The gain of a vulture fund engaging in claim flipping is counterbalanced by the loss of some other party-in-interest. The same can be said when a vulture profits from a bet against reorganization or on a total return swap as a net adverse creditor.203 When the debtor suffers the losses resulting from vultures funds’ gains, the debtor’s chances for success after emerging from bankruptcy are diminished along with the going-concern value of the business. Combine these losses with the increased propensity of the DIP to accept a plan that favors creditors over

199 See Harner, supra note 6, at 76 (“The concept of ‘relationship lending,’ where a bank would work with a troubled company to develop a mutually-agreeable restructuring plan to foster repeat business with the company, is now the rare exception rather than the rule.”). 200 Whitaker, supra note 46, at 303 (noting that claims-trading is beneficial to the extent that it provides a new source of investment, a liquid market for claims, and expertise in reorganization). 201 Fisher & Buck, supra note 119, at 24 (citing Henny Sender, Debt Buyers vs. The Indebted, WALL ST. J., Oct. 17, 2006, at C1). 202 Chapter 11 was drafted with an eye towards being non-zero sum by providing a forum where concessions would be granted to improve the payout to all parties while maintaining the going-concern value of the debtor. Thus, as envisioned, chapter 11 would create an environment where one party’s gain was accompanied at best by a gain for other parties or at worst by no gains for others but no losses as well. Claim flipping, however, creates a drain on the estate at the expense of those that do not participate. See supra text accompanying notes 120–26. 203 See supra text accompanying notes 127–41.



the viability of the business,204 and it becomes more likely that management will return the debtor to chapter 11’s protective graces, something known as a chapter 22 reorganization.205 Indeed, the rate of recidivism among chapter 11 debtors has increased with the advent of distressed-debt investing.206

While some argue that the pressure DDIs exert in favor of an expeditious exit from chapter 11 benefits creditors by preserving assets of the estate,207 the adage “measure twice and cut once” may be applicable. Though there is undoubtedly some benefit provided by pressure for an expedient exit from chapter 11,208 this must necessarily be tempered with the DIP’s duty to propose a plan that is feasible,209 such that the debtor can avoid a chapter 22 filing.210 The erosion of the DIP’s leverage has caused the pressure that DDIs assert to be more problematic because these pressures are now more influential. Therefore, the Code should be drafted in a way that ensures that a firm exits from chapter 11 neither too early, nor too late. In other words, the rules of the game should encourage emergence from bankruptcy at the optimal moment. The key is to restore a balance of leverage in negotiations, something that the drafters of the ‘78 Act attempted, with some successes and some failures. Currently, there is an asymmetry of leverage in favor of claimants. Critics of chapter 11 abhor the costs and time involved in negotiations,211 but if the identity of claimants were to remain constant, then productive negotiations would be expedited, and the debtor would exit chapter 11 at an optimal time. The main problem may not be the pressure that long-term residual owners of

204 Miller, supra note 4, at 2013 (“Fearing that the bankruptcy court will no longer grant a once routine extension of exclusivity, debtors now are rushed to propose creditor-friendly, economically deficient plans to garner enough votes to pass a plan during the debtor’s exclusivity period.”). 205 Goldblatt, supra note 110, at 26. 206 Miller, supra note 4, at 1988. 207 Goldschmid, supra note 39, at 193 (“The thesis of this paper is that distressed-debt investors generally have a salutary impact on the residual actor problem of bankruptcy by expediting business reorganizations and protecting going-concern enterprise values.”). 208 One example of this might be preventing a firm from “languishing in Chapter 11” as Eastern Airlines did in the early 1990’s. Robert K. Rasmussen, The Efficiency of Chapter 11, 8 BANKR. DEV. J. 319, 320 (1991) (noting that Eastern Airlines spent more than $600 million while under bankruptcy protection). 209 11 U.S.C. § 1129(a)(11) (2006). 210 For a discussion of the dangers of rushing to approve a plan, see Lynn M. LoPucki & Sara D. Kalin, The Failure of Public Company Bankruptcies in Delaware and New York: Empirical Evidence of a “Race to the Bottom”, 54 VAND L. REV. 231, 271 (2001) (arguing that competition among courts to attract bankruptcy filings with speedy approval rates has led to a race to the bottom, which may be “economically wasteful as well as politically embarrassing”). 211 See, e.g., James W. Bowers, Groping and Coping in the Shadow of Murphy’s Law: Bankruptcy Theory and the Elementary Economics of Failure, 88 MICH. L. REV. 2097, 2108 (1990).



claims place on the DIP, but rather the DIP’s inability to negotiate productively in response to that pressure.

C. The DDIIP: Distressed-Debt Investors in Possession

When reorganization is used proactively to implement an alternative business plan, it is an effective tool for returning a failing business to the black.212 An alternative business plan is necessary for a debtor to be successful in a traditional chapter 11 reorganization.213 Crucial for an alternative business plan’s implementation is a proactive filing; the debtor’s management needs to file before the debtor’s finances have deteriorated beyond the point of rehabilitation.214 Understanding this, Congress provided in the ‘78 Act for existing management to retain control of business operations in order to provide incentives for proactive filings–the Debtor in Possession.215 With this incentive, Congress sought to prevent debtors from delaying filings to the point where reorganization becomes impossible.216

Predatory DDIs eliminate a debtor’s incentive to file proactively in some instances. First, appreciating the corporate form is beneficial. Control in large public companies is separate from equity, creating a system where the reorganization decision and process is controlled by management rather than ownership.217 While it is true that management likely holds some equity, the managers of the distressed company derive the most value through their executive positions. The corporate form in public companies, therefore, creates incentives for managers to act in ways that preserve their employment positions.218

While traditional creditors and the debtor’s management likely cringe at the thought of a looming chapter 11, some DDIs see it as an opportunity to take control of the struggling company. Frequently, hedge funds implement a loan-

212 Miller & Waisman, supra note 29, at 178–79. 213 Id. 214 Id. 215 See supra text accompanying notes 89–95. 216 See supra text accompanying notes 89–95. 217 Hu & Westbrook, supra note 13, at 1377. 218 See Bradley & Rosenzweig, supra note 29, at 1047; see also A. Mechele Dickerson, Privatizing Ethics in Corporate Reorganizations, 93 MINN L. REV. 875, 884–85 (2008) (“[S]hareholders have an incentive to encourage managers to engage in risky behavior to resuscitate an insolvent firm because their limited liability to the firm’s creditors protects them even though the higher-risk activities make it more likely that the business will lose money and ultimately be liquidated.”).



to-own strategy,219 where the fund provides short-term liquidity with stringent conditions in order to wrest control of the business from existing management.220 In addition to loaning-to-own, DDIs use the bankruptcy process to turn debt into equity.221 In the case of Allied Holdings, Inc.,222 the distressed-debt investor, Yucaipa Companies, purchased almost 66% of Allied’s general unsecured bond debt and then used the resulting leverage to emerge as Allied’s majority shareholder after plan confirmation.223 Similarly, ESL Investments acquired 49% of Kmart Corporation’s reorganized equity when it emerged from bankruptcy in 2003 by purchasing $1.16 billion of Kmart’s publicly traded debt and $600 million of its bank debt.224 DDIs then use their equity positions to put their own management in place, if they had not already done so during reorganization.

While Congress drafted chapter 11 specifically to allow a debtor’s management to retain control of the debtor,225 it has become an important arena in the market for corporate control.226 A debtor’s existing managers are unlikely to file if they have little chance of retaining their executive positions.227 Thus, while chapter 11 attempts to balance creditor protections with debtor incentives,228 DDIs tip the scales by decreasing the incentive to file. Intensifying this problem is the BAPCPA provision that strictly limits severance payments to executives.229 Though it may seem strange to reward management that rode a large public company into bankruptcy with lavish bankruptcy payments, such payments may be a necessary evil if management is to retain control of when it will file for chapter 11 protection.

219 Harner, supra note 6, at 70 (defining loaning-to-own as “where the investor extends debtor in possession financing to the debtor in order to facilitate the investor’s eventual ownership of the debtor’s business”). 220 H. Slayton Dabney, Jr., When Hedge Funds Compete, AM. BANKR. INST. J., Jan. 2008, at 22, 22 (noting that hedge funds implement various strategies to take control of the debtor in addition to loaning-to-own). 221 See Harner, supra note 9, at 716 (“[A]n investor may purchase distressed debt to try to acquire equity in the company though a debt-for-equity exchange as part of the company’s financial restructuring.”). 222 Virtus Capital, LP v. Allied Holding, Inc. (In re Allied Holding, Inc.), No. 07-14974, 2008 U.S. App. LEXIS 18626 (11th Cir. Aug. 27, 2008). 223 Harner, supra note 9, at 705–06. 224 Goldschmid, supra note 39, at 201–02 (citing Mitchell Pacelle & Amy Merrick, Salvage Operation: Behind Kmart Exit from Chapter 11, WALL ST. J., May 6, 2003, at A1). 225 See 11 U.S.C. § 1107 (2006). 226 Skeel, supra note 100, at 918. 227 See Bradley & Rosenzweig, supra note 29, at 1047. 228 See supra text accompanying notes 68–110. 229 11 U.S.C. § 503(c)(2).



DDIs reduce the effectiveness of reorganization by decreasing the debtor’s willingness to file when reorganization is the most feasible. While the Code provides that the debtor should remain in possession and control the business as a going concern, actual practice allows for DDIs to take possession by buying leverage in negotiations. Current practice thus replaces the DIP with the Distressed-Debt Investor in Possession.230 Most important, while the incentives for a debtor to file voluntarily have been eroded by distressed-debt investing, the limitations for creditors to force a debtor into bankruptcy remain rock solid.231 Now, the limitations and incentives provided in the ‘78 Act are nowhere near equilibrium. Chapter 11 currently prevents proactive filings by providing too little incentive to management to file willingly, while simultaneously erecting too great of barriers for creditors to force the debtor to reorganize. In other words, chapter 11 does not provide enough of a carrot for a debtor’s management to file proactively, nor does it give creditors enough of a stick by which they can force a reorganization at the optimal moment. This situation creates a stalemate between management and creditors that preserves the status quo of a failing business plan. This is detrimental to the efficacy of chapter 11.

III. MOVING TOWARD A SOLUTION

Legislative reforms to the Bankruptcy Code are necessary to solve the problems that vulture funds present to business reorganizations. Currently, reorganizing a corporation with chapter 11 is like bringing a knife to a gunfight. Creditors have evolved, becoming more sophisticated and more adept at finding ways to minimize risk and maximize profit from corporate failures; meanwhile, the forum and tools available to the debtor remained unchanged.

If we are serious about retaining a system of reorganization with the goal of maintaining going-concern value,232 then the debtor must be better equipped

230 Hereinafter “DDIIP.” 231 See supra text accompanying notes 68–110. 232 The desire to preserve a system of reorganization is not a given, by any means. Academics debate whether chapter 11 (in one form or another) remains a viable system to deal with a failing business. Frequently, but not always, the modern debate places Collective Bargaining Theorists, who argue for a system of reorganization in some form, against Contractualists, who argue that chapter 11 has outlived its usefulness. See Douglas G. Baird, Bankruptcy’s Uncontested Axioms, 108 YALE L.J. 573, 576 (1998) (placing bankruptcy scholars in two camps—proceduralists and traditionalists—based on policy concerns and perceptions of the role of bankruptcy within the U.S. economy). Compare Bradley & Rosenzweig, supra note 29, at 1048 (arguing that bankruptcy is endogenous and benefits a debtor’s management to the detriment of creditors), and Robert K. Rasmussen, Debtor’s Choice: A Menu Approach to Corporate Bankruptcy, 71 TEX. L. REV. 51, 66–



and placed on a level playing field with these highly sophisticated creditors. In addition, the system must act as a gatekeeper. The participants in business reorganization are not altruistic; rather, they are rational actors that will pursue their individual interests. The system should filter out those parties that are not interested in participating in negotiations and whose interests run counter to preserving going-concern value, while at the same time encouraging parties interested in negotiations and the preservation of going-concern value to remain in the forum. The rules of the game dictate the participants’ conduct. So, if the policy goal is to preserve going-concern value and foster negotiations to restructure a failing business, then the rules of the game must be changed.

This Comment has highlighted six areas of concern directly attributable to the actions of predatory DDIs: (1) the value drain DDIs create through claim flipping; (2) the strategy of betting against the success, or for the failure, of reorganization; (3) the propensity for a DIP to retract from negotiations due to an asymmetry of information that favors creditors; (4) the creation of coercive markets within classes that are targeted by predatory DDIs; (5) the increasing rates of chapter 11 recidivism; and (6) the decreased incentive for management of public corporations to file for chapter 11 protection proactively.

To solve these issues, the Code should be revised to: (1) require disclosure of all holdings that a DDI has in the debtor; (2) require a determination by the court of whether the DDI’s interests are adverse to, or in line with, a reorganization; (3) create restrictions on the resale of claims once a creditor has sold a claim to a DDI or other creditor; and (4) allow for a bankruptcy payment to corporate management that files proactively, but eliminate the payment if creditors bring, and win, a claim based on deepening insolvency. It is important, however, to implement changes to the Code that limit only the detrimental behavior of DDIs while promoting the beneficial aspects of distressed-debt trading. The changes discussed below narrowly eliminate the

77 (1992), and Alan Schwartz, Bankruptcy Contracting Reviewed, 109 YALE L.J. 343, 344–48 (1999), and and Bowers, supra note 211, at 2100 (arguing that bankruptcy law can never be made to work, and the current system should be replaced with state collection), with Thomas H. Jackson, Bankruptcy, Non-Bankruptcy Entitlements, and the Creditors’ Bargain, 91 YALE L.J. 857, 858 (1982) (introducing the Creditors’ Bargain Theory of bankruptcy), and Lynn M. LoPucki, Strange Visions in a Strange World: A Reply to Professors Bradley and Rosenzweig, 91 MICH. L. REV. 79, 81 (1992) (calling into doubt Bradley and Rosenzweig’s data), and Miller & Waisman, supra note 90, at 200 (arguing that bankruptcy laws need to be strengthened rather than abolished), and Elizabeth Warren, The Untenable Case for Repeal of Chapter 11, 102 YALE L.J. 437, 438 (1992) (questioning Bradley and Rosezweig). While this debate is largely outside the scope of this Comment, many of the above detractors of chapter 11 point to the costs associated with reorganization—a real problem exacerbated by predatory DDIs.



detrimental aspects of claims-trading while preserving the benefits that DDIs contribute to the system of reorganization.

A. Revisions to Chapter 11 Affecting Distressed-Debt Investors

Traditional reorganization is a system where long-term creditors negotiate with the DIP to return a failing business to viability.233 This should be compared with the current system that allows non-traditional creditors to flip claims and bet against the success of reorganization, both of which drain value from the estate and decrease the efficacy of reorganization.234 A line must be drawn between detrimental and beneficial claims-trading, with rules eliminating the former and promoting the latter. The Code should be revised to: (1) require mandatory disclosure of holdings in the debtor by DDIs, accompanied by a concomitant review by the court to prevent vulture funds from betting against the success of reorganization, and (2) create restrictions on resale to prevent claim flipping.

1. Mandatory Disclosure of Holdings in the Debtor

This comment proposes that, while the debtor is in chapter 11, a DDI wishing to purchase claims from creditors would need to disclose fully its holdings in the debtor, including short positions, credit derivatives, total return swaps, as well as the prices paid for such investments. Opponents of disclosure requirements chiefly argue that DDIs’ holdings are proprietary.235 Thus, they argue, mandatory disclosure would bar entry by DDIs that wish to keep proprietary information secret, and even those DDIs that seek to consolidate claims and negotiate throughout organization would be dissuaded from participating.236

This argument is not without merit. Ideally, the law would balance the necessity of disclosure and the preference of DDIs to keep their holdings confidential. To accomplish this, the DDI would disclose its holdings to the bankruptcy court and the other creditors within the class from which the claim is being purchased. Both the court and the creditors in the class would hold the information as fiduciaries of the DDI, protecting the DDI’s proprietary

233 H.R. REP. NO. 95-595, at 220 (1977) (“The purpose of a business reorganization case, unlike a liquidation case, is to restructure a business’s finances so that it may continue to operate . . . .”). 234 See supra text accompanying notes 112–26. 235 Hals, supra note 157. 236 Id.



interests and ensuring that the DDI’s ability to negotiate with the DIP is not detrimentally affected by the disclosure. The court, after a hearing, can either approve or reject the sale of the claims to the DDI after determining whether the DDI would ultimately become a netadverse creditor.237 Furthermore, the DDI would need to place a hold on purchasing investments, such as total return swaps, which pay off when reorganization fails.

The chief benefit of mandatory disclosure would be the elimination of the DDIs ability to bet on the failure of reorganization. The disclosure requirement would limit participation to those parties that are traditional creditors, and to DDIs that wish to profit from a return on the claim. Disclosure to the court and other creditors in the class serves to screen for net adverse creditors and prevent such DDIs from buying claims to assert leverage in negotiations. By eliminating bets on the reorganizations’ failure, the disclosure requirement eliminates one cause of the Lemons Problem the DIP may experience.238 The DIP can be confident that the screening process prevented a predatory vulture fund that would have bet against the success of reorganization from purchasing the claims. Finally, by eliminating the strategy of betting against a successful reorganization, the disclosure requirement would ensure that an offer to creditors structured like a two-tiered, tender offer will not be coercive. By preventing net adverse creditors from purchasing claims, the rules would ensure that the purchasing DDI’s interests are in line with those of other creditors within the class. Having eliminated the strategy of betting against the success of reorganization, DDIs and creditors would mutually benefit from the returns on their claims. In the absence of these abusive strategies, creditors that refuse to sell to a DDI that makes a two-tiered, tender offer can rest assured that a DDI that purchases enough claims to control the class will negotiate for a beneficial return on the claims, in order to profit on extrinsic investments. Thus, the disclosure requirement eliminates the prisoner’s dilemma that claimholders face when DDIs use leverage in bankruptcy to effect non-bankruptcy holdings.

While mandatory disclosure is effective at preventing predatory DDIs from betting on the failure of reorganization and the associated dilemmas the strategy presents to negotiation, the disclosure requirement does little to prevent claim-flipping. To prevent the value drain associated with claim-

237 See supra text accompanying notes 127–41. 238 See supra text accompanying notes 163–73 (discussing the Lemons Problem that a DIP may face from the asymmetry of information that favors creditors).



flipping, changes must also be made to the process by which claims are transferred to, and by, DDIs.

2. Restrictions on Resale

The requirements for disclosure prevent DDIs from engaging in betting against the success of organization. Chapter 11 should also be revised to eliminate claim-flipping as a strategy. Such revisions would implement restrictions on the resale of claims. Initially, creditors would be able to sell to any interested DDI or other creditor. This is how chapter 11 currently functions. The proposed change would be to place a restriction on the resale of the claim by a purchasing DDI. Specifically, after the initial sale, the purchasing DDI could either sell its claim to (1) another creditor that holds a claim in that class, or (2) to a DDI that makes a bid for the entire class of claims.

These restrictions on the resale of claims would eliminate the detrimental aspects of claim-flipping. Claim-flipping is detrimental to reorganization because of the relationship-value that is lost when a creditor with knowledge and an existing relationship with the DIP sells to a DDI that has no such knowledge or relationship.239 With this change, the restriction on resale bars entry for DDIs that would engage in claim-flipping while simultaneously allowing a creditor that does not wish to engage in negotiations to exit. The creditor at the time of petition may be foreclosed from selling to a claim flipper, but it is free to sell to a creditor that will hold onto the claim and participate in negotiations with an eye toward profiting from a plan payment or converting the debt to equity.

Likely, fewer DDIs would participate in negotiations because the restriction on resale contracts the size of the market for claims by reducing demand for the claims. In this sense, the barrier to exit negotiations implemented by the restrictions on resale would serve as a barrier to entry. However, if the purpose of chapter 11 is to preserve going-concern value and to maximize returns to all creditors, then the rules must be tailored to promote this end. The restriction on resale is a safeguard ensuring that a purchasing DDI cannot flip its claim, which would be detrimental to reorganization.

239 See supra text accompanying notes 112–26 (discussing the practice, and detrimental effects, of claim flipping).



Furthermore, while claim flippers are foreclosed from participating based on the restrictions on resale, claim consolidation may still take place because creditors are permitted to sell to other creditors within the class. A DDI that purchases one claim within the class can then purchase other claims within the class irrespective of the restrictions. In addition, a creditor or DDI that has purchased a claim subject to the restrictions on resale may at any time sell its claim to another DDI that puts forth an offer for 100% of the claims within the class. While this may amount to restricted claim flipping, the detriment of such “100% flips” is outweighed by the fact that the class of creditors with disparate interests will be replaced by a single entity that will facilitate negotiations with the DIP. Thus, one of the acknowledged benefits of claim consolidation facilitated by claims-trading240 remains intact.

Finally, the confusion and delays that claim flipping creates in the negotiation forum241 cease under such a restricted-resale system. The DIP can feel confident that the purchaser of claims will be present and engaged in negotiations. The system encourages a buyer that is interested in negotiations to purchase the claim, so the asymmetry of information against the DIP ceases to be an issue.

Additionally, the pressure that DDIs assert for an expeditious exit from chapter 11242 would be less detrimental because productive negotiations would now take place without delay and confusion, increasing the DIP’s ability to negotiate a feasible and favorable plan. This in turn fosters productive negotiations. Because the DIP can negotiate productively, the pressure that DDIs assert for expeditious exits from chapter 11 can be dealt with effectively rather than reducing the DIP’s leverage derived from exclusivity.243 The culminating effect would allow the DIP to propose the most feasible plan due to the parity of leverage that this system creates. The plan would most likely be optimal for all parties, without the DIP conceding too much, which in turn reduces the probability of a chapter 22 filing.

240 See supra text accompanying notes 199–200 (discussing the benefits claims-trading provides to business reorganization). 241 See supra text accompanying notes 163–73 (discussing the confusion created by claim flipping and betting against the success of reorganization and the consequences for productive negotiations). 242 See supra text accompanying notes 206–10. 243 See supra text accompanying notes 206–10.



B. Changes to Chapter 11 Affecting the Debtor’s Management

To the extent that DDIs buy debt to take control of corporations, they consequently discourage management from filing chapter 11 proactively.244 In this sense, DDIs indirectly decrease the efficacy of business reorganization. For while DDIs do not decrease the ability of the DIP to preserve going-concern value, the prospect of a DDI taking control of a corporation and replacing the existing management does influence the actions of the debtor’s management, and this in turn decreases the efficacy of business reorganization. There are two possible solutions to this problem. First, distressed-debt investing can be eliminated. As previously mentioned, this should not be done. While certain strategies employed by DDIs are detrimental to reorganization, others are beneficial and have a salutary impact on business reorganization under the Code. The second option is to provide incentives for management that files proactively and disincentives for management that delays a filing and wastes the debtor’s assets. This second option should be pursued in order to eliminate the indirect, yet detrimental, consequence of claims-trading. Fortunately, this solution will also maintain the beneficial aspects of claims-trading. This Comment proposes that corporate management should receive a bankruptcy payment for filing proactively. However, the payment should be eliminated if creditors successfully show that the debtor’s management delayed filing to the detriment of creditors.

1. Allowance of Bankruptcy Payments for Responsible Management

Section 503(c)(2) of the Code limits executive compensation for management of businesses that file for bankruptcy:

(c) Notwithstanding subsection (b), there shall neither be allowed, nor paid . . .

(2) a severance payment to an insider of the debtor, unless— (A) the payment is part of a program that is

generally applicable to all full-time employees; and (B) the amount of the payment is not greater than

10 times the amount of the mean severance pay given to nonmanagement employees during the calendar year in which the payment is made . . . .245

244 See supra text accompanying notes 219–24 (discussing loaning-to-own and conversion of debt to equity). 245 11 U.S.C. § 503(c)(2) (2006).



Initially, the provision makes sense. Why pay the management of a failed business significant sums when creditors are receiving pennies on the dollar? Upon more careful consideration of this provision, however, the effects may be more pernicious for creditors than management. Specifically, by prohibiting compensation to executives, the Code eliminates the most significant benefit provided to management to file proactively. While filing for bankruptcy may be beneficial for creditors, the most beneficial strategy for management is to pursue non-bankruptcy strategies that it hopes will return the corporation to viability. As insolvency approaches, management will pursue more dangerous strategies and accept more risk because there is no upside to filing for bankruptcy. If the limits on compensation were lifted, management could receive bankruptcy payments that are conditional upon filing proactively. The benefit of such a payment is that it would align the interests of management and creditors, as well as promote proactive filings.

2. Eliminate the Proposed Bankruptcy Payments as a Penalty for Deepening Insolvency

Deepening insolvency is a theory based in tort that places liability on a debtor’s management, officers, and directors for failing to seek bankruptcy relief proactively.246 The claim asserts that the management of the corporation failed to fulfill its fiduciary duties by expanding corporate debt, essentially wasting funds that could have been used to satisfy creditors in bankruptcy. While some courts initially accepted this reasoning,247 recent decisions have interred the theory.248

Most recently, in In re Midway Games,249 the Official Committee of Unsecured Creditors alleged that Midway’s board of directors and officers breached their fiduciary duties of care and loyalty by taking on additional debt

246 See generally Brya M. Keilson, Relief in the Boardroom: How the Third Circuit’s CITX Decision Weakened Deepening Insolvency as an Independent Cause of Action, 52 VILL. L. REV. 975, 976 (2007) (“Deepening insolvency is a developing theory that is generally described as ‘an injury to the Debtors’ corporate property from the fraudulent expansion of corporate debt and prolongation of corporate life.’” (quoting Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340, 347 (3d Cir. 2001))). 247 See, e.g., R.F. Lafferty & Co., 267 F.3d at 340; OHC Liquidation Trust v. Credit Suisse First Bos. (In re Oakwood Homes Corp.), 340 B.R. 510, 531 (Bankr. D. Del. 2006); In re LTV Steel Co., 333 B.R. 397, 422 (Bankr. N.D. Ohio 2005). 248 See, e.g., Trenwick Am. Litigation Trust v. Ernst & Young, L.L.P., 906 A.2d 168 (Del. Ch. 2006); Official Comm. of Unsecured Creditors of Fedders N. Am., Inc. v. Goldman Sachs Credit Partners L.P. (In re Fedders N. Am., Inc.), 405 B.R. 527 (Bankr. D. Del. 2009). 249 Official Comm. of Unsecured Creditors of Midway Games v. Nat’l Amusements, Inc. (In re Midway Games, Inc.), 428 B.R. 303 (Bankr. D. Del. 2010).



rather than seeking bankruptcy relief.250 The court rejected this claim, noting that, “The Delaware Court of the Chancery and the Delaware Supreme Court, the Nation’s preeminent authorities on corporate law, interred‘deepening insolvency’ as a cause of action . . . .”251 While an analysis of the grounds for rejecting the theory of deepening insolvency is beyond the scope of this Comment, the theory and effect of such a tort is nonetheless informative.

By providing bankruptcy payments to responsible managements, and penalizing those that engaged in deepening insolvency, the law would deter managements from pursuing risky revitalization strategies. By implementing such a system, the Code would provide both an incentive for good management and a deterrent for bad management. The bankruptcy payment would thus be a conditional reward for responsible management, and it would align the interests of the management and creditors.

CONCLUSION

The problems vulture funds create during reorganization are real and will persist without change to the current system. There is profit to be made by exploiting debtors and creditors that are forced to use chapter 11 to reorganize for lack of any other choice. No person can be blamed for seeking profits alone. Blame becomes justifiable when the expense of profit seeking is shifted onto others. In the reorganization context, vulture funds profit while creating delays, confusion, and ultimately losses to both debtors and traditional creditors. While chapter 11 was premised on preserving going-concern value, this foundation is lost when vulture funds actively trade distressed debt in a predatory fashion. Steps should be taken to limit this predation. A good start would be to implement a system of mandatory disclosure, to place restrictions

250 Id. at 315 (“The clear upshot of the Committee’s claims against the Board Defendants is that Midway should have filed for bankruptcy rather than enter into the Challenged Transactions.”). 251 Id.



on the resale of claims, and to create a conditional bankruptcy payment for management that proactively files for chapter 11 relief.

RICHARD D. THOMAS∗

∗ Editor-in-Chief, Emory Bankruptcy Developments Journal; J.D. Candidate, Emory University School of Law (2011); B.A., University of Colorado-Boulder (2008). The author would first like to thank Professor William J. Carney for his guidance and insight. The help of James A. Pardo, Partner King & Spalding, was also instrumental in the writing of this Comment. The author also thanks the staff of the Emory Bankruptcy Developments Journal, particularly Daniel Maland and Joseph Minock, who worked to make this Comment publishable. Finally, the author thanks his wife, Nell, for her support, encouragement, and love over the last three years—without which this Comment, and much more, would not have been possible.

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