July 10, 2006
Junior Scholars Workshop: Adam Levitin, Finding Nemo: Rediscovering the Virtues of Negotiability in the Wake of Enron
Posted by Christine Hurt

Good morning and welcome to the final paper in the Second Annual Conglomerate Junior Scholars Workshop.  The paper we have saved for last is Adam Levitin's Finding Nemo:  Rediscovering the Virtues of Negotiability in the Wake of Enron.  The expert commentary, provided by Bob Lawless and Todd Zywicki, will appear in separate posts under this one during the day.  We invite all readers to comment on Adam's paper in the comments section of this post.

The Glom views this workshop as an academic conference in cyberspace.  Therefore, any anonymous comments will be deleted.  As with a conference environment, if you have comments you wish to share with Adam privately, feel free to email him with those comments.  The abstract of the paper is here:

Creditors have long understood that any claims they submit for repayment in a bankruptcy might be valid, but subject to subordination in the order of payment of the bankruptcy estate's limited funds if the creditor behaved inequitably as the debtor failed. A groundbreaking opinion in Enron's on-going bankruptcy has expanded the practice of equitable subordination far beyond its traditional reach. According to the court, buyers of bankruptcy claims are now subject to subordination, not just for their own conduct, but also for conduct of previous owners of the claims, regardless of whether the conduct related to the claims. In a world of active bankruptcy claims trading, Enron raises powerful policy questions about the legal rules governing property transfers that affect the doctrinal development of bankruptcy law and the survival of a secondary market that provides important liquidity to other capital markets. This article shows how Enron was erroneous from both doctrinal and policy perspectives and examines the problems Enron has created for several distinct markets. Enron is a reminder of the continuing value of negotiability in commercial contexts, for if the claims involved had been negotiable, they could not have been subordinated. Thus, this article considers what factors have traditionally determined when the law adopts a negotiability regime for property transfers and whether these factors make sense in today's financial markets. The article argues that in the bankruptcy claims context, the liquidity benefits of negotiability outweigh its costs. Accordingly, the article proposes a federal law of negotiability for bankruptcy claims to protect the liquidity of this vital market.

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Comments (6)

1. Posted by Beth Young on July 10, 2006 @ 12:00 | Permalink

On the point re: choice between negotiability and a contractual remedy . . . I did documentation of claims trading in the mid-1990s and my recollection is that there was at least one "bad acts" rep in the transfer document, so the transferee would have a claim against the transferor if the transferor engaged in conduct that resulted in equitable subordination and reduced the value of the claim. I suppose it gets a little more complicated with repeat transfers, but the basic framework for contractual liability is there unless things have changed significantly since I worked on these trades.

2. Posted by Fred Tung on July 10, 2006 @ 12:41 | Permalink

Nice paper, Adam. One question: I wonder whether you have made a little too much out of the Refco case. According to your account, BAWAG the selling claimant was itself in financial trouble when it was trying to dump its claims against Refco. Prospective purchasers were therefore doubly chilled by the prospect of subordination and the likelihood that BAWAG would not be able to stand behind its reps and warranties in the event of claim subordination.

But if BAWAG was in trouble, might there not also be fraudulent transfer risk to purchasing its Refco claims? Not only is there the murky issue of reasonably equivalent value generally, but here, value may be tricky because the claim is most valuable to Refco and its creditors if it stays in the hands of BAWAG. With BAWAG in trouble, the Refco creditor plaintiffs maximize their ultimate recovery in the suit by being able to offset their lawsuit damages against BAWAG's Refco claim(s) dollar for dollar. But if the claim is sold--presumably at a discount--Refco creditors are stuck with BAWAG's credit risk and asset insufficiency. From that perspective, BAWAG has not received REV.

If this is a real risk, then subordination risk may not have been the only factor dampening the sales of BAWAG's claims against Refco.

Again, nice paper.

3. Posted by Susan Morse on July 10, 2006 @ 12:45 | Permalink

I wonder whether the bad-claim transferee has faith in the reps and warranties? Of course the fact that the debtor is in trouble doesn't mean that his creditors are -- but it could, in some circumstances. Empirical question as to how often. I suppose this possibility just complicates the least-cost-avoider analysis further by placing more importance on the possibilities of insurance, derivatives hedging etc.

Despite the possibility that contractual methods are inadequate to protect the transferee in this case, one picture that came into my mind as I read this paper was one of savvy financial creditor claims-traders putting one over on not-savvy trade creditors. I don't know whether that picture squares with the facts of the case.

4. Posted by Adam Levitin on July 10, 2006 @ 17:52 | Permalink

Beth Young and Susan Morse raise interesting points about the utility of bad act reps on claims transfers. Such reps are only as valuable as the ability of the transferor to make good on them, as Fredrick Tung notes. Thus, claims purchasers have to be concerned about the finances of claims sellers, not just the value of the claim itself. The existence of bad acts varies depending on the type of claim being traded. Such reps are typically unavailable for bonds, for example. I would guess that the same goes for equity securities.

The situation with loans is complicated. The Loan Syndication and Trading Association was kind and generous enough to share its standardized loan transfer documentation with me. (Full disclosure: the LSTA is an amicus in the case, arguing for reversal of the bankruptcy court decision.) Distressed loans trade on different documentation than par loans. Standard distressed loan transactions include a bad acts rep; par loans do not. Because most loans do not begin their life as distressed, purchasers can rely on the bad acts rep only as far up the chain as when the loan started trading as distressed. Indeed, a purchaser of distressed debt will not always even be able to trace the identity of prior holders up the chain before the debt became distressed.

Of course, one might ask, with some justification, why there aren't such reps on all transactions. When I've asked that question to people in the debt trading industry, the response is a rather unconvincing "that's just the way it's done." I suspect that the real answer has to do with some implied cost-benefit analysis--no one used to think the reps were worth it. It will be interesting to see if the reps become more common in the wake of Enron.

Susan Morse rightly intuits that if the onus for a transferor's bad acts is placed on a transferee, there is the possibility of significant manipulation by savvy creditors. This is sort of the counterpoint to Enron's concern about "claim washing," in which a bad actor cashes out at unsubordinated value by selling its tainted claims to a good faith purchaser who is protected from subordination. I've tried to identify several types of possible manipulation that Enron facilitates, but I seem to have overlooked one of the most obvious and am grateful to Susan for bringing it to my attention.

5. Posted by Adam Levitin on July 10, 2006 @ 18:17 | Permalink

Fred Tung is right to observe that the bankruptcy claims market might have been independently chilled in Refco by the shaky finances (and hence fraudulent transfer risk) of BAWAG (the bad actor), which reduced the value of any reps and warranties made by BAWAG. The fraudulent transfer angle is a really neat twist that I did not consider, but that I will try to address in my revisions. I think fraudulent transfer is a problem that is separate from Enron, but exacerbated by it, because Enron increases the importance of sellers' reps and warranties.

An anecdotal points may help fill out the picture on the relative importance of fraudulent transfer risk: One banker I spoke who had considered purchasing BAWAG claims insisted that the deciding factor was the inability to get comfortable with the subordination risk, but he also told me that he had "protection" on BAWAG in the form of credit default swaps. Assuming that a CDS would protect against a fraudulent transfer, this can cut either way: either the banker was worried about BAWAG's finances, so he hedged, or he hedged for other reasons, so he wasn't worried.

6. Posted by Adam Levitin on July 10, 2006 @ 19:21 | Permalink

I'm very grateful to Bob Lawless and Todd Zywicki for their thoughtful comments. They have both managed to explain my paper in clearer terms that I could hope to articulate, and as I undertake revisions, I will look to their comments as models for how to make the paper less "inside baseball" for bankruptcy cognoscenti and more immediately relevant to business law generalists.

I take to heart Todd's suggestion that I consider a least-cost avoider analysis when discussing the factors involved in a choice of property transfer law and Bob's suggestion that empirical research could provide a more definitive answer about the effects of choice of property transfer law. I've always thought of LCA analysis as being a creature of tort law, and I thought of this paper as addressing a contract law question. Todd's comments make me realize that equitable subordination risk is perhaps better thought of as a "contort" issue (pace Grant Gilmore) and that much of the difficulty in the issue lies in the "contorted" nature of the problem—whether tort-type liability travels with a contract. My suspicion is that any LCA analysis in the bankruptcy claims context will be indeterminate in the abstract, as Todd posits, but it is a point well worth addressing, and one that empirical research would certainly inform.

Unfortunately, empirical research is not possible for bankruptcy claims. There is no public source of information on bankruptcy claims trading, and market participants are very secretive about the terms of their trades. The lack of transparency in the claims trading market is perhaps the most significant black hole in our understanding of the dynamics of bankruptcy. If and when data becomes available, claims trading should be a very profitable area for empirical analysis.

I am also thankful for Bob's observation that much of the opposition to claims trading within parts of the bankruptcy community comes from concerns about its effects in consumer cases. I was unaware of the impact of "One Code to Rule Them All" in the claims trading context, but it is clearly an issue I must address in revisions: my prescription of negotiability by law should apply solely to business bankruptcies.

Again, thank you so much to Todd and Bob for their helpful comments and to Conglomerate for the fantastic workshop opportunity.

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