The Northwest Airlines Disclosure Decision. In a post last week, I discussed the Bankruptcy Court’s decision in the Northwest Airlines Chapter 11 case requiring the members of an Ad Hoc Committee of Equity Security Holders to disclose detailed information about the amounts of claims or stock owned by the Committee’s members, when they acquired it, how much they paid for it, and when they sold or otherwise disposed of any of their holdings.

Rule 2019: Not So Arcane Anymore. The Bankruptcy Court based its decision on Federal Rule of Bankruptcy Procedure 2019. The rule, rarely discussed in articles or blogs, provides in part:

[E]very entity or committee representing more than one creditor or equity security holder . . .  shall file a verified statement setting forth (1) the name and address of the creditor or equity security holder; (2) the nature and amount of the claim or interest and the time of acquisition thereof unless it is alleged to have been acquired more than one year prior to the filing of the petition; (3) a recital of the pertinent facts and circumstances in connection with the employment of the entity . . . ; and (4) . . . the amounts of claims or interests owned by the entity, the members of the committee or the indenture trustee, the times when acquired, the amounts paid therefor, and any sales or other disposition thereof.

Something Of A Bombshell. As a number of articles have discussed (for example, here and here), the decision was significant because hedge funds and other investors in distressed debt and equity securities have been taking major roles in some of the largest Chapter 11 bankruptcy cases, including through ad hoc committees. Loathe to disclose their trading information, some wonder whether hedge funds will continue to be as active in bankruptcy cases. Hedge funds have been such important players in distressed situations that any retreat from their often leading role could have a big impact on Chapter 11 cases.

Decision Results In A Flurry Of Paper. The Bankruptcy Court’s decision set in motion a series of additional court filings. (You can access these pleadings by clicking on the following links.)

  • In response to the Bankruptcy Court’s decision, the Ad Hoc Committee filed a motion for permission to file the trading information under seal rather than publicly, including not disclosing it to the Debtors or the Official Committee of Unsecured Creditors. They strenuously argued that their trading information was trade secret and confidential commercial information that should be protected under Section 107(b) of the Bankruptcy Code and Bankruptcy Rule 9018, two provisions that permit the sealing of the record under certain circumstances. 
  • A number of other parties weighed in with objections or responses to the Ad Hoc Committee’s motion. These included the Debtors, the Official Committee of Unsecured Creditors, and the United States Trustee. These parties argued against sealing the Rule 2019 statement, contending that it was essential for the parties in the case to know what claims and interests the Ad Hoc Committee members held and the details of their acquisition costs.
  • In addition, Bloomberg News successfully moved to intervene in the case. Bloomberg contended that the Northwest Airlines case was of public significance and that "all aspects of it should be open to public scrutiny to the fullest extent possible." It argued that hedge funds "have become major sources of capital for distressed companies and now play a significant role in bankruptcy proceedings such as this one. The nature of the positions being taken by these key financial players, and the potentially conflicting interests they may hold in any given situation, raise the potential for precisely the types of abuse that led to adoption of Rule 2019 as a procedural device to ‘help foster fair and equitable plans free from deception and overreaching’" (quoting from the Bankruptcy Court’s prior decision).
  • The Ad Hoc Committee then filed a reply, continuing to argue for the sealing of the information, asserting that similar to real estate or car sales, the price paid is "probably the most confidential piece of information regarding the purchase of anything." 

The Court’s Ruling On The Motion To Seal. The Bankruptcy Court held a hearing on the motion on Wednesday, March 7, 2007, and announced that it would issue a ruling by Friday, March 9, 2007.  Friday afternoon, the Bankruptcy Court issued this decision, denying the motion to file the Rule 2019 disclosure under seal and requiring that it be filed within three business days. In reaching its decision, the Bankruptcy Court held as follows:

The Committee members do not advance their position when they compare themselves to car or real estate salesmen. It bears recalling that this Committee purports to control 27 percent of the outstanding stock of the Debtors and that it has repeatedly asked the Court to give credibility to its claims that the Debtors’ equity has substantial value, that the Debtors’ management has wrongfully undervalued the equity, and that it intends to mount a contest as to the valuation of these Debtors. By acting as a group, the members of this shareholders’ Committee subordinated to the requirements of Rule 2019 their interest in keeping private the prices at which they individually purchased or sold the Debtors’ securities. This is not unfair because their negotiating decisions as a Committee should be based on the interests of the entire shareholders’ group, not their individual financial advantage. Their counsel admitted at oral argument of this motion that in negotiations between a committee and other parties in interest, the question is whether a tranche is being treated fairly, not the price at which individual members might be induced to sell. If that is so, and it should be, it cannot harm the legitimate interests of members of an ad hoc committee to put pricing information on the table.

In any event, any interest that individual Committee members may have in keeping this information confidential is overridden by the interests that Rule 2019 seeks to protect. Rule 2019 protects other members of the group – here, the shareholders – and informs them where a committee is coming from by requiring full disclosure of the securities held by members of the committee and the respective purchases and sales. This Committee contends that it did not take on any fiduciary responsibility to the shareholders as a group when it appeared in these cases. Assuming, arguendo, for purposes of this motion that the Committee does not act as a fiduciary, Rule 2019 is based on the premise that the other shareholders have a right to information as to Committee member purchases and sales so that they make an informed decision whether this Committee will represent their interests or whether they should consider forming a more broadly-based committee of their own. It also gives all parties a better ability to gauge the credibility of an important group that has chosen to appear in a bankruptcy case and play a major role.

The utility to other shareholders of information as to the purchases and sales made by members of this Committee is underscored by two facts of record. First, it has been disclosed that Committee members own a very significant amount of debt, as well as stock. Rule 2019 is based on the premise that other shareholders have a right to know whether the debt purchases were made at the same time as the purchases of stock, a fact that might raise questions as to divided loyalties. Second, each of the three representative Committee members admits in his declaration that he might decide to sell out at any time. [record references omitted] The possibility that members of an ad hoc committee will sell and leave a group without a representative is exactly why there are disclosures required under Rule 2019. Rule 2019 gives other members of the class the right to know where their champions are coming from. Granting the motion to seal would scuttle the Rule.

Hedging Your Bets. Over the past several years, hedge funds, like other creditors and equity investors, have been able to play an even more significant role in Chapter 11 cases by participating in ad hoc and official bankruptcy committees. The Bankruptcy Court’s decision will certainly give hedge funds, and perhaps claims buyers generally, pause before they agree to form unofficial committees or join official ones. Although it’s possible that these investors will become more comfortable disclosing this information over time, that seems unlikely.

  • Hedge funds with large stakes in the debt or equity of a particular company will likely still act aggressively to advance their interests, but those with smaller positions may not find the expense of individual representation justified.
  • Even those with big stakes may be more likely to act on their own, rather than through a committee, to avoid facing the prospect of full Rule 2019 disclosures. 
  • If these investors step back from participating in committees, it could in turn reduce their collective influence in bankruptcy cases — one of the reasons they formed committees in the first place.
  • While it’s still too early to tell, if followed by other courts, this decision has the potential to lead to major changes both in how hedge funds and other investors participate in Chapter 11 bankruptcy cases and in the impact they have on them.

It Might Not Be Over. In what could be a sign of things to come, the Bankruptcy Court also granted a separate motion by the Ad Hoc Committee extending its time for filing an appeal from the earlier ruling. In addition, certain members of the Ad Hoc Committee filed their own motion for reconsideration of the Bankruptcy Court’s Rule 2019 order from last week, asking for a hearing on that motion sometime after a March 19, 2007 response deadline. To add to the mix, although the Ad Hoc Committee withdrew its motion for an official equity committee, it has separately filed a motion for appointment of an examiner.

Stay Tuned. With this much going on, I plan to make additional posts on the disclosure issue as events warrant. You’re welcome to subscribe to the blog to receive updates directly via email or RSS.