Sending the Debtors back to the drawing board after almost three years in bankruptcy, in a 139 page opinion, the Bankruptcy Court has for the second time denied confirmation of the Plan of Reorganization for Washington Mutual, Inc. (“WaMu”), which was the owner of the largest savings bank ever to be seized by the FDIC.

In denying confirmation, the Bankruptcy Court determined that an equityholders’ committee had stated “colorable claims” of insider trading by certain noteholders during the bankruptcy case, and, as a result, the claims of the noteholders against WaMu could be subject to “equitable disallowance.” The Bankruptcy Court directed the parties to engage in mediation to see if they could reach a settlement on these issues and thereby avoid a “litigation morass.”

The Bankruptcy Court also provided significant insight into issues surrounding a bankruptcy court’s claim settlement jurisdiction in the wake of the Supreme Court’s decision in Stern v. Marshall, including whether a plan may be confirmed despite pending appeals on issues that will be mooted by such confirmation, the interest rate certain creditors will be allowed under a plan, and the steps creditors should take to avoid insider trading liability in the future when engaged in claim settlement discussions where material non-public information might be revealed.

Background

WaMu filed for bankruptcy on September 26, 2008, the day after its banking unit was seized by the FDIC and sold to JPMorgan. Early in the bankruptcy case, disputes arose among the debtors, the FDIC, and JPMorgan regarding ownership of certain assets and various claims that the parties asserted against each other. Those disputes were ultimately resolved in a global settlement that was incorporated in the proposed plan. Certain parties who will receive little or nothing under the proposed plan objected to confirmation on multiple grounds.

Information Obtained During Settlement Discussions May Create Insider Trading Liability

The Bankruptcy Court ruled that a creditor who receives non-public material information from a debtor must either not trade or must have established a “wall” between the individuals receiving the inside information and those trading claims. This may well result in the resumption of trading orders and other methods used in the past to allow institutions to both trade and receive inside information.

The Bankruptcy Court found that a creditor trading on inside information received from a debtor could result in “equitable disallowance” of the creditor’s claim in addition to other remedies such as subordination or disallowance of a claim.

The plan objectors asserted that certain noteholders, while continuing to engage in settlement discussions surrounding their claims and receive material information regarding the debtors in the context of such settlement discussions, engaged in trading activity and, accordingly, engaged in insider trading. The Bankruptcy Court found that the plan objectors had established “colorable claims” that insider trading had occurred.

Creditors should be aware that under the Bankruptcy Court’s analysis, almost any settlement discussions with debtors could be considered material non-public information and therefore any trading should either be restricted or an ethical wall between analysts and traders established. Creditors also cannot rely upon the defense that debtors agree to “cleanse” the creditors who are party to settlement discussions by periodically disclosing any material non-public information. While the WaMu debtors agreed to disclose any material non-public information at the end of each confidentiality period, the Bankruptcy Court ruled that the noteholders could not rely on such assurances to insulate them from insider trading liability.

The Bankruptcy Court found that where possible insider trading by a creditor has occurred that would establish equitable grounds for the disallowance of the creditor’s claim, a plan cannot be confirmed without resolution of such insider trading issues, reservation of funds with respect to such claims until resolution of such insider trading issues and/or temporary allowance of such claims with the ability to “claw back” funds paid out on account of such claims depending on the ultimate resolution of insider trading issues. The Bankruptcy Court has ordered the parties to mediation in an attempt to avoid “a litigation morass” over insider trading allegations.

Correct Postpetition Interest Rate is Federal Judgment Rate and Not Contract Rate

Perhaps the most significant part of the Bankruptcy Court’s ruling is its decision that the correct postpetition interest rate paid on unsecured claims in solvent estates, including bondholder claims, is the federal judgment rate and not the rate that may have been agreed to in any contract a debtor had entered into prior to filing for bankruptcy. The effect of this ruling on banks and financial institutions that have significant unsecured claims in other bankruptcy cases, including, for example, the Tribune cases, could be substantial. There has been wide disagreement on which interest rate applies because the bankruptcy code simply states that unsecured creditors are entitled to postpetition interest under a plan at the “legal rate” where the debtor is solvent. Some courts have held that “legal rate” refers to the contract rate and some courts have held that it means only the federal judgment rate. Still other courts have opined that “legal rate” could refer to the state judgment rate. The Bankruptcy Court in WaMu found that the federal judgment rate of interest was the appropriate rate of interest in all circumstances and that “legal rate” referred only to the federal judgment rate.

In addition, the Bankruptcy Court held that the federal judgment rate of interest should be calculated as of the petition date. The Bankruptcy Court overruled the plan objectors who had asserted that interest should only be paid after confirmation of the plan. The Bankruptcy Court further held that creditors were not entitled to compounded interest (whether or not contractually required).

Although the Bankruptcy Court’s ruling on use of the federal judgment rate may have profound effects, it may not have much negative effect on the claims of senior noteholders in WaMu, as the Bankruptcy Court also ruled that junior noteholders were contractually subordinated and required to pay all interest at the contract claim to the senior noteholders before receiving any recovery on their subordinated claims.

Jurisdictional Issues Following Stern v. Marshall

The plan objectors argued that the settlement of non-bankruptcy claims must be decided by the District Court as a result of the Supreme Court’s decision in Stern v. Marshall, 131 S. Ct. 2594 (2011). Because the Bankruptcy Court was only determining whether the settlement was reasonable and did not have to rule on the underlying merits of such claims, the Bankruptcy Court ruled that it had jurisdiction. As a practical matter, it appears that bankruptcy courts will continue to assert jurisdiction over the approval of such settlements.