Over the past twenty years, a robust secondary market has emerged in the debt of Chapter 11 firms. Critics worry that the trading associated with this market has undermined bankruptcy governance, by forcing managers to negotiate with shifting groups of activist investors in the Chapter 11 bargaining process.
In my new article, ‘Bankruptcy Claims Trading’ I perform the first empirical study of trading in the financial claims of Chapter 11 debtors to learn more about how claims trading impacts the average Chapter 11 case. Using the entire record of trading in bond debt for all Chapter 11 debtors that filed for bankruptcy between 2002 and 2012, I find that nearly all Chapter 11 bonds trade very heavily throughout the bankruptcy process. In fact, Chapter 11 bonds are among the most heavily traded bonds in the corporate bond market as a whole and among the most heavily traded distressed bonds. The market is significant in size—I observe transactions with a market value of more than US$280 billion. In general, bonds trade most heavily at the beginning of the bankruptcy process—around the petition date—and trading declines as the firm gets closer to emerging from bankruptcy. The market for Chapter 11 equity is much smaller (US$335 million), but generally also characterized in active trading that is heaviest at the beginning of Chapter 11.
One of the most important policy questions about claims trading is whether claims trading makes bankruptcy negotiations more challenging. As a threshold matter, I find that trading is heavy enough to disrupt voting on a plan of reorganization in more than half of the sample cases. In a regression setting, I find that claims trading is positively correlated with an increased probability of creditor litigation, but only looking at objections to hearings at the beginning of the bankruptcy process.
However, I find that claims trading appears to be less important for bankruptcy governance than many critics fear. The activist groups that tend to participate in negotiations usually enter cases early. On average, they remain stable, neither acquiring new members or losing existing members. Their existing members tend to not buy or sell the holdings they originally disclose to the bankruptcy court. This suggests that bankruptcy claims trading is, on average, much more about passive investment and much less about activist entrance and exit. This is not to say that there are not cases where late claims trading does not disrupt bankruptcy bargaining—there are—but that is not the story of the average Chapter 11 case.
Jared A Ellias is Associate Professor of Law at the University of California Hastings College of the Law.