WaMu Plan Ruling Puts Distressed Investors on Notice

Bankruptcy lawyers will be beating each other over the heads for years to come with Judge Mary Walrath’s latest ruling in the big bankruptcy case of Washington Mutual Inc.

Rejecting the company’s Chapter 11 plan, Walrath yanked the rug out from under bondholders who thought they had cut a straight-up deal with the company to get the contract rate of interest on billions in debt. Instead, she found the federal judgment rate of interest should apply in the case, which grew out of the biggest banking collapse in U.S history, that of Washington Mutual Bank, or WaMu.

In Washington Mutual’s Chapter 11 case—which began almost three years ago—this just means holders of a class of debt called PIERS might have to kick back something to holders of top-ranking debt, according to Kevin Starke, an analyst with CRT Capital Group, which makes a market in Washington Mutual securities.

There’s likely not much of a financial incentive for the big money in the case to appeal Walrath’s decision. Many big players own both PIERS and top debt, so they’ll just be moving cash from one pocket to another. But investors in other cases where there’s a whole lot of cash to be handed out—specifically the case of Nortel Networks Corp.—had better read Walrath’s ruling carefully.

Nortel hit the jackpot on a sale of its patents, doubling the pile of money it had accumulated in Chapter 11. Investors in the debt of the defunct telecommunications company are hoping to deal their way into a better-than-100% recovery. How much better may depend on whether Nortel gives the bondholders a contract rate of interest or the federal judgment rate, which is usually much smaller.

What the bondholders don’t get could go to folks like Nortel’s retirees and disabled workers, many of whom are being left empty handed. Signs from Walrath that the bankruptcy judge should go with what’s fair and equitable when it comes to interest rates could push a finding in favor of the ex-employees.

In her ruling, Walrath also dealt a blow to some of the biggest distressed-debt players in the country, finding that Washington Mutual shareholders had sketched out “colorable” claims of insider trading against Appaloosa Management LP, Aurelius Capital Management LP, Centerbridge Partners LP and Owl Creek Asset Management LP. Appaloosa issued a statement denying there was a legitimate case to be made against it for trading based on confidential information picked up at the Chapter 11 bargaining table. The others did not respond to requests for comment.

Walrath didn’t find the hedge funds guilty. And her ruling doesn’t mean the insider-trading case will ever come to trial. The judge pushed everyone into mediation out of concern that more delay in the $7 billion case will erode the value going to creditors.

Tuesday’s ruling does mean, however, that distressed-debt players operating in big Chapter 11 cases in the future better read Walrath’s decision carefully.

The way Washington Mutual’s Big Four saw it, they were free to trade without worry as long as they were outside formal periods where they had specifically agreed to be restricted in order to get confidential information.

To ask big investors to restrict their trading activities throughout the ebb and flow of negotiations that can last years in a big Chapter 11 case is simply too much, they contended.

No, it’s not, Walrath said. It’s what they should have done.