Here is a situation: Hedge fund A has a long concentrated position in a unsecured bond with a small issue size. This bond does not trade very often. The hedge fund feels this company could go into bankruptcy or hit a rough patch. If they sell the bond, it could tip the hand of the market or cause a large decrease in the bond price because of such a large sell order. Subsequently they purchase a CDS (basically a bond option) in an amount less than, equal to, or greater than the notional value of their bond position. A few months later, the company declares it is entering bankruptcy.
On 1/9/10, a bankruptcy judge in Delaware ruled in the bankruptcy case of Six Flags (re: Premier International Holdings, Inc. Case No. 09-12019 Bankr.D. Del. Jan.9, 2010) that the ”members of an ad hoc committee of note-holders are not required to comply with the disclosure requirements of Bankruptcy Rule 2019. This ruling is different than two other bankruptcy cases involving Northwest Airlines Corp (Southern District of NY 2007) and Washington Mutual (District of Delaware 12/2/09).
Bankruptcy Rule 2019 states that any committee representing more than one creditor should list each creditor’s claim, date of acquisition, price of acquisition and other claims or interests. Normally, these committees list each of the creditors and the aggregate holdings of the committee. Bankruptcy workout groups such as Alvarez & Marsal assume they will never learn which unsecured creditor owns what as the creditors are likely to have constant movement of their holdings (e.g. derivatives, options, equities, swaps).
In the situation of our hedge fund, if they own more CDS exposure than their underlying bond exposure, they want the company to be worthless and will vote as such. There is an industry movement to enforce CDS restrictions so that the interests of the company will match the interests of unsecured bond holders.
Bottom line: If you make an allocation to a junk bond manager or a distressed bond manager, ask how Bankruptcy Rule 2019 and the current disparity of rulings from bankruptcy courts will affect his/her strategy. As an aside, Deutsche Bank just downgraded FTI from a buy to a hold as they expect corporate bankruptcies to hit a plateau and decrease after 2010. Analysts are sometimes right and sometimes not.
Always Asking, Never Assuming™
Christopher Holtby
Tags: bankruptcy, bondholders, CDS, dallas, Delaware, fee-only, financial advisor, financial planning, investment management, north texas, rule 2019, unsecured creditors, wealth management