Bankruptcy Concepts: Rule 2019

It is my pleasure to introduce readers to a net set of contributors to Distressed Debt Investing.  As I've spoken about in past months, I've been trying to add a number of regular guest writers that cover topics ranging from advanced distressed / bankruptcy concepts to European distressed debt situations.  It's my pleasure to introduce three lawyers from the bankruptcy practice at Dewey & LeBoeuf LLP: Martin Bienenstock, Phil Abelson, and Vincent Indelicato.  Dewey has a fantastic practice in the restructuring / bankruptcy space and we are absolutely thrilled to have them as regular contributors.  Enjoy!

Distressed Debt Investors Beware:  Amended Bankruptcy Rule 2019

With the increasing participation of distressed hedge funds in chapter 11 cases through the collective action of ad hoc committees and groups, Federal Rule of Bankruptcy Procedure 2019 (“Bankruptcy Rule 2019”) ignited vigorous debate over the scope of its disclosure requirements in recent years.

The controversy set in motion a titanic collision between bankruptcy judges who wanted to know which litigants held short positions and wanted the debtor’s estate to fail or diminish, and a distressed investing community that has fiercely guarded proprietary trading strategies.

In an ostensible effort to shatter the judicial uncertainty surrounding the application of Bankruptcy Rule 2019 in modern day chapter 11 cases, the Committee on Rules of Practice and Procedure of the Judicial Conference of the United States proposed a series of amendments which the Supreme Court of the United States adopted into law last April, effective December 1, 2011.

Although the drafters of amended Bankruptcy Rule 2019 sought to bring much needed clarification, the new rule did not directly address its target.  The new rule could have required that each group member simply declare whether it owned any economic interests that would increase in value if the debtor’s estate decreased in value.  It does not do that.

Rather, the new rule requires listings of each group member’s economic interests.  In some cases those listings will make clear whether the member benefits from the estate’s diminution (i.e., short sales of debt).  In other cases the court will only be able to scratch its head (i.e., synthetic total return swap).

Among other considerations, distressed debt investors must consult their legal advisors to consider the implications of the following new requirements:

Parties Required to Disclose:  Amended Bankruptcy Rule 2019 requires disclosure by “every group or committee that consists of or represents, and every entity that represents” multiple creditors or shareholders “acting in concert to advance their common interests.”  Fed. R. Bankr. P. 2019(b)(1)(A).

Notably, the new rule defines “represents” as “to take a position before the court or to solicit votes regarding the confirmation of a plan on behalf of another.”  Fed. R. Bankr. P. 2019(a)(2).  A group of creditors or shareholders that retains a law firm to monitor case developments without a court appearance does not fall within Rule 2019 disclosure requirements absent its solicitation of votes or other acts in concert to advance their common interests.

Significantly, amended Bankruptcy Rule 2019 contains numerous ambiguities that present a fertile source for litigation as bankruptcy courts begin to enforce the new rule.  For example, when and if it takes a position in court as a group, Rule 2019 disclosure would be triggered.  Other acts to advance the group members’ common interests are subject to many meanings.  Does it mean discussions with parties in interest by or on behalf of the group?  Negotiations with parties in interest by or on behalf of the group?  Are entities that execute a plan support agreement or secured lenders that submit a joint credit bid “acting in concert” in a manner that compels 2019 disclosure?  Indeed, the answers to these and other questions may ultimately determine the strategies that distressed debt investors pursue at the outset of and throughout a chapter 11 case.

Scope of Disclosure:  Those parties required to make disclosures under the amended rule must file a verified statement that shall include “the pertinent facts and circumstances” surrounding the formation of the group or committee.  See Fed. R. Bankr. P. 2019(c)(1) (as amended).  Specifically, in the case of a committee or group, each member must provide (i) its name and address and (ii) the nature and amount of its “disclosable economic interests” held in relation to the debtor as of the date of the statement on a member-by-member basis, and not in the aggregate.  See Fed. R. Bankr. P. 2019(c)(3) (as amended).  Members of a statutory committee, however, must only provide this information as of the date of committee formation.  See Fed. R. Bankr. P. 2019(c)(2)(B) (as amended).

Although the new rule does not require a group member to disclose (i) the price paid and (ii) the specific acquisition date for each of its disclosable economic interests, a member of a committee or group that claims to represent an entity that is not a committee or group member must disclose the quarter and year in which it acquired each disclosable economic interest, except for those disclosable economic interests acquired more than one year before the petition date.  See Fed. R. Bankr. P. 2019(c)(2)(C) (as amended).  The phrase “claims to represent” may relate to those situations where an ad hoc group purports to speak on behalf of an entire class of creditors or shareholders without any instrument evidencing the express authority to do so.  Most importantly, distressed debt investors must understand that nothing in the new rule eliminates the ability of a judge or party in interest to discover the price paid and the precise date of acquisition for each of an entity’s disclosable economic interests.

Like old Bankruptcy Rule 2019, the new rule does not require disclosure by indenture trustees or agents or class action representatives.  See Fed. R. Bankr. P. 2019(b)(2) (as amended).

Disclosable Economic Interests:  While amended Bankruptcy Rule 2019 does not require a party to disclose the price paid for its holdings, the new rule expands the scope of disclosure to include any “disclosable economic interest.”  The amended rule defines “[d]isclosable economic interest” as “any claim, interest, pledge, lien, option, participation, derivative instrument, or any other right or derivative right granting the holder an economic interest that is affected by the value, acquisition, or disposition of a claim or interest.”  Fed. R. Bankr. P. 2019(a)(1) (as amended).  Translated, this definition encompasses all long and short positions, including, without limitation, all options, swaps, derivatives and other claims relating to the debtor’s securities and other debts.

Supplemental Statements:  Amended Bankruptcy Rule 2019(d) requires a party to file a supplemental 2019 upon the material change of any fact previously disclosed in a Rule 2019 statement whenever it takes a position before the court or solicits votes on the confirmation of a plan.  See Fed. R. Bankr. P. 2019(d) (as amended).  The conspicuous absence of any definition of “materiality” in amended Bankruptcy Rule 2019(d), however, makes compliance with this section of the new rule very challenging.  Parties required to disclose under amended Bankruptcy Rule 2019(d) may look for guidance to the reporting requirements approved by the United States trustee in a trading order governing their respective case.

For those entities with numerous trading desks, it appears that amended Bankruptcy Rule 2019(d) would only apply to material changes that impact the holdings of the entity that serves as a member of the respective committee or group, and not those resulting from trading activities of non-committee or group personnel on the other side of the trading wall.

Failure to Comply:  Bankruptcy courts do not take the failure to comply with Bankruptcy Rule 2019 lightly.  Specifically, amended Bankruptcy Rule 2019(e) recognizes the authority of the bankruptcy court to impose sanctions for any violation of the new rule.  See Fed. R. Bankr. P. 2019(e) (as amended). Vote designation may conceivably be used by judges as a sanction that would also facilitate confirmation of a plan the group members oppose.  Beware!

Conclusion:  While the contours of amended Bankruptcy Rule 2019 largely remain undefined, one fact appears certain: the debate over the appropriate scope of 2019 disclosure will create much jurisprudence.  Accordingly, distressed debt investors will need to think carefully about the implications of the new rule before they decide to participate in a chapter 11 case as a member of a committee or group.

Martin Bienenstock
Phil Abelson
Vincent Indelicato