The bankruptcy claims trading market is growing at a rapid clip. By one estimate, the global bankruptcy claims trading market grew by five times, from $8 billion in 2009 to $40 billion in 2010. According to our sources, even with significant cash on corporate balance sheets, sovereign credit concerns are likely to lead, directly or indirectly, to corporate defaults – particularly in Europe – which will only increase the size of the claims trading opportunity set. Claims trading is complex, interdisciplinary, obscure, laborious and largely unregulated. In short, it is the sort of investment activity for which certain hedge funds are ideally structured and staffed; and, not surprisingly, trading by hedge funds has been a significant driver of the growth in claims trading. See “Treatment of a Hedge Fund’s Claims Against and Other Exposures To a Covered Financial Company Under the Orderly Liquidation Authority Created by the Dodd-Frank Act
,” Hedge Fund Law Report, Vol. 4, No. 15 (May 6, 2011). As hedge fund managers that participate in claims trading know, and as managers that consider entry into the claims trading market quickly find out, investment outcomes when trading claims are powerfully influenced by legal considerations. See “Second Circuit Adopts Broad Interpretation of Bankruptcy Code § 546(e) Safe Harbor for Securities ‘Settlement Payments,’ Ruling that Safe Harbor Applies to Enron’s Redemptions of Its Own Commercial Paper Prior to Maturity
,” Hedge Fund Law Report, Vol. 4, No. 24 (Jul. 14, 2011). And legal considerations typically apply to claims trades at two levels – the estate level and the trade level. The chief risk at the estate level is that the ultimate value of the estate will depart significantly from the expected value of the estate at the time of purchase of a claim. The chief risks at the trade level are that the claim will be disallowed, reduced or subordinated, or that the seller of the claim itself will become insolvent. This article analyzes the two levels of legal risk in claims trading by examining two different sources. First, with respect to “estate risk,” this article provides a comprehensive analysis of a recent decision by Judge Rakoff in the Madoff liquidation. That decision generally held that the Trustee does not have standing to bring common law claims against third parties on behalf of creditors of the Madoff estate or the estate itself. While one typically thinks of spreadsheets rather than standing when thinking about hedge fund returns, this decision may have a material impact on the value of Madoff claims, in which a robust market has developed. (As of immediately prior to the Rakoff decision, Madoff claims were trading for 65 to 70 cents on the dollar.) The common law claims that Judge Rakoff did not permit to proceed sought approximately $8.6 billion from deep-pocketed defendants. Further, a significant portion of the expected value of the Madoff estate consisted (at least prior to this decision) of anticipated proceeds from similar common law claims against similarly situated defendants, i.e., large financial institutions that served as “conduits” for investments into the Madoff operation. Moreover, Rakoff’s decision was stern, unambiguous and forcefully reasoned. According to our sources, the decision is unlikely to be reversed or revised on appeal. Second, with respect to trade risk, this article outlines an insightful recent article authored by Lawrence V. Gelber, David J. Karp, and Jamie Powell Schwartz, Partner, Special Counsel and Associate, respectively, at Schulte Roth & Zabel LLP. In particular, this article outlines the relevant points from the Schulte article regarding “notional amount risk,” “counterparty credit risk” and how to mitigate both categories of risk in claim trade documentation. In short, any hedge fund manager considering the purchase of a bankruptcy claim must ask two questions in order to assess whether to purchase and at what price: How big is the pie? And how secure will my access to the pie be? The purpose of this article is to highlight issues that are relevant in answering these two questions.