The emerging market for trade claims of bankrupt firms
A small but growing market has developed for exchanging claims against debtors seeking relief under Chapter 11 of the U.S. Bankruptcy Code. This market provides trade claimants an alternative to forced participation in the reorganization, thereby decreasing the costs of bankruptcy and offering new opportunities for investors.
When a debtor files a bankruptcy petition, holders of the debtor’s trade claims sometimes look for buyers to purchase these obligations and hence, an informal, unregulated, illiquid market has developed for them. To be considered for active trading, the claim must be against a debtor that is large or otherwise well-known. The number of debtors with trade claims trading in such markets has grown rapidly in recent years (1982 to 1991) as the pace of Chapter 11 filings has accelerated.
Recent studies have focused on specific aspects of Chapter 11 reorganizations. While Brown (1989), Giammarino (1989), and Bebchuk and Chang (1992) model the conflict resolution process in bankruptcy, Weiss (1990) finds that absolute priority is violated in 29 out of 37 cases, and Eberhart, Moore, and Roenfeldt (1990) document (in a sample of 30 firms) that deviations from absolute priority in reorganizations result in gains to shareholders of, on average, 7.6% of the value of the firm. Daigle and Maloney (1994) develop a hypothesis that predicts the share of the reorganized firm value retained by old shareholders. Gertner and Scharfstein (1991) find that Chapter 11 proceedings enhance real investments of troubled firms while Eberhart and Senbet (1993) argue that violations of absolute priority reduce incentives to avoid risky projects. Franks and Torous (1989) recognize that the management of companies in Chapter 11 reorganizations have considerable power, identify the sources of that power, and suggest that it helps to explain departures from the “absolute priority rule” in reorganizations (see Baird and Jackson (1988)). Finally, John (1993) reviews the literature on financial distress and suggests an agenda for further research.
This paper discusses the market for Chapter 11 trade claims. Trading in claims serves a host of private needs, and the emergence of this market offers yet another illustration of how markets arise to serve mutually beneficial interests. We describe the services provided by broker/dealers, traders, investors, and information vendors. We identify a number of the most active participants. How the products representing claims are standardized for efficient trading, a vital feature of a viable but still illiquid market, is set forth. We indicate why buyers usually are able to offer bids for any claim against a debtor, not just its trade claims. In addition, we provide important indirect evidence supporting the belief that the purchase of trade claims can be a useful vehicle for gaining corporate control, a hitherto neglected subject in the study of control. Finally, we argue that the presence of this market increases the value of the bankrupt firm above what it would be otherwise.
I. Legal Background
In general, the party buying a claim succeeds to all the rights and infirmities of the seller, including, of course, the right to the face value of the claim (Fortgang and Mayer (1990)). Infirmities include all the defenses the debtor and other parties at interest can assert to challenge the claim, i.e., fraudulent conveyance, failure to fulfill contractual terms, and so forth. Potential lender liability is also a burden on the buyer, especially of bank claims. For these reasons, buyers insist that the claims seller provide certain warranties and agree to indemnify the buyer for losses suffered if certain events occur.
In a Chapter 11 case the trade-claim buyer is a post-petition acquirer. In some jurisdictions, the buyer is advised to notify the bankruptcy court of the potential assignment so that a so-called disclosure statement may be made by the debtor to the seller. This statement, which is also available to the public, serves to inform a potentially uninformed seller of the probable value of his claim. Ironically, this is in contrast to public policy in the regulation of securities markets where the burden is upon the “seller” of securities to disclose adequate information to a presumed uninformed buyer. Note that trade claims are not “securities” within the purview of the Securities Acts of 1933 and 1934 (Fortgang and Mayer, (1990)).
Once an agreement to sell a claim is reached, Bankruptcy Rule 3001(e) of the U.S. Bankruptcy Code (1978), requires the buyer to notify the bankruptcy court of the transaction and the court, if satisfied that all requirements have been met, validates the transfer and officially records the new owners of the claim. Prices and terms of such transactions are publicly available at the court. For some legal pitfalls in claims trading, however, see Jelisavcic (1992).
Liabilities arising after a filing are generally treated as unsecured claims. They frequently emerge as a result of the debtor rejecting unexpired leases and executory contracts (i.e., contracts yet to be performed by the debtor). Rejection often leads to a claim against the debtor by the injured party. Even though rejection takes place after filing, the injured party’s claim becomes a pre-petition, unsecured claim. Exceptions to the unsecured status of post-petition claims usually include taxes, pensions, and environmental claims, which acquire a priority status.
II. Motivations for Acquiring or Selling Trade Claims
Participants in the market for trade claims have a variety of motives for acquiring and selling these claims.
A. Motives for Acquiring Trade Claims
There are at least three possible motives for purchasing trade claims. First is the pure investment motive, i.e., seeking a return without necessarily acquiring control. Investors consist of individuals, partnerships, corporations, and so-called “vulture funds” (i.e., institutions devoted solely to investing in distressed instruments either as a short-term investment or as a means of acquiring control).
Second is the broker/dealer motive. These participants bring buyer and seller together and earn a markup or a commission for their efforts. Third is the desire to earn an investment return plus a premium by achieving control of a creditor committee. Investors seeking control acquire trade claims as a vehicle for dominating such committees. Some reorganizations result in trade creditors receiving not only a new claim but also shares of common stock. Therefore, a group seeking a management takeover may buy trade claims to add to its ownership share. Reinforcing the desire of such groups to acquire trade claims is the fact that the weaker the priority of the creditor claimant, the greater is the relative likelihood that any recoveries the claimant realizes will be in the form of some equity interests in the reorganized debtor. Some such parties may value claims at a higher price than the price at which pure investors or broker/dealers would value them. A control-seeking investor may even be willing to pay a “control premium.” Influencing or dominating a committee and, in turn, being able to affect the negotiating terms with management and other creditor groups usually requires “tough” (if not confrontational) bargaining.
B. Motives for Selling Trade Claims
Knowing that the average time for settling a Chapter 11 bankruptcy is about 2 1/2 years (Weiss, 1990), and can take in excess of 7 years (as the LTV bankruptcy clearly shows), sellers of trade claims have numerous incentives for disposing of their claims. The most important motive is perhaps the view that a sum certain is preferable to an uncertain sum realizable at a still uncertain time. Other motives include a perceived need for immediate cash and the desire to realize a current tax loss. Holders of small face-value claims may conclude that retaining an attorney to represent them and protect their rights is not worth the cost. Claim holders may feel that the task of evaluating claims and participating in the negotiation process, which, as indicated above, can be quite complex, is deemed not worth the effort and opt to sell them at the best available price.
Some suppliers resist selling their claims to signal their confidence in the current management, thus putting them in a favorable position to negotiate future sales with the debtor, either during or after the bankruptcy period. In this case, the expected net present value of (1) the future business and (2) the expected proceeds upon settlement must exceed the current market value of the claim. Also, holders of very small claims (called “convenience” claims) often receive full cash payment in reorganizations (Norton and Staples (1991)).
III. Market Participants
The market participants may act as brokers, dealers, traders/investors, or information vendors. A given firm may perform one or more of these functions.
A. Description of Roles
A variety of institutions drive the market for trade credit claims. Of the 36 firms whose claims we were able to identify as trading in 1991, only a handful could be described as being very actively traded. At any given time, not all claim traders may be active; most are interested in only a small number of debtors. As a result, trades tend to take place infrequently.
Brokers, such as Seidler Amdec, act as agents (for either buyer or seller) and negotiate trades. By maintaining a network of contacts among investors, they arrange trades by seeking out trade claim holders of Chapter 11 firms. The bankruptcy court itself is an excellent source of information of creditor names, addresses, and amounts of claims. Commissions charged range from 0.5% to 1% of the value of the transaction. Approximately 25 firms were engaged in this activity in 1991.
A dealer gathers small claims against a given firm and packages them into units (typically $30,000 of face value) for distribution to traders or investors. This unit is analogous to a “round lot” in security market parlance. Participants usually refer to this activity as “retailing.” Most transactions entered into by broker/dealers, however, are on a brokerage basis.
Traders differ from dealers by degree. They consolidate claims into units of at least $250,000 (“big deals”) and either make them available to investors or hold the units themselves. Traders often label their function as “wholesaling.” An important participant in this market is T. Rowe Price & Associates. Participants we contacted were unwilling to speculate as to the minimal volume of trading in this market. Without exception, however, participants suggest that broker volume vastly exceeds dealer volume.
Individuals, partnerships (LPs), and corporations are the principal investors. Of those, investment bankers and vulture funds constitute the bulk of investors in claims. Most investors confine their holdings to firms in a given group of industries and/or to particular geographic regions. Investors seeking to buy claims can identify claims holders by consulting the claims docket at the bankruptcy court.
Investors identified from a 1991 Beard Group listing, and willing to be interviewed, indicated they require a return of 20% to 30%, which they believe is commensurate with the risk they bear. Pure investors expect a risk-adjusted rate of return lower than that expected by those wishing to dominate creditor committees and/or seeking control of management. The latter expect to realize, in addition to the pure investor’s return, the benefits of control as compensation for the added costs required to gain control.
A recently organized but short-lived vulture fund illustrates the above point. Goldman Sach’s Water Street Corporate Recovery Fund I, according to its sales brochure, was organized to buy securities “on a basis that may enable it to influence the recapitalization of those companies” (The Wall Street Journal, March 31, 1990). In effect, the fund sought an influential role on creditor committees. Typical vulture funds include, for example, Magten Asset Management, Morgens, Waterfall, Vintiadis & Co., Oppenheimer & Co., T. Rowe Price & Associates, and Foothill Group.
The information vendor, Beard Group of Washington, DC, publishes the most important source of periodical information on trade claims titled Turnarounds and Workouts: News for People Tracking Distressed Businesses. A monthly supplement contains the range in bid prices for packaged claims ($30,000 in face value) quoted by various broker/dealers. Claims reported vary from month to month along with the approximate bid prices. Only rarely is a specific claim, Eastern Airlines, for example, reported over an extended period of time. A sample of such negotiating opportunities, and their approximate bid prices, appears in Table 1. The mean of these prices is 38.75% of face value.
Table 1. Approximate Bid Prices for Trade Claims of Bankrupt Firms, $30,000
Units, May 3, 1991
Firm Approximate Bid Prices(a)
Allied Federated 0.44
Ames Department Stores 0.14
American Freight Systems 0.35 – 0.40 (range)
Apex Oil 0.20
LTV Aerospace 0.25
Public Service New Hampshire 0.92
a Fraction of a dollar per one dollar of face value
Source: Turnarounds and Workouts (1991).
Of course, when a firm announces a Chapter 11 filing, especially a small firm, many investment analysts that had been following the company lose interest in it, for obvious reasons, which reduces the flow of information about the firm. For example, while The Wall Street Journal may report a small firm filing under Chapter 11, it may not report when that firm terminates its bankruptcy, whether through liquidation or reorganization.
B. Participating Firms
Table 2 lists firms that the Beard Group’s June 1991 listing identified as potential participants in the distressed trade claims market. Some of these firms, for example, Chase Manhattan and Citibank, were not active at that time. One of the more active firms, however, was Amroc Investments. This firm brokers both trade debt and bank debt, has a regular clientele that it services as a buying agent, and also takes a long position in those instruments. R.D. Smith & Co. is very active in brokerage, dealing, and investing in claims. Another aggressive finn is Angelo, Gordon and Co., which buys trade claims for investment purposes. In addition to purchasing claims like other investors, it exploits economies of scale in investment analysis. Analyzing all of the distressed firm’s claims is usually necessary to evaluate trade debts. After completing an overall analysis of a debtor, the investor is in a position to bid on any of the firm’s claims.
The presence of scale economies in investment analysis leads to an important implication: Few investors speculate only in trade claims. Trade claims typically constitute a small fraction of a large debtor’s total liabilities, and the supply is limited. While we found some anecdotal evidence in support of this hypothesis, the investors we contacted in this market were reluctant to provide detailed information.
IV. Functions of a Trade Claims Market
The market for trade claims has become more standardized, which has reduced to some degree the costs inherent in the bankruptcy process.
A. Standardization of Products
An essential feature of an active, viable market is the availability of reasonably standardized products. This is highlighted by the contrast between the markets for commodity and financial futures contracts and the forward contract markets. Requiring a high degree of standardization, the futures markets are much more liquid than forward markets. It is therefore not unexpected to find that participants in trade-claim contracts have taken a number of steps to standardize trading units.
As a first step, it has become common to aggregate “retail” units consisting of $30,000 face value and to aggregate “wholesale” units consisting of $250,000 face value. Second, participants require the owner of the claim to provide a warranty of title, a guarantee that the claim is free of legal defects, e.g., products and/or services were delivered and accepted without reservation by the debtor, and warrant the absence of voidable preferences, equitable subordination, and fraudulent conveyance. Claims without warranties find few buyer. Third, as noted earlier, seller agrees to indemnify buyer if violations of any warranty results in financial injury to the buyer. In addition, buyers usually evaluate the seller’s ability to indemnify the buyer in the event indemnification is triggered. This implies that the buyer evaluates not only the debtor, but the original holder of the claim as well. Although such warranties and indemnification agreements are common, their wording in contracts is not identical as it is in futures and option contracts on organized exchanges. These steps toward standardization reduce transaction costs by avoiding duplication of effort and by making subsequent transfers easier.
B. Added Benefits of a Trade Claims Market
In addition to direct private benefits, the market also confers upon sellers and buyers indirect benefits. Gathering, consolidating and other acts of standardizing claims facilitates not only market transactions but the reorganization process as well. By reducing the number of creditors in each class, negotiation is simplified. For the same reason, accommodation and agreement on a proposal may be more readily achieved.
If this, in turn, leads to a quicker settlement, then the added administration costs (accounting, consultant and attorney fees, for example) of a delayed settlement are avoided, enhancing the going-concern value of the firm. This does not hurt trade-claim holders (or any other class of claimants for that matter), but whether they gain as a class depends upon the results of the bargaining process. Because the existence of a claims market with its associated standardized product increases the present value of the firm, this market performs a socially useful function.
V. Distributions to Trade Claim Holders
Identities of 220 bankrupt firms that filed petitions under Chapter 11 between 1979 and 1991 were obtained from the SEC. To obtain data on their settlement distributions, we first consulted The Wall Street Journal Index and then The Wall Street Journal. We were able to obtain a usable sample of only 56 firms. Of these firms, 4 were subsequently liquidated, while 50 were reorganized, and 2 were merged into other firms.
Only sparse data on the percentages of trade claim recoveries are available. For 10 of the 56 firms, the mean recovery rate (cash plus securities as a percent of face value) was 52% with a standard deviation of 31%. Among the firms liquidated, one distributed cash of $0.42 per dollar to unsecured creditors while the other three disbursed cash of undisclosed fractions of face value.
Trade creditors of the 50 reorganized firms received a myriad of different distributions. Information reported was often of insufficient detail to specify the precise breakdown of a distribution–i.e., the percent of cash, percent of deferred payments, and so forth.
Looking at all 50 reorganizations, there is evidence suggesting that a control-seeking investor might have an opportunity to further its objective by acquiring trade claims. At least 29 reorganizations, or 58%, provided for explicit distributions of some form of equity (preferred stock, common stock, stock rights, and warrants) to trade claimants.
An example of a vulture fund acquiring trade claims to help gain control of a bankrupt firm is the recent case of Carter, Hawley, Hale Stores, Inc. Zell/Chilmark Fund, L.P., a proponent of a debtor-proposed reorganization plan, made a tender offer to buy the claims of subordinated creditors and unsecured claimants, including trade claim holders, at $0.40 per dollar of face value. Seeking to minimize holdouts, the fund also agreed to extend the offer period in the event terms were revised, which would permit earlier acceptees to receive any higher revised price. This also assured satisfaction of that section of the bankruptcy code requiring equal treatment for all claimants in a given class (unless, of course, the claimants waive that right).
The Zell/Chilmark offer was twice amended, eventually to $0.47 per dollar of face value, and the fund ultimately acquired 63% of all individual unsecured claims (77% in terms of total face value), which was sufficient to dominate this impaired creditor class and achieve its support of the debtor’s plan. Since the confirmed plan distributed the majority of the new shares of common stock (the old shares were extinguished) to unsecured creditors, Zell/Chilmark ultimately emerged with about 75% of the reorganized debtor’s equity.
Opportunities for mutually beneficial trades appear to abound in the illiquid market for trade credit claims of Chapter 11 firms. Original claim holders sell to satisfy a time preference, to establish tax losses, or to minimize perceived risks. Investors acquire claims to yield a pure return and/or to put themselves in a position to influence management or to acquire control.
Broker/dealers and traders facilitate trades by either acting as agents for participants or by taking positions. There is evidence of a “retail” market where the standardized face value of a claims unit is $30,000, and a “wholesale” market where the unit is $250,000 of face value. Typical of cost-efficient markets, some degree of standardization of products exists. Not only are claims packaged for “retail” and “wholesale” purposes but a fairly uniform set of warranty and indemnification statements accompany each package, thus facilitating trades. The existence of the market leads to the concentration of claims in fewer hands, which hastens the agreement process, and which, in turn, reduces administrative costs of bankruptcy and hence tends to increase the value of the reorganized firm.
A number of avenues for fruitful research can be suggested. How important is the purchase of claims, whether trade, bank, or other, to the process of gaining control of bankrupt firms? Although we have already noted the case of Carter, Hawley, Hale, Inc., where trade claim purchases were shown to be very important, there are numerous other instances to be studied. Are the firms vulnerable to such takeovers likely to be in certain industries, merchandising for example, where a large proportion of liabilities consist of trade claims? What common features do vulnerable firms have?
It is of interest to establish the percentage of trade claims that change hands during bankruptcy and at what time in the reorganization process these trades typically occur. Because a debtor usually has far fewer bank lenders than trade creditors, it has been easier to acquire a given volume of bank claims than a similar volume of trade claims. Has the emergence of this market for trade claims changed the relative turnover in bank claims as compared with that in trade claims? Also, because of institutional and legal difficulties, there are impediments to the standardization of secured trade credit as compared with that of unsecured trade credit. Is then trading in the former significantly less than trading in the latter? Since factors hold the trade debt of many firms, what role do they play in the market for trade claims as both sellers and buyers? Finally, to what extent, if any, does the existence of a market for trade claims reduce bankruptcy costs? These are only a few of the challenges inviting researchers to this area.
Baird, D.G. and T.H. Jackson, 1988, “Bargaining After the Fall and the Contours of the Absolute Priority Rule,” University of Chicago Law Review (Summer), 738-789.
Bebchuk, L.A. and H.F. Chang, 1992, “Bargaining and the Division of Value in Corporate Reorganization,” Journal of Law, Economics, and Organization (April), 253-279.
Brown, D.T., 1989, “Claimholder Incentive Conflicts in Reorganization: The Role of Bankruptcy Law,” Review of Financial Studies (Spring), 109-123.
Daigle, K.H. and M.T. Maloney, 1994, “Residual Claims in Bankruptcy: An Agency Theory Explanation,” Journal of Law and Economics (April), 157-192.
Eberhart, A.C., W.T. Moore, and R. Roenfeldt, 1990, “Security Pricing and Deviations from the Absolute Priority Rule in Bankruptcy Proceedings,” Journal of Finance (December), 1457-1469.
Eberhart, A.C. and L. Senbet, 1993, “Absolute Priority Rule Violations and Risk Incentives for Financially Distressed Firms,” Financial Management (Autumn), 101-116.
Fortgang, C.J. and T.M. Mayer, 1990, “Trading Claims and Taking Control of Corporations in Chapter 11,” Cardozo Law Review (October), 1-115.
Franks, J.R. and W.N. Torous, 1989, “An Empirical Investigation of U.S. Firms in Reorganization,” Journal of Finance (July), 747-769.
Gertner, R. and O. Scharfstein, 1991, “A Theory of Workouts and the Effects of Reorganization Law,” Journal of Finance (September), 1189-1222.
Giammarino, R.M., 1989, “The Resolution of Financial Distress,” Review of Financial Studies (Spring), 25-47.
Jelisavcic, V., 1992, “Trading Claims Against Chapter 11 Debtors: Disclosure as the Criterion for the Less Favorable Treatment Standard of Section 1123(a)(4),” Journal of Corporate Law (Winter), 385-417.
John, K., 1993, “Managing Financial Distress and Valuing Distressed Securities: A Survey and a Research Agenda,” Financial Management (Autumn), 60-78.
Norton, W.L., Jr. and R.H. Staples, 1991, “The Chapter 11 Process,” in S.N. Levine, ed., Investing in Bankruptcies and Turnarounds, New York, NY, Harper Bros., 221-239.
Turnarounds and Workouts: News for People Tracking Distressed Businesses, 1991, Washington, DC, Beard Group (June), 2.
Weiss, L.A., 1990, “Bankruptcy Resolution: Direct Costs and Violation of Priority of Claims,” Journal of Financial Economics (October), 285-314.
Table 2. Firms Participating in the Trade Claims Market in 1991
Acquisitions Mgmt, Inc. Amroc Investments Angelo, Gordon & Co. Anvil Capital Barre & Co. Bateman Eichler BT Securities Cargill, Inc. Chase Manhattan Bank Chemical Bank Citibank Cowen & Company First Boston Corp. Foothill Capital Gildea Management Japonica Partners Morgens, Waterfall, Vintiadis & Co Oppenheimer & Co. Pacholder Associates Phoenix Capital T. Rowe Price & Associates M.D. Sass Investors Seidler Amdec Alan B. Slifka & Company R.D. Smith & Company Steinhardt Partners Trust Co. of the West
Sources: The Wall Street Journal (various issues) and Turnarounds and Workouts (1991).
William Beranek is Professor Emeritus and Steven L. Jones is Assistant Professor, both at the University of Georgia, Athens, Georgia.
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