Taking a Bite Out of Bankruptcy Claims

A new online exchange providing auctions of trade claims and trade-credit-insurance offers credit managers a peek at competitive bids.

Looking to attract vultures? Put out some distressed prey.

That’s a truism that a new online exchange, T-Rex (for trade-receivable exchange) wants to put into play. Launched Tuesday, T-Rex provides online auctions for bankruptcy trade claims, trade-credit insurance, and receivables-purchase contracts (also called put options). On the day that it launched, T-Rex featured its first auction—a $261,499 trade claim for bankrupt Northwest Airlines.

The exchange is out to improve the efficiency and liquidity of a market that by some estimates has grown to $500 billion. The process is straightforward: free of charge, credit managers can post an auction for their unsecured, Chapter 11 trade claims on bankrupt companies. If the exchange works as planned, the competition should give credit managers the chance to sell their claims at a higher price, and on more favorable contract terms, than those of deal struck with single buyers of distressed debt.

In general, a buyer of distressed debt (also known as a “vulture investor”) swoops in when a debtor is in trouble, offering to buy the stranded debt from creditors at deep discounts. The buyer then pools the debt with other receivables to thin out the risk and resells the package at a higher price than if the individual receivables were sold separately.

The problem with the current system, says Stephen Bastien, owner of Creditnews.com, an information service for credit managers, is that companies traditionally “fly by the seat of their pants” when appraising such offers. Bastien, a former credit manager for DeSoto Chemical (now part of PPG Industries) explains that even after poring over financial statements and credit reports to determine whether a trade claims offer is fair, it’s only an educated guess—”and often it doesn’t seem very educated.”

The exchange “makes a [traditionally] inefficient market more liquid,” notes Ray Poulos, director of credit at Tech Data Corp., a wholesale computer distributor that generates $20 billion in sales annually. Poulos, a former foreign exchange trader for Kodak, says that unlike the transparent currency markets, pricing for distressed debt “is hidden.”

“Vulture investors thrive on secrecy,” claimed T-Rex co-founder David Williams. He explains that confidentiality agreements are commonly used to prevent creditors from sharing the terms of their bankruptcy-claims sales, and that many creditors get “low-balled on pricing,” because of the lack of transparency. The idea that Williams and co-found Parker Freedman have is to make the opaque pricing transparent and let the free market orchestrate the rest.

Other distressed asset exchanges, such as Assetsforsale.com, exist. But the auctions focus primarily on consumer assets like houses, cars, and credit-card debt. T-Rex wants to take a piece of the commercial credit market.

Indeed, current market conditions may have made the emergence of an exchange like T-Rex possible. For the past two years, conventional insurance companies and new market entrants like hedge funds and specialty insurers have been introducing put options, trade credit single-debtors coverage, and other new risk-transfer products to clients, says Pieter van Ede, trade credit practice leader for insurance broker Marsh. “There is a trend toward alternative [insurance] solutions,” as bankruptcies decline (50 percent over the last year), and carriers are looking for new ways to boost business, he says.

So far, T-Rex has signed up 15 bidders for the bankruptcy claims portion of the site. The participants are either investment banks or hedge funds that have been vetted by the site as valid participants. While creditors can post an auction and review bids for free, they have to pay a $499 annual membership fee if they want to monitor closed auctions—the auctions in which they don’t participate. The exchange hopes to generate most of its revenue with the membership fee, says Freedman. He’s betting that most credit managers will want to view the bids as a way to evaluate the market value of similar claims that they hold.

At first, credit managers select bids from investors on a non-binding basis. The final price isn’t determined until the buyer and seller negotiate a deal based on the winning bid—and indeed, the seller can walk away from the deal. Once the buyer and seller have signed a contract, the bidder pays the exchange a commission fee that starts at 0.50 percent of the final transaction price.

Freedman is also hoping that the trade-credit-insurance auction section of T-Rex takes off. The trade-credit-insurance market reached $545 million in 2005, and has grown between 10 percent and 15 percent a year for the past decade, says Euler Hermes’ van de Wall. Companies buy trade-credit insurance to protect themselves against customers that cannot pay invoices because of financial problems—including bankruptcy.

But credit managers may find it hard to get a big credit insurer to cover the risk represented by a single debtor. Large trade-credit insurers usually cover a portfolio of risks for their clients, not just the risk represented by a single customer. To partly help clients deal with single-customer risk, they also provide an early-warning service that alerts clients that their customers may be in financial distress. Thus, a client can practice risk avoidance by reducing the amount of business it does with a particular customer or by pulling all its business away from the customer.

T-Rex, however, does provide a place for auctions of single-buyer coverage. Indeed, the trade-credit insurance auctions are limited to single-buyer, non-cancelable coverage of only investment-grade companies. That can be particularly useful for companies that rely on one or two major customers for most of their revenues. The auctions could be useful “for customers that know what they are looking for,” contends Arjan van de Wall, senior vice president of Euler Hermes, a trade-credit insurer.

But not all credit managers in the market for single-buyer coverage like non-cancelable coverage, says Marsh’s van Ede. That’s because cancelable coverage can provide a warning signal: when an insurer reduces or cancels coverage on a company, it alerts the client that a customer’s business is in financial trouble.

What’s more, T-Rex may run afoul of the founders’ effort get insurers to use the standardized contract the exchange offers. Cookie-cutter contracts are complicated by two issues, says Tom Jorgensen of Atradius Credit Insurance, a company that was involved in testing the T-Rex system: company underwriters generally prefer their own language and clauses, and policy language must be approved by individual state insurance commissioners. Nevertheless, Jorgensen believes that the T-Rex system is a “positive” development, “an additional way to distribute our capacity.”

Poulos, who tested the T-Rex system before it went live, agrees. The exchange “lets me throw the risk associated with trade receivables into the market and see what happens. Then I can always call an agent to help me evaluate the bid.”

To be sure, the lowest bidder doesn’t always win his business, says Poulos. He also looks at whether Tech Data has an existing relationship and good experience with the vendor and whether the vendor is rated highly by brokers and agents. In the end, “no one feels good about paying for insurance,” adds Poulos, “but the exchange should help make the marketplace more efficient.”

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