101: What is Bankruptcy Claims Trading?
Corporate Bankruptcy is one of the most misunderstood topics in the business world. For most people, the first words that come to mind when reading about a company that has filed for Chapter 11 bankruptcy are usually "failure" and "loss". Rarely is bankruptcy ever associated with a word such as “opportunity”.
Chapter 11 bankruptcy is a complex court process for both Debtors and Creditors alike. With so many intricacies and unpredictable factors that take place along the legal journey, Ch.11 doesn’t always result in a favorable recovery for the parties involved.
The fortunate news for Creditors that have been swept up into the ripple effects of an unending bankruptcy case is that there is another recovery option that is more expedient. This recovery solution is a lesser known aspect within the world of corporate bankruptcy—a common practice known as "Claims Trading".
A Background on Chapter 11 Bankruptcy
Before we dive into specific bankruptcy Claims Trading facts and details, we would like to set the stage with some background context.
When a financially distressed company files for Chapter 11 bankruptcy protection with a court, this event does not happen in isolation. Its vendors, suppliers, landlords, business partners, employees, lenders and others who have unpaid bills, wages, and outstanding invoices at the time of the Ch.11 filing are adversely impacted. Legally, these parties who are rightfully entitled to payment are collectively known as "Creditors", and the Ch.11 company that owes these unpaid debts is referred to as the "Debtor".
In the course of normal bankruptcy proceedings, Creditors assert their right to repayment by filing a Proof of Claim against the Debtor. The filed "Claim" expressly states the amounts owed to the Creditor based on their accounting records, to which the Debtor is obligated to pay. Creditors typically include—along with the filed Proof of Claim form—supporting documentation (i.e. contracts, invoices, lease agreements, etc.) as evidence of the Creditor’s bankruptcy claim.
After all of this, Creditors still must wait for the Debtor’s bankruptcy case to wind its way through the court process before their Claims can be approved and payments issued. Unfortunately, this process can take several years before a Creditor receives any of the amount they are owed.
Uncertainties for Creditor Recovery
The opportunities presented by Claims Trading are undergirded by the potential risks for Creditors in participating and persisting through the conclusion of the Chapter 11 process. For Creditors seeking recovery assurances and financial certainty, their outcomes from bankruptcy are difficult to predict. Several mandatory aspects of the Chapter 11 process and its procedural dependencies factor into this uncertainty, including the following:
The early stages of Ch.11 bankruptcy commence with the process of claims reconciliation. During this phase, the Debtor will submit to the court its Schedules of Assets and Liabilities that outlines the details of the company’s assets, liabilities, expenses, obligations, and debts owed to Creditors and parties of interest. Creditors are provided the opportunity to review these Schedules for accuracy and completeness on listed claims, and to assert their legal right to repayment by filing a Proof of Claim to contend with what has been listed.
Under this reconciliation process, submitted claims that are fraudulent or invalid are rejected by the court. While Creditor claims that are valid are deemed allowed if a Proof of Claim has been filed or the Debtor does not object to the claim. Additionally, the Debtor may pursue filing objections on claims in order to invalidate or disallow them, and thereby reduce their own liabilities for ease of restructuring. If the Debtor’s objection is successful, the claim is disallowed by the court, and the Creditor is unable to share in the repayment distribution from the Debtor’s bankruptcy estate. For Creditors, the Debtor’s objection to and the court’s disallowance of their claims can present a heightened sense of uncertainty on eventual recovery.
Another factor that causes uncertainty for Creditor recovery is bankruptcy claims priority—the result of Ch.11 claims classification process that determines the Creditor’s priority for receiving a payout. Higher priority claims, or secured claims, are paid out in full from the Debtor’s bankruptcy estate before claims of lower priority levels are paid anything. Unsecured claims and equity holders are of the lower class bankruptcy claims and are often paid just a percentage of their claim amount, offered an alternative form of payment, or do not receive a payout at all.
Debtor’s Plan of Reorganization
Within 120 days of the petition date, the Debtor is required to submit a Plan of Reorganization that outlines how they plan to restructure and re-emerge as a healthier business. However, they do reserve the right to request an extension if needed. It is not only time-consuming for the Debtor to formulate and submit the Plan of Reorganization, but also for the Creditors to review, vote on, and approve the terms of the Plan. Disagreements on the Plan are commonplace as are modifications to the terms contained within it. For Creditors, the Plan spells out when, how or whether they receive payment and as a result becomes highly contentious. Following Creditors’ approval, the bankruptcy court must also confirm the Plan before it can be effectively administered.
Upon receiving the court’s confirmation of the Plan of Reorganization, the claims resolution process begins. Finally, the Debtor can begin to implement the approved Plan and start paying Creditors in the sequential order defined by their class and seniority level. Even at this point, it is possible for Creditors with unsecured claims to not receive payment if funds in the bankruptcy estate are exhausted, or to be offered alternative forms of equitable remedy.
Even after the bankruptcy case has been concluded, it can take months for Debtors to begin distributing payouts to the long list of Creditors it owes. With so much uncertainty surrounding the road to fully recovering from Ch.11 bankruptcy, it’s nearly impossible for a Creditor to make any informed decisions for the financial health of their own business.
This is why bankruptcy Claims Trading provides a unique opportunity for a Creditor to recoup their losses and minimize uncertainty.
Bankruptcy Claims Trading Defined
As an alternative to waiting through the lengthy bankruptcy claims process with the potential for drawn out court litigation, Creditors can opt to monetize their claim in return for immediate cash. Thus, "Claims Trading" describes the financial and legal transaction whereby a Creditor sells and transfers their ownership in the bankruptcy Claim to another entity, in order to receive immediate monetary payment from the Buyer of their claim.
In simpler terms, the Creditor is selling their receivable in exchange for immediate cash from an interested Buyer. And as a result of this transaction, the official claim to this debt is recorded with the bankruptcy court and legally transferred to the Buyer, who subsequently takes on the risk of recovering payment from the Debtor.
In this regard, the Debtor’s Chapter 11 bankruptcy case provides opportunity. An opportunity for the Creditor to recover payment by selling their claim, and an opportunity for a Buyer to purchase a Creditor’s claim and potentially capitalize on an investment in the Debtor’s post-Chapter 11 future.
The Origins of Claims Trading
Although there is no official history record on the origins of Claims Trading, the first known instance of this occurred before any federal regulations were written on bankruptcy.
After the American Revolutionary War in the 18th century, the 13 Founding American colonies were financially insolvent after the war and owed debts to those individuals who participated, such as soldiers, farmers, and merchants. Opportunistic buyers purchased these claims against the insolvent colonies at discounted prices in hopes of eventually recovering full repayment under the establishment of a new American government. This is the first historically recorded instance in the US where claims were traded. 
Not until many years later were federal laws written to regulate bankruptcy. In 1978, Congress enacted the U.S. Bankruptcy Code, which paved the way for the development of the Claims Trading market as we know it today. Over the last 40+ years, trading Bankruptcy Claims has become a significant opportunity for both Creditors and Buyers to manage the risks of corporate bankruptcies.
A key point to note is that the trading of bankruptcy claims is not explicitly regulated by the Bankruptcy Code. The mechanics of claims trading are governed by Bankruptcy Rule 3001(e). Buyers and Creditors must abide by these procedures to ensure that the rights held by the original claim-holder are effectively transferred to the entity that acquires the claim. Despite the fact that there are some general provisions in the Bankruptcy Code that address the Claims trading process, the transactions are largely controlled through more generalized legal principles, contract law, and anti-fraud regulations. With its long history, the practice of Claims Trading has grown into a thriving industry.
Who's Involved When a Bankruptcy Claim is Traded?
The transactional process of Bankruptcy Claim Trading primarily involves two parties: a buyer and a seller. As the selling party, the Creditor is selling their uncollected receivable against a Debtor in a Ch.11 bankruptcy case. As the buying party, a bankruptcy claims trading firm purchases the Creditor's claim rights and ownership from the Creditor in the bankruptcy case.
Just as Creditors involved in a bankruptcy case can be an individual, a company, or a major corporation, similarly, Buyers—or bankruptcy claim traders—can come in all shapes and sizes. A Buyer of a claim might be a hedge fund, a trading division of an investment bank, a private investment company, or even an individual licensed as an accredited investor. In certain instances, a claims trading brokerage (or related bankruptcy claims companies) may also be enlisted as a “middle-man” to negotiate and facilitate the transaction between parties.
Aside from the buyer and the seller, other parties may also be involved in the Claims trading process, such as: Legal and Financial Advisors, Bankruptcy Claims Agents, and the Bankruptcy Court.
Legal and financial advisors for both parties may be involved to consult on the transaction, assist in the dealings with the Bankruptcy Court, assess claim value, perform due diligence, conduct other bankruptcy claims services and ensure that all interests are aligned by reaching a contractual agreement.
While not a party to the claim being traded, a bankruptcy claims agent may be logistically involved as a contracted partner of the Debtor within a bankruptcy court case and act as the approved legal administrator for the Claims Registrar. Thus, claim transfers and court filings would flow through a bankruptcy claims agent’s administrative operations.
Although the Bankruptcy Court does not oversee the details of a claim trade, the claim transfer in ownership is officially recorded with the court, and the Debtor in the case is notified. Any legal objections, dismissals, or modifications to payment terms on claims are ruled by and approved by the bankruptcy court.
What are the Benefits of Claims Trading?
The primary motivation for a Creditor to trade their bankruptcy claim is to obtain immediate cash liquidity on an otherwise uncollectible account. With the duration of a Ch.11 bankruptcy case easily lasting 2 years or more from the petition date to the implementation of the court-confirmed Plan, monetizing bankruptcy claims eliminate the risk of time delays awaiting case conclusion and payment distributions. The time savings and proceeds obtained from trading a claim allows the Creditor to immediately reinvest back into their company and refocus on growth.
The following is a list of 4 additional benefits for Creditors that can come from bankruptcy claims trading:
Elimination of Recovery Risk
Unsecured creditors are the lowest priority creditors and fall last in line to receive payout from the bankruptcy estate. In many bankruptcy cases, the recovered amount is low or even non-existent for unsecured claims—especially after administrative expenses are accounted for, and the higher ranking secured creditors and priority claims are paid in full. Choosing to sell a bankruptcy claim to an interested buyer for immediate cash allows you to secure a definitive recovery and avoid the risk of an uncertain outcome awaiting at the conclusion of the bankruptcy case.
Elimination of Consideration Risk
For Debtors that cannot meet the debt obligations of all its Creditors in cash payments, it is not uncommon for Debtors to structure payouts in the form of promissory notes, stock equity in the reorganized Debtor, interests in creditor trusts, or a combination thereof. For these other forms of payment consideration that are issued, it can be difficult, time-consuming and expensive to liquidate them into cash.. Selling a bankruptcy claim eliminates the risk of receiving illiquid distribution or securities by receiving cash instead
Reduction of Time and Money Spent
The lengthy and grueling process of Chapter 11 bankruptcy cases entails an extensive amount of paperwork, and back-and-forth correspondence between the Debtor, the bankruptcy court and Creditors. This can be further exacerbated if there are objections, complaints filed, injunctions, litigation, or court hearings to participate in. In addition to traveling costs and time spent in case involvement, there are also legal expenses that can pile up as a Creditor retains legal counsel to navigate the case and exercise their rights. A Creditor can minimize time, money and valuable resources that are utilized to participate in the bankruptcy proceedings by selling their bankruptcy claim instead.
Benefit from Tax Savings
Creditors can often earn a tax benefit when they sell their bankruptcy claim, especially if it is sold for an amount that is less than the original claim value. This is done by applying the loss on the uncollected portion of their receivable against their current income in their tax filings. Although tax deductions for a loss can be a possibility for Creditors who receive claim payouts from the Debtor, these Creditors who remain in the case instead of selling their claim don’t get to reap the tax benefits right away. Immediate tax savings are an additional advantage for Creditors when it comes to selling a bankruptcy claim.
How Does the Claims Trading Process Work Today?
What can a Creditor expect when trading a bankruptcy claim? Claims trading is both a legally and financially complex transaction. Therefore the process can differ from trade to trade.
Bankruptcy claims can be traded at all stages of the Chapter 11 case and may begin as soon as the bankruptcy petition is filed. Claims trading can continue until final distributions are made, and even after confirmation of the Plan of Reorganization.
Claims that are successfully traded, typically follow these basic procedural steps:
1. Filing a Proof of Claim (Form 410)
Once the Debtor has filed their petition with the bankruptcy court, the Creditors will receive Notice of Bankruptcy. The Debtor will then submit their Schedules of Assets and Liabilities which will include details about each Creditors’ bankruptcy claim. If the Creditor objects to how its claim is represented in the Schedules or wants to assert their right to repayment, the Creditor files a Proof of Claim (Form 410) against their Debtor in the Ch.11 Bankruptcy Case.
2. Listing of Bankruptcy Claim for Sale
Outside of the bankruptcy case, the Creditor separately lists their Claim for sale by looking for prospective Buyers (or receives an unsolicited offer directly from a Buyer, or indirectly via a broker to purchase their Claim).
3. Buyer Contacts the Creditor
The Buyer contacts the Creditor soliciting interest in selling their Claim. Historically, this has been done manually by interested buyers reaching out through postal mail, over the phone, or by email.
4. Providing Additional Documentation
Upon receiving an offer that sparks interest, the Creditor then is asked to provide additional supporting documentation to supplement their original Claim. This includes the same documentation that would be included with the Proof of Claim, such as promissory notes, purchase orders, contracts, outstanding invoices, delivery receipts or security agreements. Other pertinent documentation might include monthly statements, pay records and ledgers.
5. Buyer Performs their Due Diligence
Once the Creditor has shown interest in selling their bankruptcy claim to the inquiring buyer and provides the supporting documentation, the buyer will perform their own due diligence into the claim and the Debtor’s bankruptcy case. Bankruptcy claim traders will typically confirm whether there is any pending litigation between the debtor and the creditor and determine whether the creditor is readily identifiable as a target of avoidance of litigation. For example, a buyer would review the debtor’s statement of financial affairs, which lists all entities that received payments during the 90 days before filing for bankruptcy.
Furthermore, a buyer will also obtain a preference risk representation and other representations from the Creditor to ensure that they have not been involved in any misconduct that would lead to disallowance or subordination of their bankruptcy claim.
6. Buyer Makes an Offer
The Buyer will then make an official purchase offer to the Creditor.
Prices for bankruptcy claims can vary depending on the bankruptcy proceedings and certain events that are transpiring within the case.
7. Creditor Accepts the Purchase Offer
After reviewing the offer and consulting with legal and financial advisors or representation, the Creditor formally accepts the purchase offer.
8. Trade Confirmation
The Buyer prepares and sends the Creditor a trade confirmation to formally record the trade terms and purchase price. The trade confirmation will contain formal written record of the material terms of the agreed upon sale, including the following:
- Debtor’s name, case name, and case number
- Description of the claim, claim amount and claim number
- Percentage rate used to determine the purchase price (this is typically written as a percentage of the scheduled undisputed claim amount)
- Other specific terms of the trade
The trade confirmation will typically include confirmation that the sale is contingent on the execution of a “assignment of claim” agreement that is deemed acceptable by both the buyer and seller. Some bankruptcy claim traders will attach a draft of this agreement with the trade confirmation.
9. Assignment of Claim Agreement
Once the Buyer and Creditor agree to the terms that are outlined in the trade confirmation, they both sign a contractual agreement, known as the "assignment of claim" agreement. This agreement will contain standard provisions that are dependent on the following:
- The size and nature of the claim
- Relationship between the buyer and seller
- Price being paid for the claim
Creditors then review this agreement thoroughly to ensure that it does not include any non-negotiable or objectionable terms that would prevent the transaction from closing.
10. Creditor Files a Claim Transfer
The Creditor files a claim transfer (“assignment of claim”) with the bankruptcy court, in order to officially transfer ownership of the claim to the new Buyer.
11. Buyer Sends Payment
The Buyer then sends payment to the Creditor. This step can also take place before the Creditor files a claim transfer with the court.
12. Buyer Becomes the New “Creditor”
In the court register, the Buyer is now listed as the owner of the claim against the Debtor in the pending bankruptcy case. The Buyer is now effectively the new “Creditor”. The former Creditor is no longer involved with this claim in the bankruptcy case, except under specific extenuating circumstances agreed upon with the Buyer.
How Do We Make Claims Trading Better?
In the typical claims trading process, each of the aforementioned steps is self-initiated and handled manually. It is incumbent on the Creditor and Buyer to cooperate with each other in making a claim trade a successful transaction. Similar to buying a home, the process can be quite complicated, with the possibility of a deal being jeopardized in each manual step. Traditionally, the majority of the claims trading process is conducted via paper documents, wet ink signatures, fax transmissions, and phone/mail communications.
Today's process is not only inefficient and inconvenient for both parties, but it also poses great risks and lacks transparency, making it more challenging to obtain monetary recovery. At XCLAIM, we built our Bankruptcy Claims Marketplace as a centralized platform to digitally connect Creditors with Verified Buyers and provide a safe and secure online environment to trade claims efficiently and recover cash quickly.
 Aaron L. Hammer, Michael A. Brandess, “Claims Trading: The Wild West of Chapter 11s”, American Bankruptcy Institute Journal, August 2010