In Recent Years, Hedge Funds Have Engaged in So-Called "Loan-To-Own

Essay

In recent years, hedge funds have engaged in so-called "loan-to-own" pre-bankruptcy investments in which they acquire debt from distressed firms at a fraction of face value. Subsequently, they move the company into Chapter 11 intent upon converting the acquired debt to equity in a firm with sharply reduced liabilities. The hedge fund also provides DIP financing to further secure its interest in the business. The emergence from Chapter 11 is typically accomplished under section 363 (k) of the bankruptcy code which gives debtors the right to bid on the firm in a public auction sale. During the auction, the firm's debt is valued at face rather than market value, effectively discouraging any other bidders other than the hedge fund which acquired the debt prior to bankruptcy at distressed levels. Without competitive bidding, there is little chance of generating additional cash for the general creditors. How might this be viewed as an abuse of the Chapter 11 bankruptcy process?