Hedge Funds Find a Sweet Spot in Distressed Firms

It is one of the fanciful conceits of stock market trading — that the only factor separating successful traders from also-rans is the ability to separate noise from signal. Information is free-flowing, it is said, and the full force of the law will come down on anyone taking advantage of insider scoops. 

Well, maybe not. While there are clear laws and consequences to insider trading, there is one grey area that Wei Wang, Distinguished Professor of Finance at Smith School of Business, recently discovered. When hedge funds serve on the unsecured creditors’ committee (UCC) of firms that are under bankruptcy protection, they are given access to private information about those firms as well as companies with whom they have economic links — and nothing stops them from using this information in other market trades. 

Wang, working with Smith assistant professor of finance Jingyu Zhang and doctoral student Yan Yang, found that wily hedge funds are benefiting from this loophole. 

Source of access 

In the U.S., when a company files for bankruptcy protection, it goes through a court-supervised process to restructure its assets and liabilities. As part of this exercise, the company establishes a committee that represents the interests of its unsecured creditors, who, unlike secured creditors, are not protected by collateral. 

“The committee is made up of the seven largest unsecured creditors, and sometimes that includes hedge funds,” Wang says. “The legal process makes sure that unsecured creditors have a voice immediately after the formation of a bankruptcy filing.” 

Committee members are given access to the company’s private information, known as material nonpublic information, that could include the firm’s most recent business plans and management projections.

Wang says the U.S. Securities and Exchange Commission (SEC), the stock market regulator, prohibits UCC members from using the bankrupt firm’s material nonpublic information as a basis for trading securities of the bankrupt firm. 

Indeed, the British bank Barclays was fined when the SEC discovered bank officials were trading a bankrupt company’s bonds while serving on that company’s UCC. 

Material nonpublic information can also include details about firms in related industries. For example, members of the UCC for Toys “R” Us, which entered bankruptcy protection in 2017, could have access to private information about the company’s suppliers, such as Hasbro or Mattel. 

This is where Wang and his colleagues discovered a loophole that could allow a hedge fund to trade the stock of companies related to the bankrupt firm based on private information. 

“Let’s say Toys “R” Us, which is now in bankruptcy, plans its liquidation and will stop all shipping from Mattel or Hasbro,” Wang says. “A hedge fund manager serving on the company’s UCC will have access to this information. If that manager thinks Mattel or Hasbro might suffer a loss as a result, the hedge fund can start selling those stocks.” 

The devil in the details 

In their research, Wang and his colleagues looked at a sample of 144 Chapter 11 cases filed by large public U.S. firms between 1996 and 2019. They identified UCC members in each case, including which ones were hedge funds, and studied the hedge funds’ quarterly trading patterns. 

They discovered that once a hedge fund’s representative was appointed as a member of a UCC, the hedge fund was more likely to make large transactions in individual stocks and make a greater number of large transactions. They also found these large transactions were more likely to happen in the stock of a non-bankrupt firm (such as LG) that has an economic link to a bankrupt firm (for example Sears). 

Additionally, the researchers found that non-hedge-fund UCC members, such as those representing pension funds and mutual funds, do not trade differently after accessing material nonpublic information. 

Wang says there are a few reasons why hedge funds are more likely to take advantage of material nonpublic information in a bankruptcy setting than other institutional investors.

First, he says, hedge funds face fewer regulations and restrictions, such as disclosure requirements and portfolio diversification, than other institutional investors. “Non-hedge-fund institutional investors must comply with a number of federal and state laws,” Wang says. “As a result, hedge funds can take advantage of private information by timely placing a large number of trades.” 

Wang adds that hedge fund managers are also more skilled than other types of fund managers, and therefore can better identify how to exploit material nonpublic information for trading. And, he says, hedge fund managers are more incentivized to trade upon accessing such information because of their pay-for-performance structure. “Hedge fund managers get paid much more as a fraction of returns than other fund managers,” he says. 

A legal grey area 

Wang says if an insider or a party, such as an individual investor or institution, receives a tip with insider information and trades on it, it’s considered “insider trading” by the SEC. The grey area, Wang says, is that the material nonpublic information that hedge funds receive may not be directly tipped by the insiders of non-bankrupt companies. 

“It is considered insider trading if the UCC member gets the material nonpublic information and trades the bankrupt firm’s securities,” he says. “But unless regulators can find direct evidence that the information that hedge funds get from the bankrupt firm on other firms comes directly from insiders of those firms, it is hard to bring such trading to prosecution.” 

While Wang doesn’t have specific suggestions on how to close this loophole, he says regulators should be aware of the issue to ensure fairness and well-functioning financial markets. “If certain parties can profit from access to material nonpublic information, this is not fair and not right to other investors,” he says. 

But Wang makes clear that the study’s findings are not an attack on hedge funds. 

“Hedge funds do contribute value to financial markets, and I have shown their value to bankrupt companies in other papers,” he says. “But I think this speaks to more about regulation, and whether this is legal or illegal. Our purpose is to not just focus on hedge funds, but more on how the financial markets function as a whole.”