The "Trading Claims" Advantage.

When a business entity files a federal bankruptcy proceeding, the consequences go well beyond the troubled company (also known as the "debtor") itself Indeed, the cost, delay and heartache typically accompanying a corporate reorganization/liquidation under the Bankruptcy Code can have a devastating ripple effect on the debtor's key suppliers, trade vendors, landlords, bondholders and senior secured lenders.

It is unfortunate that even though these "creditors" are most impacted by a debtor's bankruptcy filing, terms like "bankruptcy," "corporate reorganization" and business restructuring" remain misunderstood and intimidating. On the other hand, savvy creditors have long taken advantage of the ability to minimize their downside risk and inevitable payment delay caused by a customer's bankruptcy filing by engaging in a phenomenon known as "claims trading." More aggressive creditors have realized even larger returns by purchasing creditor claims at bargain prices both for speculation and as a business tool to acquire either the stock or the assets of a bankrupt entity. Importantly, one need not be an investment banker, venture capitalist or corporate raider to take advantage of the opportunities presented by the bankruptcy process.

Trading Claims In Bankruptcy

In prior years, a creditor held onto its claim for the entire life of a debtor's bankruptcy case--a process that can take up to 3 years or more. This imposed great hardship on creditors who were forced to wait years to receive payment (if any) on their claims. Overtime, a large and sophisticated market for trading bankruptcy claims has developed. In this market, bankruptcy claims are routinely bought and sold based upon the buyer's and seller's expectation of the ultimate recovery in the case.

The Motivations Behind Selling Claims

The sellers of bankruptcy claims are usually suppliers and trade vendors who have extended credit to a bankrupt debtor. The financial impact of these large receivables can have a much greater impact on trade vendors than on an institutional secured creditor--an impact which can be mitigated if the vendor sells its claim at a discount to a professional claims buyer.

For example, if Company X is a supplier of semiconductor chips and its largest customer, Company Y, files for bankruptcy and suspends payment of its invoices, the impact on Company X can be immediate and severe. It is possible that Company Y's debt represents a large portion of Company X's total outstanding accounts receivable. Under these conditions, Company X may not have the time to wait for Company Y to reorganize. Even if Company X is fairly certain that it will eventually recover a large portion of the debt owed it, it simply may not be able to afford the wait.

Creditors which find themselves in these situations may choose to sell their claims at a discount. Simply put, for many of these creditors, it is better to recover thirty ($30) to sixty ($.60) cents on the dollar today (for example), rather than risk financial ruin themselves by holding out for a better return in the future. Thus, selling bankruptcy claims offers the seller an opportunity to turn a claim that otherwise might not be satisfied for many years, into cash.

The Motivation Behind Buying Claims

Although companies and individuals sometimes purchase bankruptcy claims directly from creditors, more commonly brokers and traders act as middlemen in the transaction. Generally, these middlemen maintain a network of potential investors, and search bankruptcy court dockets for potential sellers. Their usual commission is .5% to 1% of the total value of the transaction. Brokers and traders sometimes package claims into units ranging in value from as low as U.S. $30,000 to as high as millions of dollars. These packaged claims can be comprised of a single claim or a mixture of claims from several different bankruptcy filings. By mixing claims, high and low risk claims can be blended and packaged in a proportion that is attractive to potential investors.

William B. Freeman is a partner in the Los Angeles office of Pillsbury Winthrop LLP.