Shareholder Activism Comes to Chapter 11

When a company nears insolvency, a bankruptcy reorganization is a tool creditors use to protect their interests. But what happens if bankruptcy is wielded as a weapon?

That's the basic question underlying the latest frontier of shareholder activism, in which stockholders -- who are usually big losers in Chapter 11 proceedings -- try to defend themselves through the formation of court-recognized equity committees.

Shareholders are usually wiped out when a company seeks bankruptcy protection. That's because their claims come behind those of anyone who has lent the company money, such as bondholders and preferred stockholders. It's part of the bargain stockholders live with: Their upside is theoretically unlimited, but few tears will be shed for them in the event a company goes under.

Still, some hedge fund activists say that system is ripe for abuse. Called distressed investors, these pros take positions in risky stocks -- even one where the threat of bankruptcy looms -- because they see value in the company after its debts are paid. Part of their argument is that creditors sometimes force bankruptcy on companies when a less radical restructuring would suffice. A shareholder committee makes sure creditors aren't making out too well in the reorganization.

"At the negotiation table, it's possible that a company could be found solvent," says Robert Stark, bankruptcy partner at law firm Brown Rudnick. "The enterprise value is to a degree subject to opinion."

Getting a judge to appoint an equity committee is a big deal for stock investors. "Without an equity committee, shareholders get nothing," says one hedge fund manager specializing in distressed investing. "With it, shareholders get something. How much? It depends on the valuation and the negotiation."

Recently, David Tepper, founder of the hedge fund Appaloosa Management, made headlines after seeking and obtaining the creation of an official equity committee for Delphi(DPHIQ Quote). The term "official" carries some weight here. It means that the company pays for the legal representation of the shareholders.

"By getting an official equity committee, Tepper was very clever. He got somebody else to pick up his legal bills," says a distressed hedge fund manager. Tepper is also petitioning for the creation of an equity committee with Dana Corp.(DCNAQ Quote).