This article originally appeared on Law360.
In the last year, the bankruptcy claims business has been dominated by cryptocurrency bankruptcies.
These cases have also provided an avenue for the noninstitutional investor to participate in bankruptcy cases and have democratized a once closed segment of alternative investing.
The late turnaround manager Bill Brandt, one of the most renowned bankruptcy professionals of all time, used to tell me that Rule 3001(e) of the Federal Rules of Bankruptcy Procedure, which provides for thetransfer of a proof of claim, forever revolutionized the landscape of corporate bankruptcies.
Brandt's assertion was that by formally setting forth a process for conveyance of claims, investors unrelated to a particular debtor were enticed to get involved with the bankruptcy process. The same can be said for the cryptocurrency bankruptcy cases.
Bankruptcy claims investors seek to earn returns in excess of 30%. This is because bankruptcy claims are highly illiquid. They are not traded on a regulated exchange.
The only way to source these claims is by combing through bankruptcy dockets or through specialized bankruptcy claims brokers. Once you buy a claim, you may be stuck with it until the distribution date. If something goes wrong in the bankruptcy case, you can lose money. To balance the risk, the returns need to be significant.
In general, over the past several years, investing in bankruptcy claims has become more and more challenging. One reason for this is because there are fewer and fewer cases that are making distributions to creditors.
Retail bankruptcy cases have historically been good sources of bankruptcy claims because they have many vendors. Trade vendors typically do not like to wait for the conclusion of a bankruptcy case to get paid. Accordingly, they are usually open to selling their claims to a third party.
However, recent retail bankruptcy cases such as Sears Roebuck and Co., Bed Bath & Beyond Inc., Party City Holdco Inc., David's Bridal Inc. and Tuesday Morning Corp. have all provided no recovery cases for unsecured creditors.
Sears only provided a recovery to administrative expense unsecured creditors. Administrative expenses creditors are creditors who provide goods to a debtor within 20 days of the bankruptcy filing date or post-bankruptcy.
Today, there are only a handful of bankruptcy cases that are expected to pay out a distribution to unsecured creditors or investors. Two of the most significant cases, Celsius Network LLC and FTX Trading Ltd., are cryptocurrency cases.
With respect to Celsius, there are approximately 600,000 account holders who qualify as general unsecured creditors. The aggregate amount of unsecured claims is $3.75 billion. The average claimant holds a claim with a face value in excess of $6,600.
Looking at the Celsius docket, approximately 300 creditors opted to sell their claims. This is less than 0.05%, a paltry number.
While purchasing claims at a discount is a compelling business proposition, it doesn't provide investors with an opportunity to deploy large amounts of capital. Even the most persistent claims purchaser is only able to purchase over 10% to 15% of the claims, which is still not a large percentage of the overall claims pool.
There are several reasons why trading in Celsius was de minimis.
First, in cryptocurrency cases, bankruptcy courts have dispensed with the commonplace mandate of full disclosure and allowed debtors to redact creditor information in publicly reported documents, such as schedules of liabilities and proofs of claim.
This has made it substantially harder for claims traders to contact creditors. This is also contrary to the general mandate of the U.S. Bankruptcy Code, which is to provide full disclosure.
Notwithstanding the mandate for full disclosure, debtors are protective of their information. Part of the reason is that controlling information allows debtors and their professionals to control the process.
Debtors mask this motivation by arguing that by redacting the names and all associated identifying information of their customers and withholding from publication any proofs of claim, they are preserving the estate's assets.
While it is true that customer lists and related customer data are an asset of the estate, we live in a free country, and customers have every right to take their business elsewhere after a cryptocurrency exchange files for bankruptcy.
It doesn't appear that publicly disseminating the customer list would give the debtors' competitors an unfair advantage and would interfere with the debtors' ability to sell their assets and maximize value for their estates.
However, in numerous bankruptcy cases, courts have recognized that customer lists are entitled to protection under Section107(b)(1) of the Bankruptcy Code and have thus limited access to debtors' schedules and other court filings containing sensitive customer information.
Finally, debtors argue that disclosing this information could lead to negative publicity or identity theft. While most claims traders would dispute these arguments, no investor at the outset of a bankruptcy case has standing to contest this issue, nor do they want to spend money litigating what is likely to be a losing argument.
Nonetheless, the debtors' arguments ultimately hurt the very parties they seek to protect: the creditors. Requiring disclosure of creditors' names and addresses would simply result in more solicitations to purchase claims. That would provide creditors with the current market value of their debt.
One major issue all claims traders are concerned with is the integrity of the bankruptcy claim. Is there some issue that would impair the claim?
The foremost issue buyers are concerned about is preference exposure. Given that many customers actively traded in their accounts, there is a high degree of likelihood that they transferred assets within the 90-day period prior to the bankruptcy filing.
Fortunately, in both Celsius and FTX preference exposure has been limited by a materiality threshold in their respective plans of reorganization.
Additional concerns about trading in claims in cryptocurrency cases has to do with the currency risk to investors. In Celsius, the distribution will be largely in bitcoin.
Over the past several months, bitcoin has moved up and down over 30%. That dramatically affects the recovery for investors. This same concern is not present with respect to FTX because the distribution is going to be in U.S. dollars.
The last factor that has affected the trade claims market is ready access to information provided by the numerous bankruptcy claims agents and two online platforms, Xclaim Marketplace and Claims Market. The fact of the matter is that when information is easily available, anyone can purchase claims.
Recently, Forbes reported that retail investors, or noninvestment firms, were buying FTX bankruptcy claims. This has led to a rapid increase in price for current FTX holders and a lower return for typical bankruptcy claim investors. In fact, larger claims in FTX — above $1 million — have risen from 30 cents on the dollar to over 60 cents in a matter of two months.
While on the surface this might appear to be a good investment, unlike Celsius, FTX is paying out in dollars not cryptocurrency. Furthermore, it is likely that FTX will make multiple distributions over time.
Distributions in FTX will not likely occur until the third or fourth quarter of 2024. Accordingly, it is unknown when investors will get their capital returned to them.
For investors seeking returns in excess of 30%, this is an uncertain value proposition. Nonetheless, many nontraditional bankruptcy investors appear to be attracted to this investment opportunity.
Over the past several years, bankruptcy claims investing has changed significantly.
As noted, the easy access to information provided by claims agents and online sites has allowed many nontraditional bankruptcy investors to purchase claims.
These retail investors view the opportunity to buy a claim at a deep discount, and realize significant upside upon distribution, as an attractive investment opportunity. They need to tread cautiously as there are pitfalls that need to be navigated.
While traditional retail bankruptcies have not provided claims for sale, the post-pandemic wave of cryptocurrency bankruptcies has provided a reasonable amount of inventory for retail investors to purchase claims. What the future wave of bankruptcies, which appear to largely be related to real estate, will bring remains unknown.
For the next several years, however, buyers can count on FTX to wet their whistles.