There is a vibrant market in selling all forms of debt, including bank debt, bond debt, and even trade claims. Many believe that the trading of debt, particularly among sophisticated financial institutions that enter into “big boy agreements,” where both parties acknowledge that the other party may have access to information that the other party does not possess, is free from claims of insider trading. However, the SEC’s broad interpretation of “security” to encompass debt claims exposes debt traders to insider trading and market manipulation claims. In addition, various equitable remedies have been employed in bankruptcy cases to penalize debt trading by those possessing material nonpublic information.

Bank Debt As A “Security”

Market participants often assume that debt instruments are not “securities” within the meaning of the federal securities laws, and therefore trading in such instruments is not subject to securities regulation. While most recent cases agree with this assumption, the SEC has not conceded the issue. Indeed, the SEC’s interpretation of what constitutes a security remains boundless, claiming that “Section 10(b) ‘does not confine its coverage to deception of a purchaser or seller of securities . . . .’” Rather, it also includes any deception related to such sales.

If bank debt is a “security,” traders must comply with section 10(b) of the Exchange Act, which prohibits “any manipulative or deceptive device or contrivance” in connection with the “purchase or sale of any security,” and Rule 10b-5, which forbids traders from using a “device, scheme or artifice” to defraud, such as insider trading.

The misappropriation theory of insider trading has been adopted by the Supreme Court to apply to “outsiders” who are fiduciaries in possession of material nonpublic information. Specifically, application of this theory prohibits trading on the basis of material nonpublic information by a corporate “outsider” in breach of a duty owed to the information’s source. Thus, holders of bank debt who participate in confidential discussions with a borrower may violate insider trading laws if they engage in trades using material nonpublic information.

“exposes debt traders to insider trading and market manipulation claims”

To counter insider trading claims, parties used “big boy” letters containing acknowledgements that each party relied solely on its own investigations, while acknowledging that the other party may possess material nonpublic information. However, in a recent action against Barclays Bank, the SEC refused to consider these letters as a valid defense to insider trading charges because the defendants did not disclose the material nonpublic information to their trading counterparties. Thus, even the use of these “big boy” letters may not insulate debt traders from insider trading liability.

Other Insider Trading Liabilities

In addition to SEC claims for insider trading violations, insider trading claims could be made under applicable state laws, regardless of whether the debt instrument is considered to be a security. Parties may also have causes of action for breach of contract, breach of fiduciary duty, or misrepresentation based on confidentiality or nondisclosure agreements. And, significantly, trading of debt claims based on material nonpublic information in bankruptcy cases may result in the equitable disallowance of those claims. Such remedies could, in addition to equitable disallowance, include equitable subordination or the elimination of the right to vote (often referred to as the designation of votes) on a plan of reorganization.

Protection From Liability

Holders of debt in bankruptcy cases are not without some methods to insulate themselves from liability. Methods of protection against insider trading allegations include constructing “ethical walls” pursuant to Exchange Act Rule 14e-3 and obtaining so-called “trading orders,” which are orders of the bankruptcy court allowing trading of debt if the financial institution has set up an ethical information wall between the traders and the analysts receiving the material nonpublic information. In addition, the debt holder may potentially share material nonpublic information to the buyer if the buyer signs the same type of confidentiality agreement the debt holder was required to sign, known in the trade as agreeing to become “restricted” and therefore not trade to anyone who is “unrestricted,” although there is some speculation that any such agreement must be approved by the bankruptcy court in order to be truly effective.

Recent Actions Against Debt Traders

An example of an action against a bank for insider trading violations is found in the Galey & Lord bankruptcy case. Barclays was sued by a creditors committee and the U.S. Trustee for trading in bank debt based on confidential information it obtained while serving on the creditors’ committee. Barclays settled with the committee and Trustee without admitting liability, and was subsequently sued by the SEC, where Barclays reportedly paid a significant sum as part of a settlement.

More recently, in the bankruptcy case of In re Washington Mutual, Inc., the Delaware bankruptcy court granted a committee of equity holders standing to pursue their claims for equitable disallowance against four hedge funds holding bond debt for alleged insider trading violations. The bankruptcy court noted there was a colorable claim that the hedge funds owed a fiduciary duty to the classes in which they had intentionally acquired a blocking position. The bankruptcy court also interpreted the meaning of material nonpublic information broadly, finding that the occurrence of the settlement discussions themselves and the positions taken in those discussions constituted material nonpublic information. Moreover, the bankruptcy court found that the debtor’s public disclosure of material nonpublic information by filing 8-Ks at various times to “cleanse” debt holders and allow for trading among those that it had previously provided information to on a confidential basis was not a sufficient remedy and not one that had been preapproved by the bankruptcy court. Although after a settlement agreement was reached between equity holders and debt holders the bankruptcy court sought to limit the precedential value of its ruling, the ruling has changed the landscape with respect to debtors that wish to share material non-public information with their creditors in the hopes of reaching a consensual plan of reorganization. Moreover, the bankruptcy court’s rule has dramatically changed the willingness of funds to engage in reorganization discussions with debtors, particularly those funds that insist on holding only unrestricted debt so as to maintain their ability to quickly trade that debt.

Conclusion

Holders of bond debt, bank debt, and trade claims need to pay close attention to compliance with securities trading laws and should be wary of other remedies when trading.