Hedge Fund Advisers’ Systemic Risk Disclosures in Bankruptcy

Hedge funds’ distressed and default debt investments in the United States have increased dramatically in the last two decades (from around $70 billion in 1998 to around $867 billion in 2007) and hedge funds with strategies that focus on distressed investing continue to proliferate. The proliferation of distressed-focused hedge funds resulted in hedge funds’ market share of around one quarter of the total distressed-debt market and established the distressed-focused strategy as the fifth-largest hedge fund strategy.

The significant increase of hedge fund participation in the bankruptcy process, among other factors, resulted in an increased emphasis in the literature on the role of hedge funds in bankruptcy. Scholars, practitioners, and members of the federal bankruptcy bench voiced concern over hedge funds’ hidden agendas and offsetting positions, hedge funds’ attempts to manipulate the negotiation and reorganization process, and their seeking control of the debtor at the expense of other stakeholders. Because of their perceived detrimental impact on the bankruptcy process, some commentators have labeled distressed hedge fund investors as “vultures.” Others emphasize the liquidity provided by hedge funds and the corresponding enhancement of the restructuring process.

The disclosure of hedge funds’ activities in the bankruptcy context culminated in a debate over the extent of disclosure requirements under Federal Bankruptcy Rule 2019 (Rule 2019). Before 2007, disclosures by informal or “ad hoc” committees in chapter 11 cases under old Rule 2019 were rarely litigated and had not been applied to informal or ad hoc committees or groups. After the much-discussed holdings in the Northwest Airlines Corp. bankruptcy proceedings, the assessment of Rule 2019 disclosure requirements changed dramatically. In the debate over the extent of disclosure obligations under old Rule 2019, industry groups such as the Loan Syndications and Trading Association (LSTA) and the Securities Industry and Financial Markets Association (SIFMA) were opposed to any disclosures under old Rule 2019 and called for its repeal. Several academics and the federal bankruptcy bench, represented infamously by Judges Robert E. Gerber and Robert D. Drain (U.S. Bankruptcy Court, S.D.N.Y.), among others, argued for full disclosure by informal or ad hoc committees and groups. In 2011, the Federal Bankruptcy Rules Committee (Rules Committee) put forth a fully-revised version of Bankruptcy Rule 2019 (Revised Rule 2019) for adoption.

Revised Rule 2019 became effective on December 1, 2011. The Revised Rule seeks to strike a balance by, on the one hand, allowing parties to avoid disclosing price and timing of distressed investments. On the other hand, under Revised Rule 2019 parties acting in concert are required to disclose equity holdings and claims but also any derivative instruments, such as swaps, options, and shorts. Moreover, each time a group files a pleading, derivative parties are required to report material changes in disclosures.  The literature discusses if and to what extent groups that negotiated a plan without appearing in court may be able to delay or completely avoid disclosure in the bankruptcy process. Some commentators are concerned that disclosures under Revised Rule 2019 will pertain only to those parties in the bankruptcy process who participate publicly in court or serve on official committees. Disclosures may not apply to parties who merely negotiate a plan. Accordingly, Revised Rule 2019 may not have resulted in an improvement of the bankruptcy process. Rather, Revised Rule 2019 may have simply driven parties into the shadows who would otherwise have participated in the bankruptcy process.

Only seven months after the introduction of the Revised Rule 2019, the Securities and Exchange Commission (SEC) promulgated systemic risk disclosure requirements under Title IV of the Dodd-Frank Act. Title IV and SEC rules implementing the requirements under Title IV created a tectonic shift for the regulation of private funds in the United States.  Some of the more controversial requirements in Title IV of the Dodd-Frank Act and SEC implementation rules include disclosure obligations that require the reporting of, among other items, risk metrics, performance and changes in performance, positions held by the investment adviser, strategies and products used by the investment adviser and its funds, counterparties and credit exposure, financing information, percentage of assets traded using algorithms, and the percentage of equity and debt. I have provided some evidence in 2012 that Title IV of Dodd-Frank may change the hedge fund industry here.

Significant commonalities exist between the systemic risk disclosure requirements in Form PF and the disclosure requirements under Revised Rule 2019. For example, where Revised Rule 2019 requires disclosure of all “disclosable economic interests,” Form PF similarly requires disclosure and breakdown of regulatory Assets Under Management (AUM), gross and net asset value, the value of the reporting fund’s investments in equity of other private funds, and the aggregate gross asset value of the reporting fund’s controlled portfolio companies. Similarly, both Revised Rule 2019 and Form PF require disclosure of derivative positions.

Given the hedge fund industry’s strong emphasis on secrecy, the threat of public disclosure of hedge funds’ systemic risk filings in the bankruptcy process could change distressed investment practices. The threat of disclosure of systemic risk filings in combination with increasing competition in the distressed-debt market could further incentivize hedge fund manager cooperation in the bankruptcy process. In the foreseeable future, standardization of Form PF disclosures could result in fewer generic disclosures that could be increasingly relevant in the bankruptcy context. Moreover, because Revised Rule 2019 may result in less overall disclosure by distressed hedge fund investors during the bankruptcy process, systemic risk disclosures could fill this void with already existing disclosures in Form PF.

However, in the current regulatory framework, the threat of public disclosure of systemic risk filings by hedge funds via the bankruptcy process may only marginally affect hedge funds’ tactics and their role in distressed investing. Hedge funds’ disclosure obligations under the Dodd-Frank Act are still rather generic, the SEC has not yet standardized the requirements, and it is unclear if the SEC will expand the systemic risk disclosure obligations for hedge funds investing in distressed securities. The hedge fund industry’s continuous, expanding, and increasingly assertive presence in distressed securities investments could change this evaluation in the future.

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