United States: Risks For Claims Traders Who Have Access To Confidential Information: Lessons From The Recent Washington Mutual Decision

Distressed investors often find themselves confronting the dilemma over how to best exert the influence they have at critical times in the chapter 11 process, which almost always will involve negotiations over key disputed issues, and their ability to continue to trade in claims against the debtor. As demonstrated by a recent decision of the United States Bankruptcy Court for the District of Delaware in the Washington Mutual chapter 11 cases,¹ what such investors do with the potentially inside information they gain from those negotiations, and how and when they use it, may significantly affect their bankruptcy recovery and expose them to potential liability. Additionally, the decision, which is now on appeal, suggests that a creditor who has a blocking position in a creditor class may be considered an insider of the debtor and have a fiduciary duty to act for the benefit of other creditors within that class, even if the creditor does not sit on an official creditors' committee appointed in the case.

Background

In Washington Mutual, the debtors' plan of reorganization was predicated upon a global settlement agreement involving certain hedge funds (collectively, the "Settlement Noteholders"). The official Equity Committee challenged the plan and the settlement and sought standing to bring actions against the Settlement Noteholders for allegedly trading in the debtors' securities while in the possession of confidential information provided to them during plan negotiations. In the course of denying confirmation of the plan on other grounds, the Bankruptcy Court concluded that the Equity Committee had presented colorable claims regarding the Settlement Noteholders' trading activities. In an attempt to avoid having the chapter 11 process derailed with a morass of litigation, the Bankruptcy Court directed the parties to participate in mediation. Thus, it remains to be seen whether the issues will ever be litigated on the merits.

Facts

Washington Mutual was the largest bank holding company failure in the nation's history. Shortly after the commencement of its chapter 11 cases, it became embroiled in a dispute with JP Morgan Chase ("JPMC") over the ownership of $4 billion held by JPMC. JPMC and Washington Mutual thereafter engaged in protracted settlement discussions as part of the plan negotiation process. The negotiations continued off and on from March 2009 until an agreement in principal was announced on March 4, 2010, and included the exchange of various term sheets between Washington Mutual and its affiliates (collectively, the "Debtors") and JPMC. Counsel for the Settlement Noteholders participated in many of these negotiations, but were contractually precluded from sharing information with the Settlement Noteholders unless and until the Settlement Noteholders were bound by confidentiality agreements. The Settlement Noteholders themselves, who collectively held a sufficient amount of claims to have a blocking position in two classes under any plan, had also participated directly in the negotiations, and were at various times subject to confidentiality agreements. During two specific confidentiality periods, the Settlement Noteholders were required to restrict trading of the Debtors' securities or to establish an ethical wall so that confidential information was not used by their traders. The understanding of the Settlement Noteholders was that after the restricted period, the Debtors would disclose all material information, which would then allow the Settlement Noteholders to become unrestricted.

During the first confidentiality period, one of the Settlement Noteholders established an ethical wall, whereas the others restricted their trading. During that first confidentiality period, there were settlement discussions among the Debtors, JPMC, and the Settlement Noteholders. It was undisputed that, during that time period, terms of a possible settlement were discussed and various terms sheets were exchanged, but that the negotiations did not lead to a settlement. With the discussions having been inconclusive, the Debtors apparently decided that there was no need for them to disclose the fact that settlement negotiations were occurring, and, therefore, none of the terms that had been discussed were disclosed. Although no disclosure had been made by the Debtors, based upon their understanding that they had been cleansed by the passage of the first confidentiality period, immediately after that period ended, the Settlement Noteholders shared all confidential information they had received from the Debtors with their traders and resumed their trading in the Debtors' debt.

After the conclusion of the first confidentiality period, two of the Settlement Noteholders independently resumed negotiations with JPMC, and term sheets were exchanged. One of those two Settlement Noteholders restricted its trading during these negotiations, while the other restricted trading only upon receipt of a formal counter-proposal from JPMC.

When JPMC settlement negotiations resumed during the second confidentiality period, each of the Settlement Noteholders restricted trading. During that period, term sheets were exchanged and the Settlement Noteholders received information with respect to the progress of those settlement talks and with respect to a very large tax refund that the Debtors were expecting to receive. During the settlement talks, JPMC indicated a willingness to turn over the $4 billion that had been in dispute. The Bankruptcy Court concluded in hindsight that had the public been aware that there had been a meeting of the minds on that point, the value of Washington Mutual's bonds presumably would have risen, since those funds could have been used to pay bondholders under a plan of reorganization. As previously mentioned, however, the agreement was not publicly disclosed. Ultimately, however, it became clear that a deal was not imminent with JPMC and near the end of the second confidentiality period, one of the Settlement Noteholders asked the Debtors to terminate the confidentiality period one day early so it could begin trading. Because the JPMC settlement negotiations were once again inconclusive, however, the Debtors did not release to the public either the fact that the JPMC settlement talks had occurred or any of the details of those negotiations although they did disclose information regarding the anticipated tax refund. Immediately after the second confidentiality period, the Settlement Noteholders, believing that the non-public information they had received had been cleansed upon expiration of the second confidentiality period, immediately resumed their claims trading activities.

The Bankruptcy Court's Rulings

Certain Washington Mutual shareholders contended that the Settlement Noteholders' counsel, which was involved in the relevant negotiations, improperly tipped off its clients about the undisclosed JPMC agreement in violation of the terms of its confidentiality agreement. Specifically, on July 1, 2009, counsel allegedly shared summaries of the April 2009 settlement negotiations with two of the Settlement Noteholders, which were not subject to confidentiality restrictions at that time. Although one of those Settlement Noteholders voluntarily restricted its trading activities, the other continued to trade. As a result, the latter ostensibly was afforded an opportunity to profit by purchasing bonds and waiting for their value to appreciate when the agreement with JPMC was ultimately announced. While the Settlement Noteholders denied any wrongdoing and contended that they received no "material information" that would rise to the level of insider trading, the Bankruptcy Court found, based upon the evidentiary record, that the allegations against them were colorable and that further discovery was warranted before any definitive ruling could be made.

In the course of its ruling, the Bankruptcy Court made a number of notable determinations. First, it held that the alleged misconduct was not a basis upon which to find that the Debtors' plan had not been proposed in good faith because the actions of the Settlement Noteholders actually added value to the Debtors' estates. Additionally, the Bankruptcy Court rejected the Equity Committee's motion to equitably subordinate the claims of the Settlement Noteholders to the interests of the equityholders because "under the plain language of the statute [section 510(c) of the Bankruptcy Code] equitable subordination only permits a creditor's claim to be subordinated to another claim and not to equity."² However, it then determined that the rarely-used remedy of "equitable disallowance" could be invoked, if the necessary facts were established, to disallow the claims of the Settlement Noteholders on equitable grounds. Drawing on case law authority from the Supreme Court's decision in Pepper v. Litton³ and the Bankruptcy Court's and District Court's decisions in the Adelphia chapter 11 cases, Judge Walrath concluded that she did "have the authority to disallow a claim on equitable grounds 'in those extreme instances – perhaps very rare – where it is necessary as a remedy.'"⁴

In analyzing the equitable disallowance claim, Judge Walrath rejected the argument of the Settlement Noteholders that the information exchanged about the settlement discussions with JMPC did not become "material" for securities law violation purposes until an agreement in principle on the settlement was reached with JPMC. The Settlement Noteholders argued it would have created a great deal of uncertainty as to when disclosure was necessary and would have been impracticable to require disclosure prior to an agreement in principle because the proposed settlement terms were constantly changing. Nevertheless, Judge Walrath noted that the Supreme Court in Basic, Inc. v. Levinson⁵ had "rejected the 'agreement-in-principle' standard for evaluating materiality" in the context of merger discussions and found that the same rationale applied in Washington Mutual.⁶ Judge Walrath further found that the Equity Committee stated a colorable claim that the Settlement Noteholders received material non-public information, because the evidence presented up to that point showed that "the negotiations may have shifted towards the material end of the spectrum and that the Settlement Noteholders traded on that information which was not known to the public."⁷ The Bankruptcy Court concluded that discovery "would help shed light on how the Settlement Noteholders internally treated the settlement discussions and if they considered them material to their trading decisions."⁸

Additionally, Judge Walrath found that the Equity Committee stated colorable claims for securities law violations under both the "classical theory" and the "misappropriation theory" of liability of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5. Under the classical theory, the securities laws are violated when a corporate insider trades the corporation's securities on the basis of material non-public information and in violation of the insider's fiduciary duty owed to shareholders. In contrast, under the misappropriation theory, a corporate "outsider" violates securities laws when he or she misappropriates confidential information in breach of a fiduciary duty owed to the source of the information. Judge Walrath was persuaded that a colorable claim was stated under the classical theory because (i) the Settlement Noteholders became "temporary insiders" when the Debtors gave them confidential information and allowed them to participate in settlement negotiations with JPMC, and (ii) there was sufficient evidence to raise a serious question as to whether the Settlement Noteholders acted recklessly in their use of material non-public information. Judge Walrath was also persuaded that a colorable claim was stated against the Settlement Noteholders under the misappropriation theory based upon evidence that one of the Settlement Noteholders continued to trade after its counsel improperly shared confidential information about the JPMC settlement discussions with certain of the Settlement Noteholders. In making that determination, Judge Walrath found that the Settlement Noteholders might be considered insiders of the Debtors "because of their status as holders of blocking positions in two classes of the Debtors' debt structure" and therefore might have "owed a duty to the other members of those classes to act for their benefit."⁹

Judge Walrath found that it was not a valid defense to argue, as the Settlement Noteholders did, that they assumed the Debtors had complied with their obligation under the confidentiality agreements to disclose material non-public information at the end of each restricted period. She adopted the Equity Committee's argument that despite the fact that the Settlement Noteholders had strict internal policies prohibiting insider trading, they "knowingly traded with knowledge that the Debtors were engaged in global settlement negotiations with JPMC of which the trading public was unaware."¹⁰ Judge Walrath also rejected as a defense the fact that certain of the Settlement Noteholders made contrary trades which allegedly showed that the Settlement Noteholders were not trading on the basis of the confidential information they had received.

Discussion

The ruling by Judge Walrath that a creditor who has a blocking position with respect to a plan of reorganization may become an insider and thereby take on a fiduciary duty to other creditors within its class is a significant departure from the usual rule that a creditor owes no fiduciary duty to its fellow creditors and may act in its own self-interest.¹¹ Notably, however, this is not the first time that Judge Walrath has suggested that creditors can take on a fiduciary duty to other creditors within its class even though they are not purporting to represent them. Rather, she made a similar suggestion in dicta in a prior Washington Mutual decision involving a Bankruptcy Rule 9019 dispute.¹² In that decision, Judge Walrath stated that "collective action by creditors in a class implies some obligation to other members of that class."¹³ For a variety of reasons, it would be problematic if this rationale were ever formally adopted. Creditors who acquire blocking positions usually do so specifically to be able to influence plan negotiations in a way that is best suited to their own individual needs. To impose a fiduciary obligation on such a creditor would greatly alter the dynamics of the chapter 11 process and limit key parties in a chapter 11 case in ways that presumably were never envisioned. Additionally, not allowing a creditor to act in its own self-interest would likely create a great deal of uncertainty with respect to that creditor's rights and obligations, because such creditor would not always be in a position to know what the official position of the class would be or what degree of deviation from that position might be permissible under the facts of a particular case. It will be interesting to see the extent to which Judge Walrath's rationale may be followed and extended under the facts of other cases. In the meantime, creditors who hold, or are considering acquiring, a blocking position or who are purporting to take action on a collective basis that affects the larger creditor class need to take account of these risks.

In rejecting the contention of the Settlement Noteholders that equitable disallowance of their claims would have a chilling effect on investors' willingness to participate in settlement discussions in bankruptcy cases of public companies, Judge Walrath concluded that "creditors who want to participate in settlement discussions in which they receive material nonpublic information about the debtor must either restrict their trading or establish an ethical wall between traders and participants in the bankruptcy case."¹⁴ Whether or not creditors have the ability to avoid allegations that they are improperly using confidential information, however, it is not difficult to imagine that the Washington Mutual decision may discourage some creditors from actively participating in key settlement discussions in chapter 11 cases. If this were to occur, it could ultimately harm debtors whose aim is to emerge from chapter 11 by obtaining consensus among its various creditor groups.

The principal lesson from the Washington Mutual case is that claims traders who have access to confidential information need to be very careful about how and when they trade based upon that information. A tension exists between debtors and key creditors over the disclosure of non-public information that is exchanged during the plan negotiation process. Very often debtors are reluctant to publicly disclose information at the end of a confidentiality period unless a definitive conclusion has been reached with respect to the matter being negotiated, because, in their view, doing so needlessly creates a lot of extra work, inundates parties in interest with information that as a practical matter may be irrelevant, and leads to undue uncertainty and confusion. The Washington Mutual decision should serve as a reminder that creditors cannot merely rely on a debtor's contractual commitment to publicly disclose confidential information at the end of a confidentiality period, but rather need to make sure that such information is actually disclosed. In addition, the Bankruptcy Court was clear that it was not convinced that evidence that the trading market may have known about the confidential information sufficiently established that the public at large was on notice of it. In the absence of full public disclosure, the creditors who are in possession of the non-public information have not been "cleansed" and, therefore, may not be free to trade claims. Judge Walrath's ruling should serve as a reminder that claims traders and their counsel need to be vigilant in making sure that they know precisely when a debtor has released information to the public, and what information has been released, and that they do not engage in trading activities while in possession of information that is still confidential unless proper ethical walls are established and maintained.

Regardless of the outcome of the litigation and mediation in Washington Mutual, that decision is sure to place hedge funds and other claims traders squarely into the cross-hairs of equityholders and creditors in other chapter 11 cases. Indeed, it would not be surprising to see an increase in discovery requests and litigations aimed at ascertaining what information claims traders in a particular chapter 11 case had and when. If for no other reason, this would give equityholders and creditors, who might otherwise be relatively powerless in a particular case, increased leverage during plan negotiations. However, it could complicate the reorganization process from the debtor's standpoint, because, in addition to the litigation-related costs and delays, the risk of insider trading claims may cause key creditors to become less willing to participate actively in a debtor's settlement discussions and plan negotiations, both in the chapter 11 context and in out-of-court restructurings.

Footnotes

1. In re Washington Mutual, Inc., No. 08-12229 (MFW), 2011 WL 4090757 (Bankr. D. Del. Sept. 13, 2011).

2 Id. at *44.

3 308 U.S. 295 (1939).

4 Washington Mutual, 2011 WL 4090757, at *46 (quoting Adelphia Commc'ns Corp. v. Bank of Am., N.A. (In re Adelphia Commc'ns Corp.),

365 B.R. 24, 73 (Bankr. S.D.N.Y. 2007)).

5 485 U.S. 224, 237 (1988).

6 Washington Mutual, 2011 WL 4090757, at *50.

7 Id. at *51.

8 Id.

9 Id. at *53.

10 Id. at *54.

11 E.g., In re W.T. Grant Company, et al., 699 F.2d 599, 609 (2d Cir. 1983) (in which the Second Circuit concluded "[a] creditor is under no

fiduciary obligation to its debtor or to other creditors of the debtor in the collection of its claim").

12 In re Washington Mutual, Inc., 419 B.R. 271, 278-79 (Bankr. D. Del. 2009).

13 Id. at 279.

14 Washington Mutual, 2011 WL 4090757, at *55.

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