For big hedge funds that throw themselves into large bankruptcies with an eye on outsized profits, the Chapter 11 case of Washington Mutual Inc may be remembered as a game-changer.
A Delaware bankruptcy judge's ruling in the case rejecting the company's reorganization plan could chip away at the funds' underlying investing strategy and change how large restructurings are negotiated, according to legal experts.
In her ruling, Judge Mary Walrath suggested that hedge funds that buy large blocks of a bankrupt company's debt and then help negotiate a reorganization plan could be considered insiders.
Her opinion also suggests the funds have a fiduciary duty to other creditors.
"I think Judge Walrath's comments in this decision are an extreme departure from what everybody in the distressed community thought were the rules of the road," said Kurt Mayr of law firm Bracewell & Giuliani.
The case revolves around four hedge funds -- Owl Creek Asset Management LP, Appaloosa Management LP, Centerbridge Partners LP and Aurelius Capital Management LP -- which regularly take active roles in large bankruptcies.
The funds bought Washington Mutual securities at knock-down prices, banded together in an ad hoc committee and used their combined holdings to get a seat at the negotiating table.
They also traded the company's securities at the same time, although they subjected themselves to various restrictions.
The plan they helped craft paid most creditors in full but left almost nothing for the company's shareholders, who bitterly opposed the proposal.
In addition, shareholders presented evidence that the funds engaged in insider trading by cashing in on non-public, material information gleaned from the negotiations.
The funds denied the allegations, arguing among other things that they did not meet the definition of insiders.
Walrath disagreed. In her written ruling last week, she found that the funds may have become insiders when Washington Mutual provided them confidential information and allowed them to join negotiations for a reorganization plan.
She also found the funds had a fiduciary duty to other creditors because they hold such large positions in some securities that they could block any reorganization that they opposed.
Walrath did not rule on the merits of the insider trading allegations, merely that they met the low bar for being "colorable" or viable claims.
However, her ruling suggests that funds that participate in talks must take greater care when trading at the same time, or they could be at heightened risk of violating insider trading laws, said Benjamin Feder of law firm Kelley Drye.
"Obviously there is going to be significant possibility that trading on such information without protective mechanism will be a violation of securities laws," he said.
In a client note, the Davis Polk law firm said the ruling could limit the willingness of funds to participate in reorganization talks.
In turn, Davis Polk said that could make it hard for a bankrupt company to find a critical mass of creditors to support a plan to get out of Chapter 11, prolonging the reorganization process.
Walrath was not terribly sympathetic to warnings about the chilling impact she might have the reorganization process.
She noted in her ruling that official committees, which are organized by the U.S. Trustee and recognized by the court, are always subject to restrictions on trading.
"The court does not believe that a requirement to restrict trading or create an ethical wall in exchange for a seat at the negotiating table places an undue burden on creditors who wish to receive confidential information and give their input," she wrote.
The ruling is not the first time the funds felt a sting from Walrath. Early in the case she broadened what many had accepted as proper disclosure to require ad hoc committees to divulge not just their cumulative investment, but when they bought the securities and what they paid.
Shareholders seized upon information from those disclosures to accuse the four funds of insider trading, which led to the current ruling.
The case is In re Washington Mutual, U.S. Bankruptcy Court, District of Delaware, No. 08-12229.
(Reporting by Tom Hals, editing by Matthew Lewis)