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Shareholder Activism Comes to Chapter 11

Hedge funds are seeking -- and winning -- a seat for equity holders in bankruptcy court.

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



. 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.



Experts say that the size and the complexity of bankruptcy cases play a big part in the emergence of equity committees. "It's a trend," says Stark. "Since Enron, WorldCom MCI and Adelphi, cases are getting bigger and more complex, and there has been recognition that shareholders should have rights."




. The Atlanta-based energy company filed for bankruptcy in July 2003, and within two months an equity committee was established. "Equity investors got warrants within months of the bankruptcy filing, and those warrants turned out to be worth a lot of money," notes a distressed hedge fund manager.

"There is a shift taking place. There were equity committees in the past, but because of the success of Mirant and some other cases, the courts are more open-minded to appoint equity committees," says another distressed hedge fund manager.

Some of those cases include

Loral Space and Communications

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Trump Hotels and Casinos



Interstate Bakeries






Distressed investing isn't for amateurs. It's a game reserved for sophisticated hedge funds and their bankruptcy lawyers. But some piggybacking is already starting to take place.

That was the case on March 22, when Tepper obtained an equity committee for Delphi. The stock closed at 88 cents the day before and moved up to $1.02 on the announcement. Even if the stock is now down in the 65-cent range, the equity committee is seen as a first step toward value preservation. That's because courts will allow a committee only if there is enough value to cover all the debt and potential value to be given to the shareholders.

"An equity committee gives shareholders a voice. Unless shareholders are unjustified in getting a voice, usually it raises the stock price," says Dan Arbess, founder of Xerion Capital Partners, a distressed hedge fund. He cites the case of Riverstone Networks, the network-router company in which he got involved as an activist and which recently filed for bankruptcy. "In the Riverstone case, the formation of an equity committee and ensuing auction between


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increased value to the shareholders by almost 30%," Arbess says. The auction took place last month, and Lucent bought Riverstone's assets for $210 million.

Some naysayers say that shareholder activism in bankruptcy cases reflects the triumph of lawyers over common sense. "It doesn't make legal sense at all," says a hedge fund manager. "The debt holders are entitled to the assets of the company. If there are enough assets, the company did not need to go bankrupt in the first place. If there is not enough cash, then all the assets should go to the debt."

That's precisely the point activists make. To them, bankruptcies are not final, and sometimes weren't even necessary.

Some activist shareholders -- for instance Tepper in the case of Delphi -- believe their company was rushed into bankruptcy prematurely to the detriment of the shareholders and to the benefit of the debt holders. If there is money left in the company, they will fight to unlock value.

Another argument surrounds the claims on a bankrupt company's assets -- claims that activists believe are often overstated. Many bankrupt companies tend to be old manufacturing businesses with pensions and liabilities. A major thrust of this new breed of activism is that the liabilities can be shifted and ultimately removed from the balance sheet through bankruptcy litigation, leaving value for the shareholders. In the case of Delphi, activists believe that a good deal of the liabilities can be shifted through negotiation back to

General Motors

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Another example is



, a chemical company that was originally spun off from



. Litigation claims were transferred to Solutia when the business was spun off. Recently, Arbess and a group of creditors put pressure on Solutia's management. As a result, Monsanto agreed to take back certain liabilities.

Tepper is also working on some of those liabilities issues on the Delphi front. He is challenging the "indemnity" GM plans to seek from Delphi as compensation for the money it spends on its former unit's benefits. If Tepper succeeds, Delphi's shareholders may be able to squeeze some value out of the bankrupt auto-parts company. His investment will be worthless if he doesn't.