Bankruptcy Litigation Committee

Volume 6, Number 4 / June 2009

In This Issue

• Credit Default Swap Agreements: A Possible Obstacle to Plan Confirmation
• ABI's 16th Annual Northeast Bankruptcy Conference
• ABI's 5th Annual Mid-Atlantic Bankruptcy Workshop

• Committee Officers
• Upcoming Events
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• ABI World
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Credit Default Swap Agreements: A Possible Obstacle to Plan Confirmation

by: R. Travis Santos
Emory University School of Law; Atlanta

Editor’s Note: The following article, “Credit Default Swaps and Plan Confirmation,” won the prize for second place in the First Annual ABI Bankruptcy Law Student Writing Competition. The article describes the increasingly possible scenario of the interaction between credit default swap agreements and confirmation of a chapter 11 plan. The author, R. Travis Santos, is a student at Emory University School of Law. In addition to recognition and publication of his article in the Bankruptcy Litigation Committee Newsletter, Mr. Santos will receive a cash award of $750 and a one-year ABI membership. 

The First Annual ABI Bankruptcy Law Student Writing Competition was headed by the Honorable Judith K. Fitzgerald, U.S. Bankruptcy Court for the Western District of Pennsylvania,who is the Special Projects/Task Force Leader for the Bankruptcy Litigation Committee,with assistance from the leadership and members of the Bankruptcy Litigation Committee. 

Picture this: One of the nation’s largest automakers desperately needs some credit to stay afloat in the midst of dire economic times. Rather than relying on the federal government for a bailout, the giant automaker’s executives request credit from JP Morgan so it can survive. Since the automaker is a long-standing client and the two parties have maintained a strong relationship, JP Morgan purchases $75 million worth of the troubled automaker’s bonds. However, JP Morgan cannot take on the entire risk of the investment, especially given the tightening credit markets. In order to extend the credit, JP Morgan realizes it needs to consider some form of hedging.

To protect itself from this high-risk bond purchase, JP Morgan enters into a standard credit default swap agreement with a prominent hedge fund, Tudor Investment Corporation (Tudor). JP Morgan urges for restructuring the company outside of bankruptcy or prolonging the company’s prebankruptcy existence because the current increase in value of the bonds would actually force JP Morgan to pay Tudor a percentage under the terms of the credit default swap contract. A year and a half later, the automaker files for bankruptcy, making JP Morgan an unsecured creditor in the class of bondholders. After the automaker proposes the reorganization plan, JP Morgan votes to reject the plan based on its unfavorable position under the proposed plan. The remaining 12 bondholders in this class, holding $35 million in bonds, all vote to accept the plan. Since $75 million consists of more than two thirds of the class dollar amount, the proposed plan cannot be confirmed under 11 U.S.C. §1129(a)(8).

The above scenario prompts a crucial question: Should the largest creditor in a class have the ability to destroy a debtor’s proposed plan when the creditor has hedged its risk with credit default swaps?[1] Further, should the court disqualify the creditor’s vote as cast in bad faith if the creditor rejects the plan based on the related consequences of the third-party agreement underlying the credit default swap?

As the current economic market erodes, banks’ financial stocks continue to decrease amid investors’ fears concerning the viability of national lenders. Intertwined in the market’s downward spiral is the credit derivative market. The leading banks’ substantial use of credit default swaps over the past few years, the secrecy surrounding the swaps and the lack of regulation of the credit derivative market has exacerbated this economic crisis and has created larger fears.[2] Furthermore, the popularity in credit derivatives in recent years will leave behind problems that may have direct implications for many future chapter 11 bankruptcy cases.

One of the primary purposes of chapter 11 bankruptcy reorganizations is to preserve the value of a debtor’s assets and make distributions to creditors based on a priority scheme. To achieve this purpose, chapter 11 of the Bankruptcy Code “relies on creditors to check the broad power debtors have by virtue of their status as ‘debtors in possession’.”[3] As a debtor-in-possession (DIP), the debtor has the exclusive right to file a proposed plan during the first 120 days after the order for relief.[4] One check on the debtor’s power comes from the ability of creditors in each class to accept or reject the proposed plan of reorganization.[5] Additionally, the Code mandates a two-part voting rule for each class of creditors.[6] For a class of creditors to accept a plan, creditors “that hold at least two thirds in amount and more than one half in number of the allowed claims of such class” must vote in favor of the proposed plan.[7] For a court to confirm a plan under §1129(a), all classes of claims must accept the plan.[8]

Credit Derivatives and Credit Default Swaps

Credit derivatives are financial contracts with no intrinsic value but instead derive their value from some underlying asset. The underlying asset is based on a bond, loan or other form of credit. Credit derivatives are valuable tools in investment because they allow the risk attached to the value of the underlying asset to shift from one party to another.[9] Credit derivatives are useful for either hedging or speculation purposes. Investors may use credit derivatives as hedging tools to insulate themselves against economic loss arising from changes in the value of the underlying asset, or investors may use these instruments to speculate when the value of an underlying asset will move in the direction they expect, thus, acquiring risk and increasing profit.

The most common form of credit derivative is the credit default swap.[10] These instruments were created in the late 1990s as a way of sharing risks amongst multiple institutions.[11] Credit default swaps increased in popularity during this past decade and dramatically over the last few years.[12] As the market for mortgage-backed securities collapsed in 2007, banks and other lenders could no longer sell these mortgages, so they accumulated credit default swaps to mitigate the risk associated with mortgage-backed securities, essentially attempting to guard themselves against significant losses.[13]

Credit default swaps are bilateral contracts allowing one party, the “protection buyer,” to transfer the credit risk associated with a debt, or class of debts, to the counterparty, “the protection seller,” in exchange for a fee over a predetermined length of time.[14] Although the actual credit default swap involves only two parties, it entails the transfer of credit risk from a third party, who is typically unaware of the transaction.[15] The idea behind credit default swaps is similar to the concept of purchasing insurance on a house to protect against losses from fire and theft.[16] The protection seller insures the protection buyer from the third-party credit risk. In exchange for the “insurance,” the protection seller receives periodic payments or annual fees (i.e., insurance premiums).

One of the unique, yet major, problems with these insurance-like, over-the-counter contracts is the lack of regulation over the market as a whole.[17] Banks, hedge funds and other investors utilized credit default swaps because these entities viewed the swaps as easy low-risk ways to collect premiums and increase cash flow.[18] Given the reality of the current floundering economy, where large corporations are going bankrupt, holders of credit default swaps may cause significant turmoil in the reorganization of a chapter 11 DIP as such holders attempt to protect their economic interests, which are affected not just by recovery from the bankruptcy estate but from the resolution of the swap transaction.

§1126(e) – Good faith or Bad Faith
One of the purposes of a chapter 11 case is to achieve an effective reorganization of a company through a process that balances the power between the DIP and its creditors. The Code grants an initial exclusive right to the DIP to devise a plan of reorganization.[19] Once the DIP proposes the plan, the Code grants creditors the right to vote on the plan of reorganization.[20] If all provisions of §1129(a) are satisfied, the court confirms the plan.[21] However, even if all classes of creditors do not accept the plan, thus violating §1129(a)(8), the court can confirm a plan pursuant to §1129(b).[22] To confirm under §1129(b), often referred to as the “cramdown” provision, the plan must meet certain standards of fairness to dissenting creditors.[23]

Section 1126(e) of the Bankruptcy Code gives bankruptcy courts the discretion to “designate any entity whose acceptance or rejection of such plan was not in good faith.”[24] “Designate” in the bankruptcy context simply means to disqualify. Thus, bankruptcy courts have the discretion to disqualify votes by creditors not made in good faith. Since bankruptcy courts retain this discretion, a designated vote could have an impact on the requisite numbers necessary to accept the proposed plan under §1126(c). This provision states that votes designated under §1126(e) will be excluded from the computation.[25] For a class to accept a proposed plan, more than one half of the creditors must accept the plan, and creditors in the class holding at least two thirds of the dollar amount must accept the plan.[26] One or two creditors deemed by a bankruptcy court as having voted in bad faith could change the class’ status. Consequently, a modification in status could significantly affect whether the debtor’s proposed plan is confirmed under §1129.        

Establishing whether a creditor voted on the proposed plan in good or bad faith is within the bankruptcy court’s discretion and determined on a case-by-case basis. Factual differences in bankruptcy cases force courts to define the precise contours of “good faith” based on the totality of the circumstances.[27] The Bankruptcy Code’s drafters intentionally left the elusive term “good faith” undefined in the Bankruptcy Act of 1898 (Bankruptcy Act) and the Code,[28] and the exclusion of a “good faith” definition has enabled it to remain a flexible notion.

When analyzing voting in good faith in the context of §1126(e), courts frequently return to §203 of the Bankruptcy Act, which is the predecessor statute to §1126(e), and case law interpreting §203 of the Bankruptcy Act.[29] Since §203 of the Bankruptcy Act is the precursor to §1126(e), decisions construing §203, and in particular the Supreme Court decision of Young v. Higbee, set the standard for good faith under §1126(e). The language of §203 of the Bankruptcy Act appears as a condensed version of the current §§1126(c) and (e), stating that:

[i]f the acceptance or failure to accept a [proposed] plan by the holder of any claim or stock is not in good faith, in light of or irrespective of the time of acquisition thereof, the judge may…direct that such claim or stock be disqualified for the purpose of determining the requisite majority for the acceptance.[30]

Section 203 does not explain how a voting class obtains the requisite majority but leaves the door open to claims acquired at any time. Further, §203 utilizes the term “disqualified” as opposed to “designate.”

In construing §203 of the Bankruptcy Act, the Supreme Court noted that the intention of §203 was “to apply to stockholders whose selfish purpose was to obstruct a fair and feasible reorganization.”[31] Specifically, stockholders utilized these obstructive, hold-up techniques to gain undue advantages at the expense of other stockholders.[32] Essentially, the Court’s disqualification of certain votes serves a dual purpose. The Court’s elimination of the creditor’s bad faith vote acts as a punitive measure, while the Court’s prevention of an undue advantage to certain stockholders or creditors shows a protective purpose.

On the other hand, subsequent cases interpreting §203 of the Bankruptcy Act declared that purchasing other creditors’ claims for the purpose of gaining enough votes to decide the outcome of the class’s acceptance or rejection status does not equate per se to bad faith.[33] However, purchasing other creditors’ claims in an attempt to aid “an interest other than an interest as a creditor” was indicative of bad faith under §203 of the Bankruptcy Act.[34] Therefore, a creditor’s vote may be subject to disqualification if the creditor voted “with the ‘ulterior purpose’ of exacting for [it]self an undue or unfair advantage.”[35]

Courts addressing §1126(e), which incorporates the pre-Bankruptcy Code case law concerning the issue of a court’s designation of claims, have recognized two categories of bad faith: (1) a creditor attempting to derive a personal advantage not available to other creditors in its class, and (2) a creditor maintaining some “ulterior motive” unrelated to its claim against the estate.[36] The first category sufficiently explains the type of bad faith voting the drafters intended to prohibit, but the vagueness of “ulterior motive” in the second category leaves ample room for interpretation.

Even though the U.S. Bankruptcy Court for the Southern District of New York in In re Adelphia capsulized the standards satisfying a bad faith vote, the decisive test necessary for analyzing the second category above must incorporate a precise inquiry into the motives of the creditors holding the claims.[37] This could ultimately come down to a creditor’s persuasive argument to the bankruptcy court that there was not a bad faith intention involved. If a creditor exercises sound business judgment when voting, courts are unlikely to challenge the creditor’s motives.[38] In contrast, if a creditor secures some advantage to which the creditor would not have otherwise been entitled, the court may question the creditor’s voting motives.[39]

Courts have recognized that an ulterior motive is distinguishable from a selfish motive, [40] but there is fine line between ulterior motives and selfish ones.[41] Voting in pure self-interest does not rise to the level of bad faith necessary for a court to designate a creditor’s vote.[42] In fact, the Code expects creditors to “vote [for a proposed plan] in accordance with [their] perception of [their] own self-interest.”[43] If a creditor’s selfish motives are adequate to destroy a proposed reorganization plan, very few proposed plans would pass scrutiny and enter the plan confirmation stage under §1129.[44]

In comparison, a creditor voting for reasons unrelated to the claim against the estate has an ulterior motive.[45] In In re Pine Hill Collieries Co., decided prior to enactment of §203, the court established that pure malice, strikes, blackmail and attempting to destroy an enterprise to advance the interests of a competing business constitute ulterior motives sufficient for a court to designate a creditor’s vote in bad faith.[46] All of these acts by a creditor are synonymous with committing wrongdoing against the debtor. Subsequent courts, interpreting §1126(e), have described “badges” of requisite bad faith, albeit similar to the acts purported above, that would give a court the discretion to designate a vote.[47] The “badges” of bad faith include creditor votes designed to (1) assume control of the debtor, (2) put the debtor out of business or otherwise gain a competitive advantage vis-à-vis other creditors and stockholders, (3) destroy the debtor out of pure malice or (4) obtain benefits available under a private agreement with a third party which depends on the debtor’s failure to reorganize.[48] Although the fourth “badge” of bad faith involves obtaining benefits under a third-party agreement, there is no case law applying voting under a confirmation plan and this “badge” to credit default swap agreements.

If the trustee or counsel for the DIP brings a motion against a creditor for casting a vote in “bad faith,” the court has broad discretion to designate that creditor’s vote. In the situation of a credit default swap, the party bringing the motion to have the vote designated may argue that the bondholder creditor’s sole motivation was not based on its interest as a creditor in the bankruptcy case, but instead rests with the possible financial gains under the credit default swap agreement (i.e., financial gains under a third-party agreement constitutes an ulterior motive). The creditor’s vote was driven by extrinsic financial gain unrelated to distribution under the proposed plan for reorganization and runs contrary to the interests of other bondholders’ interests. If the court deems it proper to designate this creditor’s vote as cast in bad faith, the vote will not affect the class’ acceptance of the plan. Therefore, the creditor’s negative vote would have no bearing on the plan being confirmed under §1129. 

Hypothetically in contrast, the large unsecured creditor in the class of all bondholders may argue that its fundamental right to vote for a proposed plan should not be designated because it voted in its own economic interest in order to maximize its wealth (i.e., a purely selfish motivation). Courts must recognize that credit default swaps are valuable risk management tools for willing lenders to hedge against the risk of default. A creditor’s legitimate business decision to enter into a credit default swap prior to the filing for bankruptcy should help its defense and preclude the court from designating its vote under §1126(e). If the court follows this line of reasoning and does not disqualify the vote under §1126(e), the class will be deemed to have rejected the plan and the plan may not be confirmed.

Conclusion
“Good faith” in §1126(e) was meant to “be defined and developed in accordance with cases as they arose.”[49] Even if the use of credit default swaps declines, their spike in volume during the last few years ensures that they will play an integral part in many future chapter 11 bankruptcies. Given this reality, two glaring questions remain unanswered: (1) should the largest creditor in a class have the ability to destroy a debtor’s proposed plan when the creditor has hedged its risk with credit default swaps?,[50] and (2) should the court disqualify the creditor’s vote as cast in bad faith if the creditor rejects the plan based on the related consequences of the third-party agreement underlying the credit default swap? If the bankruptcy court concludes that a third-party agreement played an integral role in determining how the creditor voted, the court would appear to have sufficient discretion under the prior case law to designate the vote.