Everything Must Go: The Risks of Managing the Bankruptcy Process

Welcome to the September 2020 edition of our newsletter!  In this issue, we’ll examine how activist investors can take advantage of the bankruptcy process, and identify warning signs of trouble ahead.

Beware of Vultures Overhead: Distressed Investing and Bankruptcy Fraud

The bankruptcies of once great companies, especially in the retail space, have become commonplace in the last six months, as traffic has been slowed or halted due to the pandemic.  While some companies seek to liquidate, many – especially those which are publicly traded – are looking to reorganize and restructure debts in order to survive and rebound at a later date.  This latter group of bankruptcies provide a tremendous opportunity for distressed investors – one which unscrupulous firms can exploit.

Hedge funds that invest in distressed companies often seek leverage for their investment, often in the form of board seats and committee chairs.  This provides the firm the ability, despite often being a new investor in the company, to steer its direction and align the investment’s objectives with their own.  Most often, the goals are intrinsically aligned, as shareholders, management and employees all seek to chart a path of recovery to eventual sustained profitability.   In bankruptcy, however, distressed investors can seek a larger prize – chairing the official committee of unsecured creditors.  The committee works to develop a reorganization plan, and is also bound by the by-laws agreed to during the bankruptcy process.  In recent months, examples have surfaced of committee chairs seeking to block a higher bid for the assets of a company whose unsecured creditors the chair was leading through reorganization.

Signs of abuse or fraud by the unsecured creditors committee can vary.  For instance, in many cases removal of some existing management is warranted as part pf the reorganization process.  But is a committee member pushing aggressively for certain actions?  If so, might they have motives other than upholding the committee by-laws?    While it can be difficult for other unsecured creditors to peer into that process, a review of the public record regarding the committee chair, or other key committee members, can provide great insight, especially if that person or their firm has drawn regulatory scrutiny in the past.  By thoroughly understanding their prior actions, you and your client may be able to anticipate and understand future actions, and act accordingly to ensure that your interests are protected.