Hedge Funds Versus Private Equity in Hostile Restructurings

July 31, 2020, was an ill-fated day for financier Dan Kamensky. It began on a bright note, as his billion-dollar hedge fund stood to profit from a possible settlement in Neiman Marcus’ bankruptcy.[1] Not only had the Official Committee of Unsecured Creditors on which he served reached a tentative settlement from which they would receive shares in one of Neiman’s valuable subsidiaries, but it looked like Kamensky’s hedge fund could be in the exclusive position to purchase discounted shares from other unsecured creditors who wanted to cash out right away. That is, until 3:15 P.M. that day, when he learned that another financial institution was planning on approaching the Official Committee and offering unsecured creditors more for their shares, a move that would eat into Kamensky’s expected gains. That evening, Kamensky threatened a trader at the financial institution, pressuring him to back down.[2] Later, realizing what he had done, he tried to cover up his misdeeds, and the media fixated on these conversations.[3] Kamensky later pled guilty and was sentenced to six months in federal prison.[4]

There is another side to the story, though, one in which Kamensky is something of a vigilante. The last decade has witnessed a marked increase in aggressive strategies when it comes to the resolution of financial distress.[5] PetSmart, for example, distributed $900 million to equityholders and transferred assets worth $750 million into a subsidiary beyond the reach of its creditors even though it was burdened with debt that it was unable to repay.[6] Similarly, J.Crew’s private equity owners transferred $250 million of intellectual property into an unrestricted subsidiary, freeing up assets that they turned around and pledged as collateral to borrow even more.[7] Neiman Marcus was no different – in 2017, it transferred its crown jewel asset into a subsidiary that would be out of reach of creditors if the company eventually filed for bankruptcy.[8] Kamensky was immediately suspicious of the transfer and brought suit against Neiman Marcus that year in a case that would eventually be dismissed for lack of standing. In 2020, when Neiman Marcus filed for bankruptcy, Kamensky’s holdings of the company’s unsecured debt put him in the position to join the Official Committee, which was exactly the sort of standing he needed to renew his efforts to attack the 2017 transfer.[9]

His membership on the Official Committee was also a pivotal factor in his criminal prosecution, however.[10] Members of the Official Committee, a group that is statutorily mandated under 11 U.S.C Section 1102,[11] take on a fiduciary duty to serve the interests of all general unsecured creditors.[12] This duty, absent from the Bankruptcy Code, is a vestige of an earlier system of law known as Chapter X in which informal committees of bondholders had the power to vote the proxies of other bondholders.[13] Even though today’s Official Committee no longer has this power, it acts as an intermediary between unsecured creditors and the debtor, receiving confidential information in the process, and represents the interests of unsecured creditors in negotiations with the debtor and other bankruptcy parties.[14] Because of these privileges, four decades of judge-made law have laid these duties out in detail. Members of the Official Committee may not trade their claims, for example.[15] Several cases have afforded Official Committee members protection from liability, recognizing that they are fundamentally self-interested as claimants to a bankrupt firm.[16] Leveraging one’s position on the Official Committee to prevent other unsecured creditors from receiving a higher recovery, though, is not a situation in which those protections apply.

At the same time, the Official Committee’s fiduciary duty is somewhat unorthodox. Unlike the duties of corporate directors, for example, its purpose is not exactly to align agents with the objectives of the principals they represent. Unsecured creditors already want to maximize the value of their claims which, according to bankruptcy rules, typically means that they want to maximize the value of the claims of other unsecured creditors situated in the same class.[17] To the extent that their objectives differ – which is common, since unsecured creditors can be anyone from bondholders to unionized employees to tort victims – these differences are hard to reconcile. As Kamensky’s case indicated, unsecured creditors can have significantly different preferences over liquidity.[18] Certain features of modern-day distressed capital structures exacerbate this problem. The median cash recovery for unsecured claims across subordinated and unsubordinated creditors in bankruptcy is in the 0-10 percent range, meaning that unsecured creditors often have little else to pursue aside from litigation as a means of recovery.[19] This litigation can target the debtor’s managers, equityholders, and lenders. When a debtor encounters an Official Committee whose members have a strong preference for liquidity, it can offer them a low cash recovery in exchange for releases from liability[20] that bind all bankruptcy parties, including even hedge funds that might have prevailed in litigation.

Sophisticated investors, i.e., hedge funds that specialize in distress investing, are therefore in a difficult position. Aggressive pre-bankruptcy transactions are harmful to creditors. These transactions, many of which take place within large but privately held companies, are hard to understand and even harder to litigate.[21] The sophistication, experience, and time to conduct diligence that hedge funds possess, combined with the privileged position of the Official Committee, can benefit general unsecured creditors. At the same time, hedge funds may be deterred by the onerous restrictions of the fiduciary duties that membership entails. In 2020, hedge funds accounted for less than 4 percent of Official Committee membership in large Chapter 11 cases. Kamensky’s case will only deter hedge funds further.

And yet fiduciary duties are needed to protect general unsecured creditors. In their absence, it would be naïve to expect hedge funds to respect the interests of trade creditors and employees when they stand in the way of profits. There is therefore a tradeoff between protecting less sophisticated unsecured creditors and encouraging hedge funds to take on litigation against market participants, often private equity firms or other hedge funds, that have engaged in potentially fraudulent behavior. At least for the time being, the latter is probably more important because it can prevent the destabilization of broader credit markets.[22] If lenders continue to see collateral disappear on the eve of financial distress, they may eventually respond by charging higher interest rates or denying credit altogether.

How can we strike the right balance? One option is to encourage the formation of two separate Official Committees of unsecured creditors such as a bondholders’ committee as well as a committee for other general unsecured creditors. Members of these committees would only owe fiduciary duties to claimholders of the same type. Though multiple Official Committees are rare, precedent for them exists,[23] and some courts have established that they are allowed when the committee in place does not adequately represent a subset of creditors.[24] In cases where valuable potential litigation rights exist and the unsecured creditors willing and able to pursue them are not represented by the Committee, courts should be amenable to establishing multiple Official Committees.

ENDNOTES

[1] Amanda Cantrell, In Five Hours, Daniel Kamensky Destroyed His Career. Why? Institutional Investor (Sep. 16, 2020), https://www.institutionalinvestor.com/article/b1nds3878fmgb7/In-Five-Hours-Daniel-Kamensky-Destroyed-His-Career-Why.

[2] Id.

[3] See id. See also Gregory Zuckerman & Soma Biswas, Hedge Fund Manager Who ‘Came Undone’ Is Headed to Prison, Wall St. J. (June 12, 2021, 5:30 AM), https://www.wsj.com/articles/hedge-fund-manager-who-came-undone-is-headed-to-prison-11623490201; Sujeet Indap & Mark Vandevelde, Hedge Fund Executive Sentenced to 6 Months in Jail for Bankruptcy Fraud, Fin. Times (May 7, 2021), https://www.ft.com/content/9a2a2e7d-f671-4b07-af8b-9b0d43ef6576.

[4] Id.

[5] See, e.g., Diane L. Dick, Hostile Restructurings, 96 Wash L. Rev. 1333 (2021); Jared A. Ellias & Robert J. Stark, Bankruptcy Hardball, 108 Calif L. Rev 745 (2020).

[6] See Ellias & Stark, supra note 5 at 747.

[7] Kenneth Ayotte & Christina Scully, J. Crew, Nine West, and the Complexities of Financial Distress, 131 Yale L. J. 363, 368 (2021).

[8] Neiman Marcus v. Marble Ridge Capital: The Story Behind the $1 Billion-Plus Legal Battle, Fashion L. (Sep. 25, 2020), https://www.thefashionlaw.com/neiman-marcus-v-marble-ridge-capital-the-story-behind-the-1-billion-plus-legal-battle.

[9] See Cantrell, supra note 1.

[10] Id.

[11] 11 U.S.C. § 1102(a)(1).

[12] See In re Johns-Manville Corp., 26 B.R. 919 (Bankr. S.D.N.Y. 1983).

[13] See Daniel J. Bussel, Coalition Building Through Bankruptcy Creditors’ Committees, 43 U.C.L.A. L. Rev. 1547 (1996).

[14] 11 U.S.C. §§ 1102(b)(3), 1103(c).

[15] See Matt Porcelli, Bankrupting the Inside Job: Alternatives to the Washington Mutual Approach to Policing Creditor Committee Insider Trading, 9 N.Y.U. J.L. & Bus. 295 (2012); see also Thomas C. Pearson, When Hedge Funds Betray a Creditor Committee’s Fiduciary Role: New Twists on Insider Trading in the International Financial Markets, 28 Rev. Banking & Fin. L. 165 (2008).

[16] See Bussel, supra note 13 at 1564.

[17] 11 U.S.C. § 1129(b).

[18] See Cantrell, supra note 1.

[19] Kenny K. Tang et al., Recovering From COVID-19: Why the Timing Of Bankruptcy And Emergence Matters For Debt Recovery, S&P Global (Feb. 7, 2022), https://www.spglobal.com/ratings/en/research/articles/220207-recovering-from-covid-19-why-the-timing-of-bankruptcy-and-emergence-matters-for-debt-recovery-12253538.

[20] Jill B. Bienstock, Recent SDNY Decision Adds to the Fray: When Do Courts Approve Non-Consensual Releases?, Cole Schotz Bankruptcy Blog (Feb. 4, 2022), https://www.csbankruptcyblog.com/2019/06/articles/bankruptcy/recent-sdny-decision-adds-to-the-fray-when-can-courts-approve-non-consensual-releases/.

[21] See, e.g., Ellias & Stark, supra note 5.

[22] See Diane L. Dick, Hostile Restructurings, 96 Wash L. Rev. 1333 (2021).

[23] See, e.g., In re Family Health Servs., Inc., Ch. 11 Case No. SA 89-01549-JW (Bankr. C.D. Cal. Filed Mar. 15, 1989); PG&E Corp., 603 B.R. 471 (2019).

[24] See Pub. Serv. Co., 89 B.R. 1014. See also In re Enron Corp., 279 B.R. 671 (Bankr. S.D.N.Y. June 21, 2002).

This post comes to us from Kate Waldock, a second-year student at Columbia Law School and a research fellow at the Ira M. Millstein Center for Global Markets and Corporate Ownership.

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