Hedge funds that invest in bankrupt companies are demanding protection from insider-trading lawsuits before agreeing to take part in restructuring talks -- a reaction by the industry’s top performers to an obscure court decision involving the 2008 collapse of Washington Mutual Inc.
The ruling by a Delaware federal judge let shareholders pursue allegations that four hedge funds involved in the bankruptcy traded on inside information about talks between WaMu, JPMorgan Chase & Co. and the Federal Deposit Insurance Corp.
While the 2011 decision was ultimately rescinded, some funds and other investors in bankrupt companies have begun to demand “comfort orders” to protect themselves from such liability if they simultaneously trade in an ailing company’s securities and take part in its confidential bankruptcy talks, according to U.S. Bankruptcy Judge James Peck.
“Funds are suffering from what I call the WaMu effect,” said Peck, 68, a New York judge who presided over some of the biggest bankruptcies in U.S. history, including Lehman Brothers Holdings Inc. Speaking at a symposium this month at St. John’s University School of Law in New York, he said the ruling “spawned a new normal: Funds first want protection from risks.”
Funds that trade in distressed companies rank among the best performers in the hedge fund industry. They returned 14.37 percent for the year ended in August, more than any other type of hedge fund, according to a Credit Suisse Group AG index.
Majority Stakes
Many of those funds ended up owning large chunks of reorganized companies. About 127 of 490 large bankruptcy filings from 1980 to 2012 had at least one fund take part in the case and emerge with a majority stake, according to a study co- authored by Michelle Harner, a professor at the University of Maryland Francis King Carey School of Law.
Peck asked whether some funds are “overreacting to a remote risk” by calling in lawyers “to fight the phantom dragons at the gate to the conference room.” He cited the bankruptcies of Mexican glassmaker Vitro SAB and mortgage company Residential Capital LLC as examples of cases where hedge funds received comfort orders from judges.
The orders, which state that parties engaged in settlement negotiations in bankruptcy cases don’t have special status or duties as a result, have become the “the industry-standard presumed antidote” to potential allegations of insider trading, Peck said. Such allegations can be brought as suits or as claims by other creditors that they didn’t get equal treatment.
Hedge funds often own large stakes in a bankrupt company’s debt. Without them, a debtor can’t reach consensus with its biggest stakeholders and reorganize. As a result, hedge funds often take part in talks with regulators or other creditors, or are privy to financial projections and business contracts.