What is Creditor Claims Trading?
Creditor Claims Trading is the purchase and sale of valid claims on debtors by creditors hesitant to participate in the Chapter 11 reorganization.
Creditor Claims Trading in Chapter 11 Bankruptcies
The exchange of the claim and the written contracts are negotiated privately.
Once negotiations have ended, the claim on the debtor is legally transferred from the seller to the buyer, and a notice about the change in ownership is reported to the Court.
Buyers capitalize on the reluctance of the seller to partake in the bankruptcy process by being able to purchase claims at a discounted purchase price.
The buyer hopes to receive a full recovery on the claim (or a near equivalent amount), which can yield strong returns given the discounted price.
Creditor Claims Trading Market
Once a debtor has filed for chapter 11 bankruptcy, the initial period post-petition tends to carry the most uncertainty for prepetition lenders. At this point, how the restructuring process will be run and the viability of a successful reorganization is unknown for the most part.
The in-court bankruptcy process has become standardized, such as the role of the U.S. Trustee and features offered to the debtor under Chapter 11 (e.g., debtor in possession financing, critical vendor motion).
However, the concerns of creditors early on pertain more to management, the proposed plan of reorganization (POR), and the length of the process before emergence.
After the restructuring process is underway, the duration is unknown as the time spent under bankruptcy protection can be prolonged from internal disagreements and the inability to reach an agreement. There also remains the potential for unexpected legal issues to arise and disrupt the bankruptcy.
Even at the conclusion of a reorganization, it can take several months for the recovery proceeds to be distributed. Given all these uncertainties around the amount and timing of recoveries, it can be easy to see why some lenders opt for claims trading instead.
Types of Debtor Claims Traded
Since unsecured claims with lower priority in terms of the claim waterfall come with more uncertainty surrounding their recoveries, holders of such claims are more willing to sell their holdings.
Therefore, the vast majority of claims trading centers around trade claims, which are unsecured obligations of the debtors. Examples of unsecured claims include riskier debt instruments and general unsecured claims (“GUCs”) such as those held by suppliers/vendors.
The pricing discounts are more profound the lower one goes in the capital stack. In contrast, creditors holding senior secured debt are much less inclined to sell their claims given their possibility of recovery is relatively high.
For example, the holder of a term loan would be more comfortable with their chances of potential recovery since the outcome is favorable towards higher claim holders, whereas those holding unsecured claims below the fulcrum security would be far more worried.
It is rare for a senior lender to sell their claims, in part due to the complexities arising from the contractual terms regarding the liens. Sometimes, however, an institutional lender may not be willing to participate in the reorganization. While the full recovery of the initial claim is near guaranteed, it may not be part of the lender’s business model.
For larger debtors, the reconciliation process can be lengthy, making the option to receive cash upfront through claims trading more appealing for creditors. As a result, the volume of claims trading tends to be higher for bankruptcies involving larger debtors where a complex restructuring is more probable.
Creditor Claims Trading: Buyers and Sellers Motives
Selling a trade claim eliminates the delay associated with Chapter 11 and the risk of receiving partial or no recovery following the lengthy bankruptcy process.
From the perspective of sellers, creditor claims trading allows them to recoup a portion of their claim value right away.
Certain creditors cannot tolerate the risk and desire no involvement in the reorganization process, which is why they often opt for immediate monetary compensation by selling their claim.
Sellers will trade their claims to avoid the potentially time-consuming, drawn-out process of Chapter 11 and uncertainty regarding recoveries.
Another consideration is the opportunity cost for the seller. The seller, if they sell their claims, receives cash on hand immediately that it can spend at its discretion. A seller may decide to sell under the assumption that the immediate cash proceeds could be better spent elsewhere (e.g., invested into other securities, re-invested into operations).
Creditor Claims Trading: Seller Tax Benefit
The seller can also potentially receive tax benefits for selling the claim at a lower value than the face value. This benefit can be received relatively quickly by filing the uncollected portion of their claim (i.e., the loss from the investment/loan) in their tax filings in the current taxable year.
Tax deductions are not exclusive to claim traders, as creditors that opted to remain in the restructuring process can benefit, as well. But a tax benefit is not reaped until a liquidity event, which could take years for the full restructuring process, while the seller of a claim can reap the benefits in the current taxable year of the sale.
Unlike the seller in the transaction, the buyer is willing to wait out and see how the reorganization plays out and can tolerate the risk of receiving a lower recovery due to the reduced purchase price.
On the other side, the buyer is betting on the outcome that the restructuring will be a success.
Often, the buyer will be a distressed investment firm, accredited investor, pre-petition creditors, and other institutional investors.
The transaction will normally be of a “fire sale” nature, enabling the buyer to take advantage of the seller’s desire to exit quickly and avoid the reorganization altogether.
As a result, even “decent” claim recoveries as part of the POR could result in profitable returns, given the hefty price discount.
Another reason a buyer might knowingly purchase a high-risk trade claim is to accumulate a larger stake, which can pay off greatly if the reorganization pans out well for the lower stake claims, as well as give them more negotiating leverage (e.g., meetings held by unsecured creditor committees).
Creditor Claims Trading: Buyer Downside & Risk Protection
Since the risk of receiving low recoveries (or none) is present, proper diligence will need to be done into various factors like the catalyst for distress and credit metrics.
To achieve the desired return, the buyer must purchase the claim at a discount, which helps increase the probability of at least breaking even.
Additionally, to help mitigate the risk of capital loss, certain provisions can be included in the contract (i.e., the claim assignment agreement) protecting against scenarios such as the debtor disputing the claim and the claim subsequently becoming invalid, or otherwise decreasing or eliminating the claim amount.
Two of the major provisions found in all claim assignment agreements is that the claim being sold is valid, and the claim amount is not less than the amount initially stated.