GM judge aims to prevent insider trading by distressed debt funds

By Alison Frankel
July 15, 2013

Remember the shocking ruling a couple of years ago by U.S. Bankruptcy Court Judge Mary Walrath in the bankruptcy of Washington Mutual Inc? In September 2011, Walrath refused to approve a hard-fought $7 billion reorganization plan for WMI because of concerns that four distressed debt hedge funds might have traded WaMu notes based on confidential information they or their lawyers obtained in negotiations to resolve the bankruptcy. The hedge funds were outraged by Walrath’s decision, which they said was wrong on both the facts and the law. Ultimately, however, they agreed to make the whole mess go away by kicking about $30 million of their expected recovery to WMI shareholders, who had first raised the insider trading accusations.

But Walrath’s ruling continues to loom over the twilit world of distressed debt trading, most notably right now in a heated fight over noteholders’ claims to about $2.7 billion from the bankruptcy estate of General Motors. In an order late last month authorizing the appointment of a mediator, U.S. Bankruptcy Judge Robert Gerber of Manhattan said explicitly that noteholders participating in the mediation must establish screening procedures to insure that confidential information doesn’t fall into the hands of traders in the securities. Gerber was even more explicit in a June 11 hearing on the prospective mediation: If hedge funds that own the notes trade them based on developments in the settlement negotiations, they risk being found in contempt of court. Gerber’s warnings establish some bright-line boundaries in a generally opaque market.

The incredibly complex GM dispute centers on notes issued in late 2008 and early 2009 by a subsidiary called Nova Scotia Financing Company, whose only assets were intercompany loans to GM Canada. Investors who bought up the notes knew they had great leverage against GM, which was desperate to keep its Canadian business out of bankruptcy. So as GM finalized its petition for Chapter 11 bankruptcy in the United States, it reached a deal in which the Nova Scotia noteholders would drop their claims against GM Canada in exchange for a $367 million consent fee and a promise that GM would back their $2.7 billion claim against its estate. (I’m leaving out reams of ancillary details, but you get the gist.)

GM’s other creditors, who hold about $50 billion in claims, would very much like to knock out the Nova Scotia noteholders, which include Elliott Management, Fortress Investment Group and Drawbridge DSO Securities. Last March, the trustee appointed to uphold the interests of unsecured creditors sued the noteholders, arguing that GM improperly transferred money to GM Canada to pay the noteholders’ consent fee. According to the trustee, GM and the Nova Scotia noteholders didn’t sign their deal until after GM filed for Chapter 11, which would make the agreement subject to the approval of the bankruptcy court. At a bench trial before Judge Gerber last summer and fall, the trustee’s counsel at Dickstein Shapiro put forth the argument that because the bankruptcy judge wasn’t informed of GM’s transfer of cash to GM Canada, his approval of the 2009 sale agreement that led to the creation of the New GM was invalid. (New GM’s lawyers at King & Spalding, as well as counsel for the hedge funds that held Nova Scotia notes, Greenberg Traurig, have argued that the deal with Old GM predated the Chapter 11 filing and was anyway disclosed in various documents submitted to the court.) New GM has said that if the court reverses Old GM’s deal with the Nova Scotia noteholders, the new company could face as much as $918 million in liability to the hedge fund noteholders; there’s even a remote possibility that invalidation of the Nova Scotia deal could tank the entire sale order creating New GM.

The final round of post-trial briefing concluded on Thursday. Gerber has said he also wants to hear final arguments from all sides. But in the meantime, several Paulson funds, represented by Curtis, Mallet-Prevost, Colt & Mosle, asked the judge to order mediation, even though a previous round of mediation failed to produce an agreement. (The Paulson funds became major holders of Nova Scotia notes after GM filed for bankruptcy, when the only value in the notes was their claim against the estate; Paulson is apparently betting that New GM will pay noteholders to drop that claim and end uncertainty about the fate of the reborn company.)

The trustee, New GM and the hedge funds all agreed that mediation would be a good idea, and all agreed that it should take place before Gerber’s Manhattan bankruptcy court colleague Andrew Peck. Near the end of the June 11 phone session on the mediation request, though, hedge fund lawyer Bruce Zirinsky of Greenberg asked Judge Gerber about whether funds could implement screening procedures that would allow them to participate in the mediation yet continue to trade the Nova Scotia notes.

The judge’s answer reflected his understanding of the distressed debt market: “I am not offended by trading being ongoing while this goes on but I will, of course, insist on an ironclad ethical wall,” he said. “I want it to be a court order that embodies the obligations or that incorporates a document that embodies the obligations. I want people to understand that if they trade in violation of the restrictions, it’s not just a breach of contract but it’s a contempt of court or capable of being a contempt of court.” And as he promised, the June 27 mediation order makes it clear that anyone who participates in the sessions or otherwise receives confidential information about the negotiations may not trade on that information.

The docket is silent on whether mediation has actually begun, and none of the lawyers in the case returned my calls. So we don’t know whether some Nova Scotia bondholders that may have wanted to be part of talks decided to stay on the sidelines because they couldn’t set up an ethical wall and didn’t want to forego trading in the notes. But this is, for sure, a new complication for distressed debt investors.

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