Bankruptcy Claims Trading Rules Need a More Level Playing Field

Purchasing claims in bankruptcy cases has become a large industry, but claims trading is less regulated than other markets. This environment can lead to fraud and misrepresentation, raising the question of how to make claims trading more transparent.

Simply stating that no one is forced to sell their claim overlooks the financial pressures individuals can face after suffering significant losses. Professional fees may be prohibitive for those in distress, and creditors may feel pressured to sell their claims quickly because of financial distress.

Individuals may be particularly vulnerable to fraud when their current income from an investment is cut off. Sellers might not have all relevant information about their claim or the debtor’s situation, creating opportunities for buyers to misrepresent facts.

Bankruptcy claims are often difficult to value, particularly for those unfamiliar with the process. It is difficult even for attorneys not familiar with bankruptcy. Large Chapter 11 cases—including those involving Bernard L. Madoff Investment Securities LLC, Pacific Gas and Electric Co., and Lehman Brothers Holding Inc.—can take years to reach dividend distributions.

Creditor recovery involves understanding possible legal actions and their potential value—which may be known only to a case’s largest creditors and to bankruptcy professionals handling it. Individuals might not understand docket entries or lengthy pleadings listed on the docket, and they shouldn’t be expected to comprehend what’s happening in a case from reviewing a docket sheet.

Case dockets don’t necessarily tell the full story necessary to estimate a recovery. Often, the only way to get the full story is by speaking with a professional in a bankruptcy case—which individual creditors rarely do.

Making important disclosures more easily accessible and understandable would enhance transparency and informed decision-making. Sellers of claims can review the docket for legal pleadings. But while public case dockets are accessible, laypeople often can’t fully understand the implications of the entries, which can number in the hundreds.

Further, they may not understand when or if their claim has priority over general unsecured claims or the significance of priority status. If fraud occurs, legal action may be an option, but the bankruptcy court’s power to reverse a sale is uncertain. The Bankruptcy Code doesn’t speak to the validity of claim transfers, and the Bankruptcy Rules provide only procedures for the filing of notice required for a transferee to be recognized as the holder of the claim.

The local bankruptcy rules should require financial institutions that purchase claims to be listed prominently on the court’s docket and on the claims agent’s website. Individual creditors are unlikely to be familiar with the universe of institutions purchasing claims.

When solicited by a potential claim buyer, individuals should know who else is purchasing claims so they can compare offers. There should be a notice to creditors in the initial notice of the case’s commencement of that: Selling their claim means they no longer will be a creditor in the case, the recovery for creditors may exceed or be less than the price at which a claim is sold, and that they aren’t under any obligation to sell their claim if solicited to do so.

Creditors should be advised to consult with professionals regarding tax implications, including determining whether the sale result in a loss or in a taxable gain, whether the gain or loss be ordinary income or capital gain, what reporting will be required for tax purposes, whether the sale will impact the creditor’s tax attributes, and whether the sale can be structured to defer recognition of gain or loss.

The documentation of a claim sale should contain certain information. To start, sellers should be able to reverse the transaction for a time (preferably at least 14 days) without being contacted by the contract buyer. This would help eliminate creditors being pressured into selling their claim with subsequent regret.

This would enable individuals to reconsider selling when they can think clearly rather than when they are under pressure. Disclosure of fees and costs related to the sale are important so sellers understand the net dollars they will receive.

The rules should require an outline of the selling process, including documentation and timelines, so sellers know what to expect. The payment deadline should be disclosed, and the sale should be reversible at the seller’s sole discretion if payment isn’t made timely.

There is an imbalance of power between individuals and claims buyers. These proposed disclosures and contract provisions will help individual creditors makes more informed decisions under less pressure with reduced risk of the creditor being misled.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Kenneth Rosen practices debtor and creditors’ rights law and advises companies on practical strategies for resolution of financial distress.

Write for Us: Author Guidelines