Risks For Claims Traders Who Have Access To Confidential Information: Lessons From The Recent Washington Mutual Decision

Distressed investors often find themselves confronting the dilemma over how to best exert the influence they have at critical times in the chapter 11 process, which almost always will involve negotiations over key disputed issues, and their ability to continue to trade in claims against the debtor. As demonstrated by a recent decision of the United States Bankruptcy Court for the District of Delaware in the Washington Mutual chapter 11 cases,1 what such investors do with the potentially inside information they gain from those negotiations, and how and when they use it, may significantly affect their bankruptcy recovery and expose them to potential liability. Additionally, the decision, which is now on appeal, suggests that a creditor who has a blocking position in a creditor class may be considered an insider of the debtor and have a fiduciary duty to act for the benefit of other creditors within that class, even if the creditor does not sit on an official creditors' committee appointed in the case.

Background

In Washington Mutual, the debtors' plan of reorganization was predicated upon a global settlement agreement involving certain hedge funds (collectively, the "Settlement Noteholders"). The official Equity Committee challenged the plan and the settlement and sought standing to bring actions against the Settlement Noteholders for allegedly trading in the debtors' securities while in the possession of confidential information provided to them during plan negotiations. In the course of denying confirmation of the plan on other grounds, the Bankruptcy Court concluded that the Equity Committee had presented colorable claims regarding the Settlement Noteholders' trading activities. In an attempt to avoid having the chapter 11 process derailed with a morass of litigation, the Bankruptcy Court directed the parties to participate in mediation. Thus, it remains to be seen whether the issues will ever be litigated on the merits.

Facts

Washington Mutual was the largest bank holding company failure in the nation's history. Shortly after the commencement of its chapter 11 cases, it became embroiled in a dispute with JP Morgan Chase ("JPMC") over the ownership of $4 billion held by JPMC. JPMC and Washington Mutual thereafter engaged in protracted settlement discussions as part of the plan negotiation process. The negotiations continued off and on from March 2009 until an agreement in principal was announced on March 4, 2010, and included the exchange of various term sheets between Washington Mutual and its affiliates (collectively, the "Debtors") and JPMC. Counsel for the Settlement Noteholders participated in many of these negotiations, but were contractually precluded from sharing information with the Settlement Noteholders unless and until the Settlement Noteholders were bound by confidentiality agreements. The Settlement Noteholders themselves, who collectively held a sufficient amount of claims to have a blocking position in two classes under any plan, had also participated directly in the negotiations, and were at various times subject to confidentiality agreements. During two specific confidentiality periods, the Settlement Noteholders were required to restrict trading of the Debtors' securities or to establish an ethical wall so that confidential information was not used by their traders. The understanding of the Settlement Noteholders was that after the restricted period, the Debtors would disclose all material information, which would then allow the Settlement Noteholders to become unrestricted.

During the first confidentiality period, one of the Settlement Noteholders established an ethical wall, whereas the others restricted their trading. During that first confidentiality period, there were settlement discussions among the Debtors, JPMC, and the Settlement Noteholders. It was undisputed that, during that time period, terms of a possible settlement were discussed and various terms sheets were exchanged, but that the negotiations did not lead to a settlement. With the discussions having been inconclusive, the Debtors apparently decided that there was no need for them to disclose the fact that settlement negotiations were occurring, and, therefore, none of the terms that had been discussed were disclosed...