In a significant expansion of the potential risk for distressed claims traders, the Delaware bankruptcy court has recently ruled 1 that traders who engage in insider trading may have their claims subordinated to equity, and that traders who amass claims sufficient to block a plan of reorganization owe fiduciary duties to all other creditors and shareholders during plan negotiations.
Washington Mutual, Inc., a bank holding company that formerly owned Washington Mutual Bank (“WaMu”), was once the nation’s largest savings and loan association, having over 2,200 branches and holding $188.3 billion in deposits. When WaMu filed for bankruptcy protection in September, 2008, disputes immediately arose among a number of parties regarding the ownership of certain assets and various claims that the parties asserted against each other. After more than a year of negotiations, a settlement was reached among some, but not all of the parties (the “Settlers”), and was incorporated into a proposed plan of reorganization that offered to pay creditors but would leave nothing for shareholders. The non-settling parties, including the Debtor’s Equity Committee (“Equity”), sought, among other things, to equitably subordinate the Settlers’ claims on account of alleged insider trading and to hold the Settlers liable as “temporary insiders” for breach of fiduciary duty because the Settlers held claims that were sufficient to block confirmation of any other plan.
Equity claimed that, during the course of the settlement discussions which ultimately lead to the proposed plan of reorganization, the Settlers obtained material, non-public information about WaMu and traded in its securities. They further claimed that the Settlers maintained a blocking position which would prevent the confirmation of any plan that did not have the support of the Settlers. By virtue of their leverage, the Settlers then “dominated” plan negotiations to assure that their settled claims would be paid while nothing was given to WaMu’s equity.
Based on these facts, Equity sought to equitably subordinate the claims of the Settlers despite the fact that other courts have held that the Bankruptcy Code does not authorize the disallowance of a claim on purely equitable grounds. Notwithstanding prior case law, the Delaware bankruptcy court held that it had the power to equitably subordinate claims if they were subject to a defense outside of bankruptcy (in this case, a securities law violation).
A securities law violation can be established if a corporate insider trades in the securities of his corporation on the basis of material, non-public information. The court found a colorable claim for liability because the Settlers traded in WaMu’s securities with knowledge that a settlement was being discussed, including the relative stances the parties were taking in those negotiations over the course of the discussions, and with knowledge of the settlement term sheets exchanged by the parties, all at a time when the public knew only that WaMu and its creditors were engaged in contentious litigation.
The court found no merit in the Settlers’ arguments that Equity was simply utilizing 20/20 hindsight based on the fact that a settlement had ultimately been agreed upon or that, until a deal in principle is reached, mere negotiations do not constitute material, non-public information. The court noted that, as the negotiations progressed, it became clear to the parties involved — but not the public — that a settlement was becoming more probable and that the funds available to the bankruptcy estate were increasing. The court also dismissed the Settlers’ argument that the fact that some Settlers bought claims, some sold, and some did neither, demonstrated that the information gleaned during the negotiations was not material, because unwise or contrary trading does not provide a defense to a securities law violation.
Breach of Fiduciary Duty
Equity also contended that the Settlers became “temporary insiders,” which include those who have entered into a special, confidential relationship in the conduct of the business of the enterprise and are given access to confidential information solely for corporate purposes. Equity asserted that the Settlers became temporary insiders when they were given access to the settlement term sheets and participated in confidential settlement discussions. As insiders, the Settlers owed a fiduciary duty to act for the benefit of all creditors and shareholders, which was breached when they supported a plan that paid nothing to the shareholders. The Delaware bankruptcy court agreed with Equity, deeming the Settlers temporary insiders, and ruling that they owed fiduciary duties to all other creditors and shareholders because they held blocking positions in two classes of WaMu’s debt structure. The court authorized Equity to commence litigation against the Settlers for breach of that fiduciary duty.
Washington Mutual teaches at least two valuable lessons for distressed claims traders. First, claims traders who wish to be active participants in bankruptcy proceedings, especially in connection with negotiating a plan of reorganization, should either avoid any trading during negotiations or should be especially careful to erect a state-of-the-art ethical wall to prevent traders from obtaining any information whatsoever from the bankruptcy participants. Second, by acquiring sufficient amounts of debt to control the vote under a plan of reorganization, traders may be taking on fiduciary duties during negotiations to act in the best interests of all other creditors and shareholders.