In a September 13th opinion denying Washington Mutual’s modified plan of reorganization, the Honorable Mary Walrath of the United States Bankruptcy Court for the District of Delaware issued a clear reminder that general insider trading principles apply to material non-public information learned in bankruptcy plan negotiations. Judge Walrath found that the equity committee had stated a colorable claim against four hedge funds for violations of insider trading laws. The hedge funds filed an appeal this week. The following in an excerpt from a memo sent in by our friends at Sullivan & Cromwell discussing the decision:
Washington Mutual, Inc. (“WaMu”) is the former parent holding company of Washington Mutual Bank (“WaMu Bank”) and is the lead debtor in the three year old chapter 11 case pending before Judge Mary Walrath in the United States Bankruptcy Court for the District of Delaware (the “Court”). WaMu filed its chapter 11 petition on September 26, 2008, one day after WaMu Bank, its primary banking subsidiary, was closed by the Office of Thrift Supervision and the FDIC was appointed as receiver (the “FDIC Receiver”).
Following WaMu’s bankruptcy filing, WaMu, creditors of WaMu, JPMC, and the FDIC Receiver litigated in multiple fora, among other things, disputed claims to ownership of billions of dollars in assets. A global settlement agreement (the “GSA”) providing for resolution of the competing claims to the assets and other disputes among WaMu, the FDIC and JPMC was announced on March 12, 2010. That GSA was finalized in May 2010 and serves as the foundation of WaMu’s proposed plan of reorganization.
In connection with a contested July 2011 confirmation hearing on the Debtors’ Modified Sixth Amended Plan, the equity committee brought a motion for standing to commence an adversary proceeding seeking to, among other things, equitably disallow claims of four hedge funds (referred to as the “Settlement Noteholders”) on the basis that the Settlement Noteholders violated insider trading laws. Evidence in support of the equity committee’s allegations was presented at the confirmation hearing. In granting the equity committee’s motion, the Court held that equitable disallowance could be an appropriate remedy, and that the equity committee had presented a “colorable” claim against the Settlement Noteholders.
The facts were largely undisputed as to the Settlement Noteholders’ participation in the plan negotiation process. The dispute centered on the Settlement Noteholders’ duties and the nature of the information they possessed while trading in WaMu’s securities. At various times during the intermittent settlement negotiations that took place between March 2009 and May 2010, the Settlement Noteholders and WaMu executed confidentiality agreements that permitted the Settlement Noteholders to receive MNPI and participate in settlement discussions with the debtors, JPMC and the FDIC Receiver. The confidentiality agreements contained provisions requiring WaMu to publicly disclose MNPI provided to the Settlement Noteholders at the end of specified periods (the “Confidentiality Periods”).
Each of the Settlement Noteholders claimed to have followed their restricted trading procedures during the Confidentiality Periods or refrained from trading during those periods. Each Confidentiality Period ended with WaMu, in light of its agreement to disclose MNPI, publicly disclosing certain information in the Settlement Noteholders’ possession. WaMu, however, did not disclose the fact that settlement negotiations had commenced, nor the status of those negotiations, nor any of the substantive terms of the proposals and counter-proposals to which the Settlement Noteholders had been privy during the Confidentiality Periods.
A central theme of the equity committee’s insider trading allegations was that the existence, status and terms of the settlement negotiations in and of themselves constituted MNPI, and the Settlement Noteholders improperly traded on the basis of that information outside of the Confidentiality Periods. In response, the Settlement Noteholders and WaMu took the position that the terms of the failed negotiations were not material and that their involvement in discussions outside of the Confidentiality Periods did not expose them to MNPI.
INSIDER TRADING ANALYSIS
The Court undertook a detailed analysis of the classical and misappropriation theories of insider trading under section 10(b) of the Securities Exchange Act of 1934, as amended, and Rule 10b-5 promulgated thereunder. Under the classical theory, the law is violated “when a corporate insider (i) trades in the securities of his corporation (ii) on the basis of (iii) material nonpublic information (iv) in violation of the fiduciary duty owed to his shareholders.” Under the misappropriation theory, insider trading can be established where “(1) … the defendant possessed material, nonpublic information; (2) which he had a duty to keep confidential; and (3) … the defendant breached his duty by acting or revealing the information in question.”
The Court found that the equity committee had established a colorable claim that the Settlement Noteholders violated insider trading rules based on the classical theory, and in the case of one Settlement Noteholder, the misappropriation theory. Although the full opinion is worth reviewing for its application of general insider trading doctrine to bankruptcy negotiations, we believe five points of the Court’s analysis are particularly noteworthy:
Negotiating Creditors May Become Temporary Insiders. The Settlement Noteholders argued that they were only creditors, and not “insiders” for purposes of the classical theory of insider trading. The Court rejected this argument and held that the equity committee stated a colorable claim that the Settlement Noteholders had become temporary insiders of WaMu by executing confidentiality agreements, receiving MNPI, establishing a blocking position in a class of claims, and participating in multi-party negotiations with the shared goal of reaching a settlement that would form the basis of a plan of reorganization.
Negotiations Themselves Can Be MNPI. The Settlement Noteholders also argued that knowledge of the negotiations and the positions taken by parties is not itself material because of the distance between the parties’ proposals and the uncertainty whether a party’s position at any one time would remain that way in future complex negotiations. The Court disagreed, applying general materiality principles and stating that the Supreme Court “has explicitly rejected the argument that there is no materiality to discussions until an agreement-in-principle has been reached.”
The Debtor’s View of What is MNPI is Not Dispositive. The Settlement Noteholders argued that they did not act with scienter because there was no evidence that they knowingly or recklessly traded in WaMu securities while in possession of MNPI. They pointed to the cleansing provision contained in the confidentiality agreements and argued that WaMu had the burden to assure that all MNPI was disclosed at the conclusion of each Confidentiality Period. The Court rejected this argument, specifically noting that each Settlement Noteholder has its own obligation to comply with securities laws and could not use WaMu’s own view as to the materiality of the information as a “shield” if they violated those policies.
Courts May Be Skeptical About Use of Outside Counsel as “Gatekeepers.” The Settlement Noteholders engaged an outside law firm that executed a confidentiality agreement directly with WaMu. The agreement prevented the law firm from disclosing information to its clients, unless the clients agreed to keep the information confidential and to refrain from trading until the information was publicly disclosed. The Settlement Noteholders and the equity committee disputed whether as a matter of fact confidential information was shared with the Settlement Noteholders in violation of that agreement. The Court noted it had “substantial doubts” about the Settlement Noteholders’ assertions on this point and that further discovery would clarify.
Application of Insider Trading Laws Will Not Chill Creditor Participation. Finally, the Settlement Noteholders suggested that the equity committee’s pursuit of insider trading in this context would stifle a debtor’s ability to effectively hold plan formation and settlement discussions with significant holders. The Court was unmoved and issued a clear reminder: [C]reditors who want to participate in settlement discussions in which they receive material nonpublic information about the debtor must either restrict their trading or establish an ethical wall between traders and participants in the bankruptcy case. These types of restrictions are common in bankruptcy cases . . . . The Court does not believe that a requirement to restrict trading or create an ethical wall in exchange for a seat at the negotiating table places an undue burden on creditors . . . ..
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 On September 25, 2008, JPMorgan Chase Bank, N.A. (“JPMC”) purchased substantially all of the assets and certain liabilities of WaMu Bank from the FDIC Receiver pursuant to a purchase and assumption agreement.
 Sullivan & Cromwell LLP is lead counsel to JPMC in these matters.
 The court stayed its order granting the equity committee’s standing pending court ordered mediation on a potential settlement of the issues. In re Washington Mutual, Inc., No. 08-12229 (MFW), 2011 WL4090757, at *56 (Bankr. D. Del. Sept. 13, 2011).
 Id. at *47.
 Id. at *55 (quoting SEC v. Lyon, 605 F. Supp. 2d 531, 541 (S.D.N.Y. 2009)).
 Id. at *52-53.
 Id. at *51 (citing Basic, Inc. v. Levinson, 485 U.S. 224, 238 (1988)).
 Id. at *54.
 Id. at *55.