Vulture fund alleged insider trading sinks WaMu Chapt. 11 deal

By Alison Frankel
September 14, 2011

The shadowy market of distressed debt investing — trading in the bonds of troubled companies as they enter and exit Chapter 11 — has rarely, if ever, received the kind of public scrutiny it has been subjected to in the bankruptcy of Washington Mutual Inc., the parent of WaMu Bank.

Since 2008, when WaMu collapsed and its parent company went into Chapter 11, WMI notes were snapped up by some of the biggest players in the distressed debt game, including the hedge funds Appaloosa Management, Aurelius Capital, Centerbridge Partners, and Owl Creek Asset Management. The funds bought and sold WMI debt as the company negotiated its way to a $7 billion reorganization plan that would have paid all bondholders in full. But just as the plan was on the verge of confirmation, out-of-the-money WMI shareholders — in a truly last-ditch attempt to squeeze some money out of the WMI reorganization — claimed the hedge funds had traded on insider information about the settlement talks that led to the proposed plan.

Delaware federal bankruptcy Judge Mary Walrath gave enough credence to the shareholders’ allegations that in February she granted the equity committee’s lawyers at Susman Godfrey permission to investigate the insider-trading claims. And when she held hearings on the WMI confirmation plan in July, Susman Godfrey and Arkin Kaplan Rice (representing WMI trust-preferred securities holders) pounded hedge fund witnesses about whether they’d received confidential information about WMI’s settlement talks with JPMorgan Chase, which had acquired WaMu Bank on the cheap in 2008, and the Federal Deposit Insurance Corporation, which oversaw the WaMu sale.

Near the end of closing arguments in the confirmation hearings, Walrath asked equity committee counsel Parker Folse of Susman Godfrey whether he planned to add the two hedge funds he hadn’t already named in a proposed adversary complaint to his insider trading suit. It wasn’t entirely clear at the time whether the judge’s question was merely procedural, or was a portent of her assessment of the evidence Susman Godfrey and Arkin Kaplan put on against the hedge funds.

On Tuesday night we got the answer: it was a portent. In a shocker of a ruling, Walrath denied confirmation to a $7 billion reorganization plan she had already found to be fair and reasonable. The judge had some relatively small problems with the plan itself — most significantly, she concluded that the federal judgment rate, rather than a contract rate, should apply to post-petition interest, reversing her previous ruling — but otherwise agreed with plan supporters on most provisions of the actual deal. She rejected objectors’ arguments, for instance, that WMI had acted in bad faith by including the hedge funds and their lawyers at Fried, Frank, Harris, Shriver & Jacobson in settlement talks.

But then, on page 112 of the 139-page opinion, Walrath came to the question of the equity committee’s “claim for equitable disallowance” — the shareholders’ proposed adversary proceeding against the hedge funds for alleged insider trading. If the hedge funds engaged in trading based on confidential information about WMI’s settlement talks with JPMorgan and the FDIC, the equity committee and trust preferred securities holders argued, they should not be permitted full recovery under the WMI reorganization.

Susman Godfrey and Arkin Kaplan had asserted two theories at the confirmation hearings. First, the equity committee argued that the funds engaged in classic insider trading, buying and selling WMI notes when they knew prices were likely to rise or fall when the public learned of developments in the settlement talks; and second, in an argument put forth by the trust-preferred shareholders, that Centerbridge traded on misappropriate confidential information it received from Fried Frank, in a breach of confidentiality by the law firm.

Walrath found “colorable claims” under both theories, despite vociferous arguments by the hedge funds that they didn’t have access to confidential information through much of the negotiating process and when they did, they didn’t engage in improper trading.

“Based on the evidence presented thus far,” the judge wrote, “it appears that the (settlement) negotiations may have shifted towards the material end of the spectrum and that the settlement noteholders traded on that information which was not known to the public. Consequently, the court finds that the equity committee has stated a colorable claim that the (hedge funds) received material nonpublic information.” The judge said she couldn’t discern a pattern in the hedge funds’ trading, but found that the equity committee “has made sufficient allegations and presented enough evidence to state a colorable claim that the (hedge funds) acted recklessly in their use of material nonpublic information.”

Walrath also said she had “substantial doubts” about the hedge funds’ assertions that although they discussed the reorganization plan with their lawyers at Fried Frank, Fried Frank did not give them confidential information. The equity committee’s closing brief, which lays out the details of Fried Frank’s involvement in settlement talks and its communications with its hedge fund clients, included assertions that at one critical juncture, the law firm violated a specific instruction from WMI’s lawyers at Weil, Gotshal & Manges not to disclose details of reopened talks between WMI and JPMorgan to the hedge funds. (One of the funds, according to the equity committee, proceeded to trade even when it learned of this obviously material breakthrough in settlement talks.)

WMI and the hedge funds argued to Walrath that any finding they’d engaged in insider trading would “chill the participation of creditors in settlement discussions of bankruptcy cases of public companies.” The judge said in her ruling that there’s a simple solution to the problem. Distressed debt funds (or other creditors) should simply set up ethical walls between settlement negotiators and traders, as some of the funds did at various points in the WMI case. In practice, however, the WMI case, with its on-again, off-again settlement talks and multiple parties, shows the complexity of distinguishing between confidential and public information in bankruptcy negotiations. Hedge funds make money by being smart and well-informed. Walrath’s ruling may blunt the edge they need to make money in Chapter 11 investing.

Walrath ordered all of the parties in the WMI Chapter 11 to mediation, in the obvious hope that bondholders will throw enough money to stockholders to bring them into the settlement fold. The case is burning money at a rate of at least $30 million a month, so everyone who hopes to get money from the WMI reorganization is losing out as the case drags on. On the other hand, it’s not clear whether the hedge funds with WMI holdings will be willing to make concessions to the equity committee, given the smirch Susman Godfrey has left on their reputations.

Brian Rosen of Weil Gotshal, WMI’s lead bankruptcy counsel, told me WMI intends to modify the proposed plan to reflect Walrath’s ruling on the post-petition interest rate and a few other minor points, and then ask her once again to approve the plan. (The insider trading complication, after all, is really between the hedge funds and the equity committee, and doesn’t technically address the merits of the proposed plan.)

Susman Godfrey, meanwhile, is elated that Walrath actually caught its Hail Mary pass, which means WMI shareholders may end up with some money after all. “We had a good feeling about how the plan confirmation hearing went and also felt optimistic after closing arguments,” Folse told me. “We’re gratified that the court denied confirmation of the plan and has authorized the equity committee to proceed with our disallowance case.”

Fried Frank, which represents three of the hedge funds, declined to comment. An Aurelius spokesman didn’t get back to me with a response.

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