Courts struggle to keep up with canny Wall St in credit disputes

Less than two weeks ago, Daniel Kamensky, once a star distressed debt investor, reported to a suburban New York prison to begin a six-month sentence.

Kamensky had infamously tried to secure a sweetheart deal for his hedge fund in the 2020 bankruptcy proceedings of luxury retailer Neiman Marcus, despite owing fiduciary obligations to other creditors of the retailer.

His treachery was secretly recorded on tape; at one point he acknowledged in the midst of his spree that “maybe I should go to jail”. He was eventually arrested by the FBI and pleaded guilty to bankruptcy fraud.

Even hardened Wall St observers believe the market norms and judicial oversight that historically constrained bad actors have simply failed to keep up

Kamensky should not be written off as a one-off finance rogue who faced accountability. Rather, his shocking crime and subsequent punishment are the culmination of an extraordinary period of disorder that has rocked the corporate credit markets.

Prolonged low interest rates along with billions flooding into bond and loan funds to take advantage of distressed debt situations amid the pandemic have upped the ante on opportunism. Even hardened Wall Street observers have come to believe that both the market norms and judicial oversight that historically constrained bad actors have simply failed to keep up.

In another stunning episode from this year, a federal judge allowed a group of hedge funds to keep $500m that had been mistakenly repaid to them by Citigroup, the bank that had been administering the loan in question, which had been borrowed by cosmetics company, Revlon. 

In a recent paper, former corporate lawyer and now Duke University law professor, Elisabeth de Fontenay, argues that the Citigroup saga distils many of the pathologies gripping the credit investing ecosystem. In another era, lenders would simply have returned the money. Here, however, the funds that kept the money were furious over a balance sheet restructuring that Revlon and Citigroup had executed months earlier that had sent the value of their debt plunging.

The mistaken repayment was a chance to either get their money back or at least pressure Citigroup over the disputed restructuring. Judge Jesse Furman of the Southern District of New York, who ruled in favour of the hedge funds, had relied on a ruling from three decades ago, well before the current development of the modern credit market.

De Fontenay writes in her paper: “At various points in its reasoning, the Citibank court relies on sources that transactional lawyers would never imagine to be relevant to the agreements that they helped draft.”

She went on to write that the decision, from a non-specialised judge, had offered neither consideration of marketplace expectations nor what the correct public policy interest may be. Such reasoning in legal opinions is intentional as they rely on so-called common law, legal precedents and generic doctrines to guide rulings on specific disputes.

Other recent disputes in credit markets have involved “asset stripping”, where private equity firms, sometimes in concert with a subset of creditor hedge funds, shift assets out of the reach of other creditors. Such transactions have become increasingly brazen in the past five years.

Kamensky had impressively helped to secure a $172m settlement from Neiman’s private equity owners over allegations of such fraudulent conveyance. He committed his crime by trying to snatch a lion’s share of that pot while he represented all unsecured creditors on an official committee in the bankruptcy. His misdeeds all happened within a few hours last summer and, according to court documents, he attributed his lapse to “stress” and the strains of the pandemic. 

He also argued, provocatively, that his wrongdoing could have been resolved in the civil bankruptcy proceedings and that criminal charges for his breach of duty were essentially unprecedented (Kamensky’s own admissions of guilt and cover-up attempts caught on tape were unhelpful in pleas for mercy).

De Fontenay speculates about more complex legal contracts or new forums to govern these modern disputes but remains sceptical that they would be improvements. As to why this market has broken down, she blames the “decline in norms and relationships among investors and their lawyers”. Perhaps someone going to jail is the wake-up call the market needs to police itself.

sujeet.indap@ft.com