Hedge funds that invest in bankrupt companies are demanding protection from insider-trading lawsuits before agreeing to take part in restructuring talks -- a reaction by the industry’s top performers to an obscure court decision involving the 2008 collapse of Washington Mutual Inc.
The ruling by a Delaware federal judge let shareholders pursue allegations that four hedge funds involved in the bankruptcy traded on inside information about talks between WaMu, JPMorgan Chase & Co. and the Federal Deposit Insurance Corp.
While the 2011 decision was ultimately rescinded, some funds and other investors in bankrupt companies have begun to demand “comfort orders” to protect themselves from such liability if they simultaneously trade in an ailing company’s securities and take part in its confidential bankruptcy talks, according to U.S. Bankruptcy Judge James Peck.
“Funds are suffering from what I call the WaMu effect,” said Peck, 68, a New York judge who presided over some of the biggest bankruptcies in U.S. history, including Lehman Brothers Holdings Inc. Speaking at a symposium this month at St. John’s University School of Law in New York, he said the ruling “spawned a new normal: Funds first want protection from risks.”
Funds that trade in distressed companies rank among the best performers in the hedge fund industry. They returned 14.37 percent for the year ended in August, more than any other type of hedge fund, according to a Credit Suisse Group AG index.
Many of those funds ended up owning large chunks of reorganized companies. About 127 of 490 large bankruptcy filings from 2000 to 2012 had at least one fund take part in the case and emerge with a majority stake, according to a study co-authored by Michelle Harner, a professor at the University of Maryland Francis King Carey School of Law.
Peck asked whether some funds are “overreacting to a remote risk” by calling in lawyers “to fight the phantom dragons at the gate to the conference room.” He cited the bankruptcies of Mexican glassmaker Vitro SAB and mortgage company Residential Capital LLC as examples of cases where hedge funds received comfort orders from judges.
The orders, which state that parties engaged in settlement negotiations in bankruptcy cases don’t have special status or duties as a result, have become the “the industry-standard presumed antidote” to potential allegations of insider trading, Peck said. Such allegations can be brought as suits or as claims by other creditors that they didn’t get equal treatment.
Hedge funds often own large stakes in a bankrupt company’s debt. Without them, a debtor can’t reach consensus with its biggest stakeholders and reorganize. As a result, hedge funds often take part in talks with regulators or other creditors, or are privy to financial projections and business contracts.
“It’s a mutually beneficial relationship, a symbiosis,” Steven Wilamowsky, a bankruptcy partner at Bingham McCutchen LLP, said at the conference. “The estate needs them at the table no less than they need a seat.”
Funds have traditionally tried to avoid insider-trading questions by agreeing not to trade during certain periods, or putting up an “ethical wall” that separates their trading arm from the arm involved in the bankruptcy.
Securities laws that apply to stocks and bonds don’t cover bank debt, which also can be traded during a bankruptcy, said Gregory Milmoe, a partner at Skadden, Arps, Slate, Meagher & Flom LLP who advises on restructurings.
“There has always been this kind of curious tension in the bankruptcy practice as to whether securities law precepts actually apply,” Milmoe said in an interview.
Determining whether funds are trading on inside information isn’t only a task for regulators, said Alistaire Bambach, chief bankruptcy counsel to the U.S. Securities and Exchange Commission.
“Courts have tremendous discretion to decide on the conduct in front of them,” she said at the conference.
In the WaMu case, U.S. Bankruptcy Judge Mary Walrath in Wilmington, Delaware, said on Sept. 13, 2011, that shareholders had established grounds to pursue claims against Aurelius Capital Management LP, Centerbridge Partners LP, Appaloosa Management LP and Owl Creek Asset Management LP. All four funds denied engaging in any insider trading, saying the information they got as participants in WaMu’s bankruptcy was either public or not material.
The funds, which together owned $2.54 billion in WaMu debt, used inside information from two rounds of settlement talks to buy and sell the bank’s securities, lawyers for shareholders said. Aurelius was accused of finding out through its law firm that the secret talks were going as the fund had hoped.
Creditors “who want to participate in settlement discussions in which they receive material nonpublic information about the debtor must either restrict their trading or establish an ethical wall between traders and participants in the bankruptcy case,” Walrath said in the ruling.
She later agreed to rescind her order, which had been on appeal. In doing so, she was criticized by shareholders’ lawyers who claimed the hedge funds’ were seeking to restore their reputations. Seattle-based WaMu had sought to resolve the dispute so it could end the litigation and negotiations that had kept it in bankruptcy for three years.
Walrath’s initial decision “shines a light on something that is not easy to grapple with,” said Eric Fisher, a partner at Dickstein Shapiro LLP and a former assistant U.S. attorney in New York. The primary objective of hedge funds -- to make money -- often conflicts with the chief goal of bankruptcy: to be fair to all creditors, he said at the St. John’s conference.
While hedge funds can help finance a company through tough times and reorganize, “it seems reasonable to require they restrict trading or establish an effective wall, as a precondition to obtaining access to material nonpublic information,” Fisher said in an interview after the conference.
Many funds, however, don’t want to limit trading or erect a wall between their trading operation and participants in bankruptcy talks, Peck said. Such walls are seen as costly and burdensome, and trading restrictions may be unacceptable to hedge funds in volatile markets, he said.
“You want to know what the rule is so you can comply with the rule,” Dan Kamensky, a senior vice president at Paulson & Co., the New York-based hedge fund, said at the conference.
Paulson recently agreed to trading curbs while taking part in talks to resolve a lawsuit between general creditors in the General Motors Corp. bankruptcy and holders of notes in the automaker’s Nova Scotia unit.
Peck, who oversaw that mediation, declined to discuss specifics of the GM case. A settlement of that dispute goes before a bankruptcy judge for review on Monday.
Comfort orders aren’t bulletproof, according to Peck and Fisher. They don’t protect from SEC probes, and other creditors can still sue over claims that the funds violated rules barring acts that give some creditors an advantage over others in the same class, Fisher said.
Specific circumstances will determine what constitutes an insider and what information is material, Fisher said. For example, a hedge fund that says it doesn’t want material nonpublic information still might ask a lawyer involved in settlement talks whether closing arguments in the underlying lawsuit are going forward at a certain date.
“If I tell them, ‘No, closing arguments are going to be put off,’ the party could know that a settlement is close,” Fisher said. “There’s lots of room for mischief.”
Insider-trading concerns also can be addressed through what some lawyers refer to as “big boy” letters, which state that parties won’t sue each other over a transaction that may involve material nonpublic information, Milmoe said.
“Powerful peer-group pressure” prevents the parties from suing, Milmoe said. A hedge fund that signed a big boy letter and then accused another fund of insider trading probably would be excluded from future deals, he said.
A big boy letter differs from a comfort order as it covers only a privately negotiated transaction between two parties, whereas a comfort order is a general pronouncements to all parties in advance of any potential trades, Fisher said.
Peck confronted the issue of comfort orders in the ResCap bankruptcy when some bondholders refused to receive nonpublic information without one. Members of the group, which held more than $900 million of ResCap notes due this year, said they couldn’t take part in mediation over how much interest they would collect on the notes because of “uncertainty as to whether such participation would expose them to liability.”
The group, which included Appaloosa, Loomis Sayles & Co. and David Kempner Capital Management LLC, asked Peck to enter an order like the one issued in Vitro’s case on behalf of Aurelius, billionaire Paul Singer’s Elliott Management Corp. and other holders of more than $720 million of the company’s senior notes.
“I was generally unsympathetic to the request,” he said. After an impasse of several months, however, Peck entered an order July 29 that he described as the new “gold standard for comfort orders of this type.”
Parties could participate in mediation without being deemed insiders, according to the ResCap order, and they wouldn’t be found to have misappropriated information or to have fiduciary duties to others. The SEC and other regulatory agencies still could pursue claims, though, Peck said.
It’s not a “universal protector,” he said.
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