Hedge funds will defend their coveted secrecy against bankruptcy judges who want more information about their economic interests before granting them an active role in Chapter 11 reorganizations.
The two sides will make their case on Friday before a regularly scheduled federal rule-making panel that will try to bring consistency to an increasingly unsettled issue that has divided normally like-minded judges.
The body, which includes bankruptcy judges and legal professionals, has proposed expanding the amount of disclosure required by parties in a bankruptcy.
The proposal will mostly affect hedge funds, and the hearing follows recent rulings that exposed a sharp judicial split on the issue.
Proponents of added disclosure want more information about all positions of a group, particularly when financial instruments such as credit default swaps muddy the issue of the group's economic interests. This might reveal, for example, that an ad hoc committee fighting against a reorganization plan could actually benefit if the company liquidates.
Hedge funds are particularly protective of prices paid for a claim. Such information could reveal their investment strategy and might give others an upper hand in a reorganization if they know what return a hedge fund is making on its claim.
Today, because of derivatives and the other sorts of financial technology it is increasingly the case that someone who owns the claim doesn't bear the risks or burdens associated with it, or doesn't need to, said Richard Hahh, a bankruptcy attorney with Debevoise & Plimpton.
It recently burst into the open in Delaware's bankruptcy court, where judges have broken from their usual unity and issued very different rulings on the matter.
Judge Mary Walrath required broad disclosure from a group of holders of Washington Mutual bonds, noting in particular the role of complex financial instruments. She also cited the proposed rule change in support of requiring disclosure.
Delaware Judge Christopher Sontchi denied a request to compel disclosure by an ad hoc group of Six Flags bondholders a few weeks later, focusing his attention on the definitions of a committee. He noted taking into consideration the price paid for a claim went against 600 years of common contract law.
Stephen Lubben, a law professor at Seton Hall Law School in Newark, New Jersey, said Walrath tried to address larger issues.
Over the last decade there has been such a growth of financial products and other investment strategies that reduce transparency in the bankruptcy process, said Lubben.
The rule governing disclosure, known as 2019, requires every group representing more than one creditor to provide information about the value of their holdings, when those holdings were acquired and the amount paid, among other things. Few parties regularly comply in full.
The rule was drafted more than 30 years ago when it was assumed that creditors to a bankrupt company would hold their claims through the case and would benefit from a successful reorganization.
That has changed dramatically in recent years.
The original creditors in large cases now often have sold their claims to investors in distressed debt who have experience with the bankruptcy process. They buy these claims at deep discounts and may be able to a profit even with very limited recoveries of pennies on the dollar.
Robert Gerber, a bankruptcy judge for the Southern District of New York, recommended in a letter to the panel that rule 2019 require disclosure of holdings that would benefit from a fall in price of a claim or failure of a reorganization. The rule should also require the information from each participant in the group, he said.
Most importantly, Gerber said if those changes were made the rule could drop the controversial requirements for price disclosure.
The panel will consider the comments before issuing a final recommendation. That will eventually go to the U.S. Supreme Court for approval and a review by Congress before taking effect.
Opponents of wider disclosure tend to focus on prices.
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, wrote Abid Qureshi, a lawyer with Akin Gump Strauss Hauer & Feld, which often represents ad hoc groups, in testimony submitted to the panel.
Gerber said in his letter to the panel that if investors do not want to disclose their holdings, they can simply participate passively, rather than actively appearing in court with a group, and no disclosure is required.
Hahn said Gerber's suggestions had appeal.
What's gummed up disclosure is in a large part price disclosure ... if that requirement were eliminated there would be a lot less criticism of broad disclosure.
(Additional reporting by Caroline Humer; Editing by Steve Orlofsky)