Bankruptcy claims trading involves buying and selling claims against a bankrupt debtor. When a company files for bankruptcy, its creditors, who are owed money, hold claims against the debtor. These bankruptcy claims represent the right to receive a portion of the debtor’s assets or the proceeds from the sale of those assets to satisfy the outstanding debt after legal, advisor and other professional fees are paid.
Creditors may not want to speculate on the outcome, wait for the lengthy bankruptcy process to run its course, or they may need to raise cash quickly. In such situations, they have the option to sell to a trader buying bankruptcy claims in four steps. These buyers are typically hedge funds, private equity firms, distressed debt investors, or other financial institutions.
Recovery risk refers to the possibility that a class of creditors will receive lower payments than expected. This can occur if the debtor’s assets are worth less than projected, the claim pool is larger than expected, the bankruptcy process takes longer and costs more than anticipated, or if the creditors are treated less favorably than they had hoped. That’s part of why selling to a claims trader buying bankruptcy claims is a viable option for some liquidity.
In the Delphi bankruptcy cases, for example, the debtors received much less money for their assets than anticipated. As a result, general unsecured creditors initially expected to be paid in full but ended up with only a small percentage of their claims due to unexpected events during the prolonged bankruptcy process and the company’s declining value during an economic downturn. When you trade claims in bankruptcy, however, you eliminate this particular kind of risk.
Receiving less favorable treatment than anticipated can happen when the terms of the treatment are determined by the bankruptcy plan. In the Charter Communications bankruptcy cases, for instance, certain senior claims against affiliate debtors received diminished recoveries because the court evaluated the total enterprise’s value instead of each affiliate debtor separately during the confirmation process. This can lead to discrepancies in the expected payments for different classes of creditors. See more about how bankruptcy works when you trade claims.
Overall, recovery risk is a critical factor to consider in bankruptcy cases, as it can significantly impact the amount of money creditors ultimately receive from the debtor.
Notional amount risk refers to the possibility that a bankruptcy claim may receive a lower amount compared to similar bankruptcy claims in the same class. This can happen if the bankruptcy claim is deemed partially or entirely invalid, or if any previous bankruptcy claim holder’s issues or disabilities are applied to reject the claim. The claims resolution process, which generally occurs after the confirmation of the reorganization plan, involves reviewing and challenging bankruptcy claims based on various grounds, potentially leading to negotiations or legal disputes.
To illustrate the potential consequences of not addressing notional amount risk when you trade claims in bankruptcy, consider an investor who buys a $100 million claim for $30 million, expecting a recovery between 25% and 40% for a potential profit or loss ranging from negative $5 million to positive $10 million. However, if the debtor disputes the bankruptcy claim and, after litigation, agrees to allow it at only $70 million, the investor has already paid 43% of the new claim amount, meaning the investor has paid significantly more for the claim and only has a narrow chance to book a profit on trading bankruptcy claims. This can be further explained when you submit a bid request form for buying your bankruptcy claim.
During the claims resolution process, a bankruptcy claim may be disallowed or reduced based on the debtor’s records, indicating a lower amount owed, or if the debtor is found to have the right to set off the debt. Additionally, a bankruptcy claim could face disallowance if the claim holder received preferential transfers from the debtor or if the claim is subordinated to other claims within the same class due to inequitable behavior of a previous or current bankruptcy claim holder. There are many complexities to selling and buying bankruptcy claims. To mitigate notional amount risk, a bankruptcy claims buyer can conduct more extensive due diligence before acquiring the claim and negotiate for effective protections, such as representations and warranties, indemnities, and other safeguards, in the bankruptcy claims purchase contract. Taking these precautionary measures can help minimize potential losses and uncertainties related to notional amount risk when you trade claims in bankruptcy.
Counterparty credit risk is the third risk factor in buying bankruptcy claims. It emerges when the buyer of a bankruptcy claim relies on the seller for indemnification due to breaches of representations and warranties specified in the bankruptcy claim purchase contract or when claim distributions from the debtor’s estate are mistakenly directed to the seller. Should the seller of the bankruptcy claims face insolvency or become involved in a bankruptcy case, the person buying the bankruptcy claim may lose any viable means of recourse against the seller for breaches of the claim purchase contract or for claim distributions that were originally directed to the seller. This situation highlights the importance of assessing the creditworthiness and financial stability of the claim seller to mitigate potential risks and safeguard one’s interest in buying bankruptcy claims.
The market for selling bankruptcy claims will remain strong as sellers seek to expedite their recovery, while buyers speculate on case outcomes. If you intend to sell a bankruptcy claim, conduct thorough due diligence on potential preference actions and other aspects of the claims trade.
