A “bankruptcy claim” is generally defined as any right to payment held by creditors against a bankrupt debtor. A claim also vests its holder with the right to be heard in a bankruptcy case and, generally, the right to vote in favor of or in opposition to a plan of reorganization. These claims include secured and unsecured debt, bank loans, and a variety of contractual obligations and company payables. A “trade claim” is any unsecured claim against a company that has filed for bankruptcy protection. They are mainly debts owed to trade vendors, but may also include claims by landlords, lawyers, leasing companies, unions, and individual employees of the debtor. These claims can range in value from a few hundred dollars to several hundred million dollars. Trade claims are a fungible commodity in the sense that all claims with the same priority get paid out at the same rate by the bankruptcy estate. Generally speaking, trade claim holders have the same payout status as unsecured loan and bondholders in a bankruptcy case.

The bankruptcy claims market is estimated to be a $500+ billion marketplace ($1+ trillion including Lehman Brothers), of which nearly $300 billion consists of general unsecured claims. However, only a fraction of that market has traded historically, which is usually concentrated in the largest bankruptcy cases. According to SecondMarket analysis, during the 12 months between January and December 2008, under $2.0 billion in unsecured claims changed hands, or less than 5% of the estimated market.

In addition, corporate bankruptcies are on the rise. In the first three quarters of 2008 there were 29,960 business bankruptcy filings in the U.S., versus 19,727 and 14,228 in the same 9 month periods in 2007 and 2006, respectively. With a slowing economy, the credit crunch, and difficult financial markets, companies have struggled to stay afloat, and the number of bankruptcies has been increasing accordingly. Industry experts expect these upward trends to continue and to result in a large increase in 2009 filings compared to 2008, which should continue to drive an increase in bankruptcy claim volume. 

Bankruptcy Types

There are six types of bankruptcy in the United States, named for their respective chapters in the United States Bankruptcy Code.  The type of bankruptcy that one files depends on several factors, including whether the filer is an individual or corporation, for example, and whether or not the filing was voluntary. The vast majority of corporate bankruptcy cases, and therefore claims which SecondMarket tracks and facilitates transactions in, arise from Chapter 11 bankruptcy cases as corporations try to re-organize and emerge as a going concern. Due to soaring budget deficits and plunging fiscal revenues, it is quite possible that we will see a spike in municipal (Chapter 9) cases and related claims as well. Futhermore, with the high cost of DIP financing and exit financing, we may see far more liquidations than in recent years. Here are the six bankruptcy types, for your reference:

Chapter 7 – Individual and Business Liquidation: In Chapter 7 bankruptcy, a person or business surrenders their property to a bankruptcy trustee, who liquidates the assets and returns the proceeds to creditors.  In this bankruptcy, the debtor ceases payments immediately upon filing, and all debts are then cleared.   

Chapter 9 – Municipal Bankruptcy: Chapter 9 Bankruptcy is known as the municipality bankruptcy. The principal use of this type of bankruptcy is to give a defaulting municipality protection from the people and organizations it can’t pay fulfill its obligations to. Reorganization of debt is done in this type of bankruptcy, but only the municipality has the right to file a relief in this case.

Chapter 11 – Business Reorganization: Chapter 11 bankruptcy is known as the corporate bankruptcy or the reorganization bankruptcy.  Simply put, when businesses are unable to pay their creditors, or if the debts owed to creditors exceed what the businesses can pay, then they file for Chapter 11 bankruptcy.  In this bankruptcy, both company debts and assets are restructured in order to help the business continue as a going concern, as well as providing the greatest long-term value to creditors and shareholders (in theory, more value than simply liquidating the company outright).

Chapter 12 – Farmer and Fishermen Rehabilitation: Chapter 12 bankruptcy was designed to enable farmers or fishermen, who have a regular annual income, to file a case and repay their debts in whole or in part.

Chapter 13 – Individual Rehabilitation: This type of bankruptcy enables individuals to pay off their debt, while keeping their property intact. In order to file for Chapter 13 bankruptcy, individuals are required to have a steady job and regular income. In this type of bankruptcy, they have the option to pay off their debts over a 3-to-5 year period and to retain their property.

Chapter 15 – International or Cross-Border: Chapter 15 bankruptcy is designed for international or cross border affairs. This bankruptcy gives rights to foreigners to take part in the state’s bankruptcies cases.

Chapter 11 and 7 Business Bankruptcy Claim Types

Under the Bankruptcy Code, there is a pecking order for creditors holding claims. This pecking order or “priority” determines which claims are paid first from the bankruptcy estate. All claims with a higher priority must be paid in full before claims with a lower priority receive anything. All claims with the same priority share pro rata.   This pecking order has an enormous impact on pricing in the claims trading market- generally speaking, the higher the priority, the higher the price.

In a typical Chapter 11 case, claims are divided into secured and unsecured claims, and the unsecured claims are often divided further based on the type of claim. Secured claims generally receive payment priority over unsecured claims in any distribution plan, while the unsecured claims are again prioritized so that administrative expense claims (including professional fees, employee wage and benefit claims, tax claims and claims of creditors providing post-petition credit to the debtor) usually take priority over pre-petition unsecured creditors. 

In a nutshell, bank loans secured by corporate assets are first, followed by unsecured senior debt, junior debt, and then stock or equity. In many Chapter 11 cases, the original equity holders are hopelessly underwater since they are last in line. Trade claim creditors fall somewhere in the middle and are more likely to recover at least a portion of the money they are owed when the dust finally settles.

Vendors continue to be the most common type of trade claim creditor. Most of these creditors hold “pre-petition” claims, meaning debts arising from the sale of goods or services to the debtor prior to the that debtor’s bankruptcy filing.   Pre-petition, non-priority vendor claims are the bread and butter of investors who specialize in buying trade claims. While such claims can exceed $1 million, most are less than $100k.

Lease / contract rejection claims consist of damages arising from the debtor’s rejection of unexpired leases and executory contracts (i.e., contracts yet to be performed by the parties). Rejection often leads to a claim against the debtor by the injured party. Even though rejection takes place after the filing, the injured party's claim becomes a pre-petition, unsecured claim. Exceptions to the unsecured status of post-petition claims usually include taxes, pensions, and environmental claims, all of which acquire a priority status.

Other variations of trade claims such as lease and contract rejection claims are becoming increasingly common. For example, in recent airline bankruptcies, the majority of trade claims related to the renegotiation of leases and employee collective bargaining agreements. As you might expect, large finance companies and unions normally hold these claims- such claims can be enormous, sometimes exceeding $1 billion.

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