WaMu Plan Denied Confirmation for Second Time Amidst Insider Trading Allegations
Earlier this month, the Delaware Bankruptcy Court denied confirmation of the Modified Sixth Amended Joint Plan (“Modified Plan”) of Washington Mutual, Inc. (“WMI”) and its affiliated debtors (collectively, the “Debtors”),1 thereby again delaying the distribution of about $7 billion in assets, net operating losses with an estimated $17.7 billion in face value and other consideration. The court concluded that creditors who trade a public debtor’s securities when they merely have knowledge that confidential settlement negotiations are transpiring may be guilty of insider trading, notwithstanding compliance with a protocol to prohibit trading until after the debtor had made public disclosure. Judge Walrath also determined that creditors of a solvent debtor are entitled to post-petition interest at the lower federal judgment rate rather than the contract rate, although subordination agreements may permit senior creditors to recover the ensuing shortfall from subordinated creditors.
This saga began just over three years ago at the outset of the global financial crisis. In the ten-day period beginning September 15, 2008, the date that the Lehman Brothers bankruptcy filing sparked the crisis, over $16 billion in deposits were withdrawn from Washington Mutual Bank (“WMB”). On September 25, 2008, the FDIC took over WMB, marking the largest bank failure in our nation’s history. On the same day, the FDIC sold substantially all of WMB’s assets to JPMorgan Chase Bank, N.A. (“JPMC”) for $1.88 billion plus the assumption of more than $145 billion in deposit and other liabilities of WMB. The FDIC, as the receiver of WMB, retained claims that WMB held against other parties. The next day the Debtors filed chapter 11 petitions and disputes soon arose among the Debtors, the FDIC, JPMC and other parties. These disputes centered on the propriety of the sale to JPMC and ownership of various assets, and engendered acrimonious litigation in multiple jurisdictions.
In March 2010, the parties announced a global settlement agreement (“GSA”) that was ultimately incorporated into the Sixth Amended Plan. In an Opinion and Order dated January 7, 2011, the Court concluded that the GSA was fair and reasonable, but declined to confirm the Sixth Amended Plan because its release, injunction and exculpation provisions were too broad.2 The Sixth Amended Plan and the GSA were modified on March 16 and 25, 2011, in an attempt to address the Court’s concerns. The Modified Plan was supported by the Debtors, JPMC, the FDIC, the Creditors’ Committee, the WMI Senior Noteholders’ Group and other parties (collectively, the “Plan Supporters”), and opposed by the Equity Committee, holders of Litigation Tracking Warrants, certain WMB Noteholders and other shareholders and creditors (collectively, the “Plan Objectors”).
Judge Walrath’s decision addressed two issues that are likely to provide guidance to future participants in chapter 11 cases: (1) allegations that some Senior Noteholders had traded on material nonpublic information, and the ramifications thereof; and (2) whether the federal judgment rate or the contract rate of interest should be paid to Senior Noteholders, and the interplay of subordination agreements.
Insider Trading Allegations
The Equity Committee and others alleged that the Modified Plan should not be confirmed because the so-called Settlement Noteholders (consisting of Appaloosa Management, L.P. (“Appaloosa”), Aurelius Capital Management LP (“Aurelius”), Centerbridge Partners, LP (“Centerbridge”), Owl Creek Asset Management, L.P. (“Owl Creek”), and several of their respective affiliates) had engaged in improper trading during settlement negotiations. This alleged improper trading formed the basis for two objections to confirmation: (1) that the Modified Plan was not proposed in good faith; and (2) that the claims of the Settlement Noteholders should be equitably disallowed.
Between March 2009 and March 2010, the Debtors and JPMC negotiated a resolution of their disputes. Counsel for the Settlement Noteholders participated in many of these negotiations, though they were precluded from sharing information with the Settlement Noteholders unless the latter were under confidentiality agreements. At times, the Settlement Noteholders also participated directly in the negotiations, but their participation was conditioned on their entering into confidentiality agreements with the Debtors, during which time the Settlement Noteholders were required to restrict trading of the Debtors’ securities or to establish an ethical wall. At the end of two separate confidentiality periods, information was released to the public by the Debtors and trading restrictions were removed.
Section 1129 of the Bankruptcy Code sets forth the standards for plan confirmation, including that the plan must be proposed in good faith and not by any means forbidden by law.3 Judge Walrath opined that, to meet this standard, the plan proponent must establish that “(1) [the plan] fosters a result consistent with the Code’s objectives …, (2) the plan has been proposed with honesty and good intentions and with a basis for expecting that reorganization can be effected …, and (3) there was fundamental fairness in dealing with the creditors.” The Debtors agreed that the conduct of the Settlement Noteholders was in accordance with the terms of the parties’ written confidentiality agreements and did not violate any law or duty that the Settlement Noteholders might have had. The Equity Committee asserted that the Settlement Noteholders “dominated” or “hijacked” the settlement negotiations and engaged in inequitable conduct, including trading in the Debtors’ securities while in possession of material nonpublic information, and used such material nonpublic information to acquire a blocking position in the various creditor classes to assure that their claims got paid while nothing was given to the shareholders. The court found that the conduct of the Settlement Noteholders did not mean that the Modified Plan was proposed in bad faith, and in fact the actions of the Settlement Noteholders appeared to have helped increase the size of the JPMC settlement.
However, the Settlement Noteholders did not fare as well when the court considered the Equity Committee’s objection to confirmation based on equitable disallowance of the Settlement Noteholders’ claims (and accompanying motion for standing to prosecute such an action).4 If the claims of the Settlement Noteholders were disallowed, any distribution to which they would have been entitled would be redistributed to other creditors and ultimately to the shareholders. The court determined that the appropriate standard was whether the Equity Committee had stated a “colorable” claim which the Debtors have unjustifiably refused to prosecute, which sets a low threshold and mirrors the standard applicable to a motion to dismiss a complaint for failure to state a claim.5
The court had not permitted full discovery on the Settlement Noteholders’ internal trading decisions, but nevertheless concluded that the Equity Committee had presented sufficient evidence to make out a “colorable” claim of insider trading. Judge Walrath rejected the contention of the Settlement Noteholders that the only material nonpublic information which they received from the Debtors during the confidentiality periods were the estimated amounts of the Debtors’ tax refunds, which were disclosed by the Debtors to the public before the Settlement Noteholders resumed trading. Instead, the court focused on the following facts known by the Settlement Noteholders but not the general public: (1) the knowledge that a settlement was being discussed, (2) the relative stances the parties were taking in those negotiations, (3) the parties were exchanging term sheets, and (4) the parties were conceding issues at a time when the public knew only that the Debtors, JPMC, and the FDIC were engaged in contentious litigation. The court gave credence to the fact that over the course of negotiations it became clear that a settlement was more probable (as issues were resolved) and that the funds available to the estate were increasing. The Plan Objectors argued that the materiality of the information was evident from the fact that the Settlement Noteholders had traded on that information as soon as they were free to do so. The Equity Committee characterized such post-negotiation trading as a “buying spree” concentrating on acquiring (at a discount) junior claims because the Settlement Noteholders knew (although the public did not) that the junior creditors were likely to receive a recovery.
Judge Walrath was unconvinced by the contention of the Settlement Noteholders that, at the conclusion of both confidentiality periods, the parties felt that the negotiations were dead because of the extreme distance in their positions. The court also rejected the argument that it would have been sheer speculation that JPMC’s position on one or more potential settlement terms in March or November 2009 could have provided assurance that JPMC would take that same position in future complex, multi-party, multi-issue negotiations. Moreover, Judge Walrath discounted the fact that some of the Settlement Noteholders were selling while others were buying or not trading at all. For example, while both Appaloosa and Centerbridge received a summary of the Debtors’ April negotiations and JPMC’s August 2009 counter-offer during their own separate negotiations, they engaged in opposite trades after receiving that information. In another striking example, Aurelius sold Preferred Income Equity Redeemable Securities (“PIERS”) on March 8, 2010, four days before the announcement of the GSA, after which the price of the PIERS skyrocketed.
The court further found a “colorable” claim that the Settlement Noteholders had become “temporary insiders” of the Debtors when the Debtors gave them confidential information and allowed them to participate in negotiations with JPMC for the shared goal of reaching a settlement that would form the basis of a consensual plan of reorganization. In doing so, the court rejected the contention of the Settlement Noteholders that they and the Debtors had diverse interests, and that the Debtors always knew that the Settlement Noteholders’ purpose for participating in the negotiations was to further their own economic self-interest, not to pursue a common goal that might give rise to an insider relationship.
Finally, Judge Walrath rejected the notion that a finding of insider trading would chill the participation of creditors in settlement discussions in bankruptcy cases of public companies, noting an “easy solution” – creditors who want to participate in settlement discussions in which they receive material nonpublic information about the debtor must either restrict their trading or establish an ethical wall between traders and participants in the bankruptcy case.
While Judge Walrath denied confirmation and granted the Equity Committee’s motion for standing to seek disallowance of the claims of the Settlement Noteholders, she stayed prosecution of such action and directed the parties go to mediation because she was concerned that the case would “devolve into a litigation morass.”
Appropriate Interest Rate and Effect of Subordination Agreements
The Plan Objectors argued that the Modified Plan failed to comply with the best interests of creditors test because the Modified Plan provided for the payment of post-petition interest on creditors’ claims at the contract rate of interest rather than at the federal judgment rate, thereby permitting creditors to receive more (with the shareholders accordingly receiving less) than they would under a chapter 7 liquidation. The best interests of creditors test is found in Section 1129(a)(7) of the Bankruptcy Code and requires that, unless every holder in the class has accepted the plan, each impaired class of claims or interests (stock) must receive or retain under the plan property of a value that is not less than the amount such holder would receive or retain in a chapter 7 liquidation.6 Generally, unsecured creditors are not entitled to recover post-petition interest unless the debtor is solvent. In a chapter 7 liquidation of a solvent debtor, unsecured creditors are entitled to post-petition interest on their claims at the “legal rate” before shareholders receive any distribution.7 Thus, the court had to determine whether the “legal rate” meant the higher contract rate as urged by the Senior Noteholders or the lower federal judgment rate as urged by junior classes.
After canvassing the case law, Judge Walrath concluded that the federal judgment rate applied because, inter alia, where Congress intended that the contract rate of interest apply its will was clearly expressed (such as in Section 506(b) with respect to an over-secured creditor),8 and the use of the federal judgment rate promotes two important bankruptcy goals: “fairness among creditors and administrative efficiency.” Imposition of the lower federal judgment rate rather than the contract rate freed up hundreds of millions of dollars and meant equity would receive a recovery, but the court denied this was a factor in its decision.
The Plan Supporters argued that payment of the various contract rates of interest as provided in the Modified Plan was warranted because the distribution scheme is simply a function of the subordination provisions in the various creditors’ contracts which mandate that the subordinated creditors pay the senior creditors their claims in full, including contract interest. The Court noted that just because some creditors have contractually agreed to pay their distribution to other creditors does not mean that the Debtors must pay senior creditors more than required under the Bankruptcy Code. Instead, the Debtors could effectuate the subordination agreements through a plan of reorganization by diverting payments from subordinated creditors to senior creditors without affecting the total claims against the estate.
Junior creditors asserted that the subordination provisions did not require that they pay the senior creditors their full contract rate of interest because the agreements did not explicitly refer to the rate of post-petition interest to which they are subordinated, and so the interest they are subordinated to should only be the rate the court determined was appropriate. They relied on the Rule of Explicitness, which provides that if the subordination provisions are unclear or ambiguous as to whether post-petition interest is to be allowed a senior creditor, the general rule that interest stops on the date of filing of the petition in bankruptcy is to be followed.9 The court rejected the argument of the senior creditors that the Rule of Explicitness no longer applies since passage of the Bankruptcy Code and the enactment of Section 510(a), which provides that a subordination agreement is enforceable in a bankruptcy case “to the same extent that such agreement is enforceable under applicable nonbankruptcy law.”10 However, the court agreed with the senior creditors that the “subordination provisions adequately apprised the subordinated creditors that their payments were subordinate to all contractual post-petition interest, even if the Court allowed none. They certainly, therefore, were on notice that they were subordinate to contractual post-petition interest if the Court allowed some.” Therefore, the Modified Plan did not violate the Bankruptcy Code by giving effect to the subordination provisions in the indentures and requiring subordinated creditors to pay senior creditors post-petition interest at the contract rate, even though the Debtors were only required to pay post-petition interest at the federal judgment rate.
The court also resolved a subordination dispute between the WMB Noteholders (who had stipulated that their claims were subordinated under Section 510(b) to general unsecured claims because they held claims arising from rescission of a purchase or sale of a security of WMB), and the Indenture Trustee for the PIERS over whether the WMB Noteholders were subordinated to the Indenture Trustee’s claim for post-petition interest. The court agreed with the Indenture Trustee that Section 510(b) required subordination to all claims of creditors, which included claims for unmatured post-petition interest. Judge Walrath determined that interest should be calculated using the federal judgment rate in effect as of the petition date, rather than the effective date of the plan. This was a fairly significant victory for senior creditors because shortly after the case was filed the federal judgment rate fell precipitously from 1.95% to as low as .18% as of June 16, 2011. Finally, the court concluded that the creditors’ contractual right to compound interest was eliminated by Section 502(b)(2), which disallows claims for unmatured interest, and the federal judgment rate only permits annual compounding of interest.11
The WaMu decision could have tremendous repercussions for chapter 11 cases of public companies. While Judge Walrath believed that her ruling would not chill creditor participation in settlement discussions because creditors could either restrict their trading or establish an ethical wall, there was substantial evidence that the Settlement Noteholders did just that in WaMu. WaMu’s holding could certainly encourage junior classes in other cases to cry foul by pointing to “suspicious” trading activity, a “buying spree” immediately after the end of a confidentiality period or the acquisition of a blocking position. In fact, WaMu can be read to mean that mere knowledge that a settlement was being discussed may be sufficient to make out a “colorable” claim of insider trading, despite the fact that some of the Settlement Noteholders made opposite or losing trades. Thus, the WaMu ruling could increase the odds that chapter 11 cases “devolve into a litigation morass.” At the very least, creditors of public companies who acquire material nonpublic information during their participation in settlement discussions will have to tread carefully, implement stringent trading restrictions during confidentiality periods, take steps to assure strict adherence to such policies and be prepared to substantiate compliance therewith. Nevertheless, unless full disclosure of all material information is made before trading resumes, creditors may be subjected to exposure if they resume trading while possessing any material information that was not publicly disclosed. However, full disclosure of all material information is likely to be resisted by participants in settlement negotiations, especially disclosure of sensitive matters such as the positions the parties have taken and concessions they were willing to make to get a deal done.
For More Information
For more information on how these issues may affect your rights, contact Nicholas F. Kajon at 212.537.0403.
This News Alert has been prepared for informational purposes only and should not be construed as, and does not constitute, legal advice on any specific matter. For more information, please see the disclaimer.
1 — B.R. —-, 2011 WL 4090757 (Bkrtcy.D.Del.).
2 In re Wash. Mut., Inc., 442 B.R. 314, 344–45, 365 (Bankr.D.Del.2011).
3 11 U.S.C. § 1129(a)(3).
4 The Equity Committee also sought to equitably subordinate such claims, but because that remedy would still rank the Settlement Noteholders ahead of shareholders, the court denied standing. Presumably, under the same set of facts, equitable subordination could have been successfully invoked by a junior class of creditors. For a general discussion of the doctrine of equitable subordination, see Kajon, Lenders Beware: Deepening Insolvency and Other Pitfalls to Avoid Before the Next Wave of Bankruptcies, March 30, 2006.
5 Fed. R. Civ. P. 12(b)(6) (providing that a complaint may be dismissed for failure to state a claim upon which relief can be granted).
6 11 U.S.C. § 1129(a)(7).
7 11 U.S.C. § 726(a)(5) & (6) (nsecured creditors are entitled to interest at the legal rate from the date of the filing of the petition before any payment can be made to the debtor or equity holders).
8 11 U.S.C. § 506(b) (permitting an over-secured creditor to recover interest, and any reasonable fees, costs, or charges provided for under the agreement under which the claim arose).
9 See, e.g., Chem. Bank v. First Trust of N.Y. (In re Southeast Banking Corp.), 93 N.Y.2d 178, 186 (N.Y.1999) (“In accordance with the Rule of Explicitness, New York law would require specific language in a subordination agreement to alert a junior creditor to its assumption of the risk and burden of allowing the payment of a senior creditor’s post-petition interest demand.”).
10 11 U.S.C. § 510(a).
11 28 U.S.C. § 1961(b) (providing that “[i]nterest shall be computed daily to the date of payment … and shall be compounded annually.”).