To (mis)quote the now-defunct band R.E.M., Delaware bankruptcy judge Mary Walrath's shocker of a ruling in the Washington Mutual Inc. Chapter 11 was the end of the (bankruptcy) world as we know it. On Sept. 13, you'll recall, the judge refused to confirm the reorganization plan of WaMu Bank's onetime parent, concluding that WMI's out-of-the-money shareholders had managed to come up with a "colorable claim" that four big distressed debt hedge funds had engaged in insider trading, buying and selling WMI notes even as they were briefed on ongoing talks to settle the multibillion dollar bankruptcy. As Tom Hals subsequently reported for Reuters, Judge Walrath's decision threw the business model of distressed debt funds-and the future of big bankruptcies-into doubt.
Now it's the hedge funds turn to have their say. And boy are they making the most of it.
On Tuesday, Aurelius, Appaloosa, Owl Creek, and Centerbridge filed motions requesting leave to appeal Judge Walrath's ruling, accompanied by a pair of briefs that can only be described as scathing. Judge Walrath committed "a series of fundamental errors," Aurlieus's Kramer Levin Naftalis & Frankel lawyers wrote in their 54-page filing. She rewrote decades-old rules and produced a decision that "effectively declares open season for creative and aggressive bankruptcy litigation by allowing a deeply out-of-the-money constituency to bring a derivative suit found meritless by both the debtors and the creditors' committee," Aurelius asserted.
The other three funds, which filed a 54-page joint brief, were even more unbridled in their criticism of the judge. "This case presents a troubling instance of a bankruptcy court misapplying the federal securities laws to force an outcome that has no basis in law," the brief said. "Ignoring virtually every requirement of the insider trading laws as well as its own findings of fact, and in violation of Congress's express directive to apply heightened pleading requirements to the claims asserted here, the bankruptcy court authorized the equity committee to stand in the shoes of the debtors and bring an action against the [hedge funds]The absence of any legal support for the bankruptcy court's decision is palpable." (The joint brief is signed by Blank Rome; Paul Hastings; Schulte Roth & Zabel; and Latham & Watkins.)
The heart of both briefs is an account of how Judge Walrath supposedly went wrong in concluding there's evidence that the hedge funds engaged in insider trading-despite the judge's own factual finding that the funds agreed to confidentiality restrictions when they participated in good-faith settlement talks that ended up benefiting the entire WMI estate. Judge Walrath, the funds contended, found no evidence that they acted with fraudulent intent in trading WMI bonds, which is a necessary element of insider trading. But "the bankruptcy court waived these fatal deficiencies away, ignoring the absence of deception in the case and holding that the [hedge funds] should be required to prove the absence of fraudulent intent," the joint brief said. "That is not the law--in fact, it is the opposite of the law."
The whole insider trading enquiry, the hedge funds contended, was misguided. Judge Walrath allowed it under the theory of equitable disallowance, which holds that parties can't recover if they engaged in wrongdoing. But the funds said there's no such remedy in the Bankruptcy Code. Moreover, they argued, the equity committee's lawyers at Susman Godfrey only named Aurelius and Centerbridge in their proposed equitable disallowance complaint. Appaloosa and Owl Creek were never named, so, according to the joint brief, Judge Walrath violated their due process rights by lumping them in with the other funds and granting the equitable disallowance motion against them.
The hedge funds also assert that the judge should never have concluded they're insiders with duties to WMI. "On the contrary, at all times, the settlement noteholders, as in most large bankruptcy cases, were one of many interested parties acting in their own independent capacity and in their own interest," the joint brief said. Just because those interests happened to align with WMI's, the brief argued, doesn't mean the hedge funds are "temporary insiders" under Judge Walrath's flawed reasoning.
One final point the joint brief makes: Judge Walrath had cast a black cloud over the conduct of Fried Frank Harris Shriver & Jacobson, which was counsel to at least two of the funds during settlement talks. The funds said that was unfounded. "There was no evidence at trial that Fried Frank had violated [a confidentiality] agreement. Indeed, at the close of evidence, [WMI's] lead counsel, as an officer of the court, affirmatively represented on the record that 'the debtors have seen nothing, and no one has presented any evidence that such confidentiality agreements with Fried Frank, with White & Case, or with any other party that had one executed was breached by any of those counsel," the joint brief said. "Thus, as the debtors' attorney made clear, at no time did Fried Frank breach any agreements with the debtors or fail to adhere to its confidentiality undertakings."
I asked Parker Folse of Susman for comment on the briefs but he said he was traveling and hadn't read them.
(Reporting by Alison Frankel)
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