Current market conditions have dramatically changed the credit market landscape. One striking feature of this changed landscape is the distressed debt market. Distressed debt is essentially debt of a financially distressed company that is likely (or perceived to be likely) to default on its debt payment obligations. According to a commonly-used definition, debt securities are distressed if they trade on the secondary market yielding more than 1,000 basis points over benchmark Treasury securities.

A wide variety of players from hedge funds to private equity investors to traditional large financial institutions invest in distressed debt. In a 2009 survey of hedge funds and other institutional investors by Debtwire, over 60% of respondents indicated that investing in distressed debt is their core investment strategy, a staggering number given the high risks involved.

Whether they expect to use their holdings to take on an activist role with the company, convert to equity and sell their equity interest at a profit or hold out until maturity, distressed investors expect that they will reap the benefits of their investment at some point in the life of the company. The quick answer to why firms continue to invest in distressed companies is that the potential returns can be very rewarding. Although distressed investors suffered considerable losses on their bets in 2008, a substantial majority expect returns of over 15% in 2009, and many are forecasting over 20% returns in 2009 (Debtwire).

There are three main ways of investing in distressed debt:

While distressed investing can provide solid returns, there are legal hurdles that may affect the extent to which distressed debt investors are willing to participate in this market.

Whether in a distressed context or otherwise, directors always owe fiduciary duties to the company. They also owe fiduciary duties to stockholders or creditors, depending on the company's financial condition. This means directors must tread carefully when considering what financing options a distressed company can pursue, particularly in the case of those directors who are investor appointees. Distressed investors need to understand these duties to ensure their investment tactics do not trigger breaches and give rise to claims from other stakeholders.

Courts recognize that directors have few financing options. "If a company desperately needs financing and is faced with limited and unappealing choices, it is difficult to see what options directors really have," says Douglas Urquhart, a banking and finance partner at Weil, Gotshal & Manges LLP. So courts are reluctant to second-guess board decisions absent clear cases of breach, for example where a decision by the board is tainted by a conflict of interest.

For a solvent corporation, the board of directors must manage the company in the best interests of its stockholders, who have standing to assert direct claims and derivative claims on the company's behalf against directors for breaches of fiduciary duty. On insolvency, directors' fiduciary duties shift to creditors because the interests of stockholders are subordinate to those of creditors. Distressed debt investors then become the beneficiaries of these duties.

However, North American Catholic Educ. Programming Found., Inc. v Gheewalla, 930 A.2d 92 (Del. 2007) confirmed that creditors cannot assert direct claims for a breach of fiduciary duty against directors. This would create a conflict for directors between their duty to maximize the value of the insolvent corporation for the benefit of all constituents and their direct fiduciary duty to individual creditors.

In re Granite Broadcasting Corp., No. 06-12984, (Bankr. S.D.N.Y. 2007) also served as a warning call for distressed investors, suggesting that distressed debtors and their prospective lenders must ensure that the debtor's board of directors has adequate procedures when assessing restructuring or reorganization options. Boards should form an independent committee of directors to evaluate these options, particularly where potential conflicts of interest exist.

For more information on the fiduciary duties of directors in a distressed context, see Practice Note, Fiduciary Duties of Directors of Financially Troubled Corporations.

From an investor's perspective, betting on distressed companies is a complex and litigious strategy, often commercially hostile, and one that involves serious legal and financial risk. While comprehensive data is not available on current trends, one survey indicates that 36% of hedge funds invested in distressed debt in 2008 compared to 48% in 2007 (HedgeWorld & Dykema 2009 Insolvency Outlook Survey). Less than half of the investment managers surveyed expect lending to distressed companies to increase in 2009. But the financial crisis has had ripple effects on all kinds of investing, so these numbers are not surprising.

The stark reality is that financing in current credit markets is scarce. "The basic problem is not legal but financial − there is very little deal money around," says Landers. Companies need to seek out the best available option to shore up their balance sheets and will look to willing lenders and investors to do so. Even as liquidity starts seeping back into the markets, it is not clear that distressed investors and their tactics will disappear any time soon. According to Douglas Warner, a private equity partner at Weil, Gotshal & Manges LLP, the amount of debt maturing in the next couple of years far surpasses likely available credit, which in turn will fuel distressed investment strategies for some time.

Whether distressed debt investing will withstand the financial and legal setbacks it has been dealt depends on how distressed debt investors expect to manage their risks going forward, including the regulatory risks that they anticipate. That the supply of distressed debt money has not dried up entirely, however, is telling. It must be that for those who continue to play this game, the returns are just too tempting to walk away.