Hedge funds are secretive by nature. In contrast, bankruptcy is an open, public process, where full disclosure of legal rights, claims, relationships among parties and potential conflicts is expected as a matter of due course. A number of recent bankruptcy cases, mostly in the Southern District of New York, provides ample evidence that these contradictory forces are butting directly up against each other. As Congress, the SEC and other federal regulators continue to debate hedge fund regulation, a number of bankruptcy judges appear to be filling the void with rulings designed to force hedge funds that are appearing in cases before them into a more transparent mode.
Bankruptcy courts, of course, are often faced with exigent circumstances requiring immediate rulings and lack the luxury of being able to wait for legislatures or regulators to act. A look at rulings in recent SDNY bankruptcy cases involving hedge funds as both debtors and creditors strongly suggests that the judges are going to be insistent on obtaining disclosures which they deem necessary to the relief being sought. The SDNY judges also appear to be sending pointed messages regarding litigious behavior by hedge fund creditors.
Hedge Funds as Debtors
1. Bear Stearns Funds. As has been widely reported, Judge Burton Lifland denied the request of the Bear Stearns funds to have their Cayman Island liquidations recognized under the new Chapter 15 of the Bankruptcy Code, which essentially would have provided protection to the funds’ U.S. assets while funds’ liquidation is overseen by the Cayman courts. Judge Lifland denied the relief even though no party had raised any objections and, in making a finding that the funds’ Cayman presence amounted to little more than a “letter box”, made clear that the Court was not going to be a “rubber stamp” to facilitate the funds winddown outside of the U.S. Whether justified or not, an unspoken premise here is that the funds were to some extent engaged in “forum shopping”, and were seeking proceedings that might be easier on fund insiders than a U.S. chapter 11 case.
2. Basis Yield Alpha. Judge Robert Gerber followed Judge Lifland’s precedent in denying Chapter 15 relief to another Cayman Islands fund, in the absence of greater information regarding the fund’s Cayman contacts. The Cayman liquidators seeking recognition have been ordered to show detailed information not only about the fund’s assets, creditors and employees, but also the number and location of the fund’s equity investors and the relative percentages of the applicable equity that investors in each locale hold.
Hedge Funds as Creditors
3. Northwest Airlines. In Northwest Airlines, Judge Alan Gropper held that a group of hedge fund equity holders represented by common counsel constituted a “committee” for purposes of Rule of Bankruptcy Procedure 2019. The equity holders were therefore required to provide information setting forth “the amount of claims or interests owned by the members of the committee, the times acquired, the amounts paid therefor, and any sales or dispositions thereof”. (A judge in a similar case in Texas subsequently reached the opposite conclusion).
4. Granite Broadcasting. In this case, Judge Gropper resolved a battle for control of the debtor by coming down squarely in favor of a “loan to own” senior hedge fund lender (i.e., had put its money on the table), and rejected the efforts of a group of preferred equity holders that challenged the valuation of the enterprise that left them out of the money: “People who must back their beliefs with their purses are more likely to assess the value of the [asset] accurately than are people who simply seek to make an argument.” The Court also acerbically noted an internal e-mail exchange prior to the commencement of Granite’s bankruptcy between two officers of one of the preferred equity holders, in which the decision was made not to make an alternative proposal to the senior lender’s but instead to “have a fight in chp.11.”
It is clear that hedge funds are going to be playing major roles in most significant cases, and continuing financial market volatility means that there will be more hedge fund failures that will need to be resolved. As default rates begin to return to normal from the historically low levels at which they have lingered for the past 36 months, the SDNY bankruptcy judges look to be seeking now to lay down some guideposts regarding hedge fund activities.