Selling Bankruptcy Claims: Opportunities and Risks

In the last several years, the size, scope, and complexity of the bankruptcy claims marketplace has changed dramatically. Once dominated by individual trade creditors hoping to receive some value for their uncollected debt in Chapter 11 bankruptcies, buying and selling unsecured bankruptcy claims has become big business. Hedge funds and investments banks are seeking to earn significant profits by buying up bankruptcy claims, especially in large bankruptcies.

Now, just about any unsecured trade creditor may be approached to sell (transfer) its claim to a third party. Although these claims are a liability to the creditor, buyers consider them assets for which they are willing to pay cash.

According to a 2010 scholarly article titled Making Sense of Claims Trading written by Adam J. Levitin, Associate Professor of Law, Georgetown University Law Center:

The creation of a market in bankruptcy claims is the single most important development in the bankruptcy world since the Bankruptcy Code’s enactment in 1978. Claims trading has revolutionized bankruptcy by making it a much more market-driven process. Instead of serving as a forum for creditors to negotiate a restructuring of the debtor’s finances with the goal of limiting their losses, bankruptcy is now a general investment opportunity. The development of a robust market for all types of claims against debtors has changed the cast of characters involved in bankruptcies. In addition to long-standing relational creditors, like trade creditors or a single senior secured bank or bank group, bankruptcy cases now involve professional distressed debt investors, whose interests and behavior are often quite different than traditional relational counter-party creditors.

Who’s Buying, Who’s Selling Bankruptcy Claims

Buyers purchase bankruptcy claims:

To make a profit (probably the most common reason)
To obtain control over the reorganized debtor
To block any Chapter 11 plan they oppose

In most cases, buyers are professional claims traders, who may either hold the claim or resell it, usually to large or multi-strategy hedge funds. In either case, the goal is to hopefully garner a significant profit. Some, including hedge funds and other distressed investors, may buy claims directly or through a broker. These purchases are made either to make a profit, or with the strategic objective of controlling the direction of the Chapter 11 case by owning a substantial percentage of one or more classes of creditors. (Buying more than one-half the number of claims or one-third the dollar amount, provides the purchaser substantial control of a customer’s plan of reorganization. See Introduction to Chapter 11 for the basic process followed in a U.S. Chapter 11 Bankruptcy.)

The seller’s motivation is:

To realize an immediate cash payment
To avoid the risk of delayed recovery, less recovery, or potentially no recovery
To eliminate their risk of receiving illiquid stock or notes instead of cash

A seller can be any trade creditor with a significant unsecured claim. However, members of the official Unsecured Creditor’s Committee will generally have to resign prior to selling any claim.

What is Being Bought and Sold

Obviously, not all unsecured bankruptcy claims are equal. And, not all will be of interest to a trade claims buyer. In general, claims that are being purchased are:

Relatively large
Undisputed in the customer’s schedule of liabilities filed with the bankruptcy court. (Sometimes a buyer may offer to buy the undisputed portion of a claim, with a further option to purchase the balance should it be recognized as valid at a later date)
Recognized as valid by the Bankruptcy Court
503(b)(9) claims, which enjoy priority of payment over other unsecured claims

How Selling Bankruptcy Claims Works

Generally, buying and selling claims is freely allowed in Chapter 11 bankruptcies and can be of benefit to both the creditor and the claims buyer.

The following steps outline the typical process involved in selling bankruptcy claims. However, if the trade creditor sells its claim before the customer files bankruptcy, the sale is governed by state contract law. If the creditor sells the claim before filing a proof of claim, no bankruptcy court involvement is required. However, if it is sold after the filing of a proof of claim, Federal Bankruptcy Rule 3001(e) governs the sale.

Note that the mechanics of buying claims are not set out in the bankruptcy law and the Bankruptcy Court is not involved in negotiating or approving the purchase price. There are a few notice requirements provided in the law and there are restrictions on claim trading among insiders.

Step 1: The Offer

The process usually begins with a buyer offering, in written or verbal form, to purchase a creditor’s claim. Offers are expressed as a percentage of the claim amount. While there have been offers in certain bankruptcies for as high as 90% to 100+% of the claim these are very rare. Typically, an offer of much less is made. The higher the likelihood of a good payout, the higher the offer will be.

Step 2: Confirmation

Often after a price is agreed upon, a Confirmation Document which outlines the key terms of the offer is prepared by the buyer. Alternatively, the offer may actually be presented via this document. It usually includes:

Claim amounts to be purchased
Purchase price
Other terms of the sale

All terms of the Confirmation should be carefully reviewed by the seller and his attorney. In addition, the seller should request that the document contain the same “walk-away” rights as the buyer is provided should the sale is not completed by an agreed deadline.

The Confirmation Document is like a letter of intent and usually states that the sale of the claim is subject to a mutually acceptable Claim Assignment Agreement, which generally is the document that conveys title.

Step 3: Claim Assignment Agreement

This document provides the right to transfer the claim. Some key terms that may be included:

Provision for the increase or decrease of the claim as more information about the creditor’s recovery becomes available. This protects both the seller and the buyer.
Put Options, which are basically “escape clauses” that benefit the buyer only. Put Options provide the buyer the right to sell all or the disputed part of the claim back to the seller, including interest charges for the entire assignment period. This right is usually available upon the breach of standard representations or the filing of an objection, even if the objection is ultimately defeated. Triggers for Put Options include preference avoidance actions.

The seller should ensure that the Claim Assignment Agreement:

Provides for payment on the date the claim is assigned
Outlines the timing and enforceability of payment by the buyer on any disputed portions of an assigned claim. This will usually involve a deferred payment that will not occur until and unless the claim is allowed by the Bankruptcy Court
Requires the buyer to purchase, at the agreed percentage, any excess claim amount should it be increased by the Court
Includes a reasonable interest rate on any repayments (see Put Options).
Requires the buyer to notify the seller of any objection to the claim and to provide the seller adequate time to defend the objection. (See Evidence of Transfer of Claim below)

Step 4: Evidence of Transfer of Claim

This is usually required by the Bankruptcy Court as a means to notify other parties of the claim transfer and provides the parties of interest 20 days to file an objection to the claim transfer. The transfer of claim does not mention the price paid.

Recommendations if you are Considering Selling a Bankruptcy Claim

Don’t accept the first offer. If there is one entity offering to buy, there are probably others that are also interested. Proactively search for other distressed debt purchasing firms that might have a better offer.
Research your bankruptcy claim before you sell. The more you know about the customer’s assets and business, the better you can determine a reasonable price for your claim. If possible, obtain a disclosure statement that projects what the potential distributions on allowed claims might be.
Most important: Do not sign anything without first getting professional advice. Consult legal counsel or an expert in bankruptcy claims trading. Bankruptcy claims trading is largely unregulated and the bankruptcy courts provide only limited oversight.

Check out these other Bankruptcy articles on our website.