Vulture funds and hedge funds play major roles in business reorganizations under chapter 11 of the Bankruptcy Code. Unlike mutual funds, vulture funds and hedge funds are often not required to disclose their investments or strategies, and they operate in relative secrecy with minimal regulation and oversight. But a recent decision from the Northwest Airlines bankruptcy case threatens to force these companies to reveal perhaps their most secret information—the price they pay to acquire their positions. This court decision highlights the risks that companies take when they interject themselves into the bankruptcy proceedings of another company.
Business reorganization is a difficult process involving numerous stakeholders with divergent interests. The chapter 11 reorganization process seeks to ensure that all stakeholders are adequately and fairly represented. The Bankruptcy Code makes use of committees to represent groups of stakeholders. For example, a debtor-company’s unsecured creditors are usually represented by an official unsecured creditors’ committee, and equity holders at times are represented by an equity holders’ committee. These committees are subject to rules and Bankruptcy Code provisions that help ensure that the committees are able to adequately represent their constituencies with transparency and fairness.
Rule 2019 of the Federal Rules of Bankruptcy Procedure requires that each appointed committee file a statement under oath setting forth, among other things, the name and address of each committee member, the amount of the member’s claim against (or equity interest in) the debtor, and the amount paid for the claim. This information is required to ensure that an “insider group” does not manipulate the system. It allows the bankruptcy court to verify that the committee members actually represent the claims or interests that they purport to represent.
Vulture funds and hedge funds often acquire interests in companies that they believe are undervalued and hope to realize a gain on their investment by manipulating or influencing the restructuring process. These funds may hold a variety of debt and equity positions in a distressed company, and depending on the type of position held, the goals of the fund may differ from the goals of other creditors or interest holders.
For example, if a fund acquires bond debt at a discount and the company is able to successfully reorganize and pay the bond debt in full, then the vulture fund or hedge fund realizes a gain equal to the difference between the face value of the debt and the amount that it paid for the debt. In such a situation, the fund benefits when the debtor company performs better, and its interests are aligned with those of other creditors. But if a vulture fund or hedge fund acquires a short position (as they often do) in the distressed company, then the fund benefits if the debtor’s reorganization is made more difficult and the debtor’s financial condition worsens. Not surprisingly, other creditors may suffer when this happens because the payout to other creditors will decrease.
When the goals of a chapter 11 stakeholder—like a vulture fund or hedge fund—do not align with the goals of the committee that represents it—like the unsecured creditors’ committee or the equity committee—problems arise. One solution that has often been embraced is to form a new committee, and if an officially sanctioned committee is not (or cannot be) formed, stakeholders will often ban together to form an unofficial (or ad hoc) committee to protect their interests. The Bankruptcy Code was not drafted with ad hoc committees in mind, and it is unclear whether an ad hoc committee must comply with the disclosure requirements of Rule 2019 and other similar rules. This ambiguity allows ad hoc committees a shroud of secrecy that is not available to members of an official committee. But that may be changing.
Earlier this year, in the first case of its kind, an ad hoc committee of equity holders (which had various hedge fund members) was ordered to comply with Rule 2019. In the Northwest Airlines bankruptcy case, the ad hoc committee disclosed that it represented 13 members who owned stock and debt with a face value exceeding $264,000,000. In Northwest Airlines, the debtor sought a court order to compel the ad hoc committee to comply with Rule 2019 and provide more information. The hedge funds opposed providing the information, claiming that this information was proprietary. Among other things, the hedge funds were concerned that if they disclosed their pricing information, then their competitors could reverse-engineer their investment analysis and strategies, which could then be used by their competitors to gain an advantage in the marketplace.
Despite these concerns, the bankruptcy judge ordered the ad hoc committee to comply with Rule 2019. The judge required each committee member to disclose the amount of each claim or interest it owned, when each claim or interest had been acquired, the amounts paid by the committee members for each of their claims or interests, and whether the committee members had sold any of their claims or interests during the bankruptcy case.
It is unclear how the vulture fund and hedge fund industries will respond to the decision from the Northwest Airlines bankruptcy court. Some suggest that this will have a chilling effect on the investment by these industries. Others believe that the industries will find away around the ruling, such as choosing to only purchase short positions, which are not actual stock holdings.
Regardless, the case will affect more than just the vulture and hedge fund industries. This case should serve as a reminder to all that before agreeing to serve as a member of an official or ad hoc committee in a bankruptcy case, a creditor or equity holder must carefully weigh that decision. The creditor or equity holder may have an incentive to participate in the bankruptcy process to help ensure that it receives the maximum value possible for its claim or equity interest. But that participation will come at a cost. The creditor or equity holder may be forced to divulge pricing and other proprietary information, and that information may become publicly available to all the creditor’s or equity holder’s competitors. It is not a decision to be made lightly.
 Baron & Budd, P.C. v. Unsecured Asbestos Claimants Comm., 321 B.R. 147, 166 (Bankr. D.N.J. 2005).
 9 Collier on Bankruptcy § 2019.02 (15th ed. rev. 2007).
 See In re Northwest Airlines Corp., 363 B.R. 701 (Bankr. S.D.N.Y. 2007).
 Eric B. Fisher & Andrew L. Buck, Hedge Funds and the Changing Face of Corporate Bankruptcy Practice, 25-10 Am Bankr. Inst. J. 24, 24-25 (Dec. 2006/Jan. 2007).