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January 9‚ 2012
Distressed Claims Trading: Insider Trading May
Lead to Disallowance of Bankruptcy Claims and Breach of Fiduciary Duties
By Paul J. Ricotta
In a significant expansion of the potential risk for
distressed claims traders, the Delaware bankruptcy court has recently ruled 1 that traders who engage in
insider trading may have their claims subordinated to equity, and that
traders who amass claims sufficient to block a plan of reorganization owe
fiduciary duties to all other creditors and shareholders during plan
negotiations.
Washington Mutual, Inc., a bank holding company that formerly
owned Washington Mutual Bank (“WaMu”), was once
the nation’s largest savings and loan association, having
over 2,200 branches and holding $188.3 billion in deposits. When WaMu filed for bankruptcy protection in September,
2008, disputes immediately arose among a number of parties regarding the
ownership of certain assets and various claims that the parties asserted
against each other. After more than a year of negotiations, a settlement
was reached among some, but not all of the parties (the “Settlers”), and
was incorporated into a proposed plan of reorganization that offered to pay
creditors but would leave nothing for shareholders. The non-settling
parties, including the Debtor’s Equity Committee (“Equity”), sought, among
other things, to equitably subordinate the Settlers’ claims on account of
alleged insider trading and to hold the Settlers liable as “temporary
insiders” for breach of fiduciary duty because the Settlers held claims
that were sufficient to block confirmation of any other plan.
Equitable
Subordination
Equity claimed that, during the course of the settlement
discussions which ultimately lead to the proposed plan of reorganization,
the Settlers obtained material, non-public information about WaMu and traded in its securities. They further claimed
that the Settlers maintained a blocking position which would prevent the
confirmation of any plan that did not have the support of the Settlers. By
virtue of their leverage, the Settlers then “dominated” plan negotiations
to assure that their settled claims would be paid while nothing was given
to WaMu’s equity.
Based on these facts, Equity sought to equitably subordinate
the claims of the Settlers despite the fact that other courts have held
that the Bankruptcy Code does not authorize the disallowance of a claim on
purely equitable grounds. Notwithstanding prior case law, the Delaware
bankruptcy court held that it had the power to equitably subordinate claims
if they were subject to a defense outside of bankruptcy (in this case, a
securities law violation).
A securities law violation can be established if a corporate
insider trades in the securities of his corporation on the basis of
material, non-public information. The court found a colorable claim for
liability because the Settlers traded in WaMu’s
securities with knowledge that a settlement was being discussed, including
the relative stances the parties were taking in those negotiations over the
course of the discussions, and with knowledge of the settlement term sheets
exchanged by the parties, all at a time when the public knew only that WaMu and its creditors were engaged in contentious
litigation.
The court found no merit in the Settlers’ arguments that
Equity was simply utilizing 20/20 hindsight based on the fact that a
settlement had ultimately been agreed upon or that, until a deal in
principle is reached, mere negotiations do not constitute material,
non-public information. The court noted that, as the negotiations
progressed, it became clear to the parties involved — but not the public —
that a settlement was becoming more probable and that the funds available
to the bankruptcy estate were increasing. The court also dismissed the
Settlers’ argument that the fact that some Settlers bought claims, some
sold, and some did neither, demonstrated that the information gleaned
during the negotiations was not material, because unwise or contrary
trading does not provide a defense to a securities law violation.
Breach of
Fiduciary Duty
Equity also contended that the Settlers became “temporary
insiders,” which include those who have entered into a special,
confidential relationship in the conduct of the business of the enterprise
and are given access to confidential information solely for corporate purposes.
Equity asserted that the Settlers became temporary insiders when they were
given access to the settlement term sheets and participated in confidential
settlement discussions. As insiders, the Settlers owed a fiduciary duty to
act for the benefit of all creditors and shareholders, which was breached
when they supported a plan that paid nothing to the shareholders. The
Delaware bankruptcy court agreed with Equity, deeming the Settlers
temporary insiders, and ruling that they owed fiduciary duties to all other
creditors and shareholders because they held blocking positions in two
classes of WaMu’s debt structure. The court
authorized Equity to commence litigation against the Settlers for breach of
that fiduciary duty.
Lessons Learned
Washington Mutual teaches at least two valuable
lessons for distressed claims traders. First, claims traders who wish to be
active participants in bankruptcy proceedings, especially in connection
with negotiating a plan of reorganization, should either avoid any trading
during negotiations or should be especially careful to erect a
state-of-the-art ethical wall to prevent traders from obtaining any
information whatsoever from the bankruptcy participants. Second, by
acquiring sufficient amounts of debt to control the vote under a plan of
reorganization, traders may be taking on fiduciary duties during
negotiations to act in the best interests of all other creditors and
shareholders.
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Click here to view Mintz Levin’s Distressed Debt
& Claims Trading attorneys.
1 In Re Washington
Mutual, Inc., 2011 WL 4090757 (Bankr. D. Del.
2011).
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