Bankruptcy Claims Trading

A retailer files for Chapter 11. It owes a landlord $2 million in unpaid rent and a supplier $800,000 for delivered goods. Both are now unsecured creditors standing in line behind the company's lenders, and neither has any idea how many cents on the dollar they'll eventually recover, or when — bankruptcy cases can take years to resolve. Both would rather have cash now. A distressed-debt fund offers to buy each claim outright at a discount, taking on the uncertainty and the wait in exchange for a chance at a bigger eventual payout. Once bought, that claim can itself be resold — it has become a tradable instrument.

Pricing the claim

The value of a claim comes down to two questions: how much will the estate ultimately pay unsecured creditors per dollar of claim (the recovery rate), and how long will it take to get there (since money received in three years is worth less than the same amount today). A buyer estimates both from the company's asset values, the size of claims ahead of this one in priority, and how contested the case looks likely to be, then discounts the expected payout back to a present price.

$$\text{claim price} \approx \frac{\text{expected recovery rate} \times \text{claim face value}}{(1 + \text{required return})^{\text{expected years to payout}}}$$

In words: take what the claim is worth if everything plays out as expected, then discount it for both the risk of being wrong about the recovery and the time value of waiting for it.

Worked example

A vendor holds an $800,000 unsecured claim against a bankrupt retailer. Based on comparable cases and the estate's disclosed asset values, a distressed fund estimates a 40% recovery rate, paid out in an expected 2.5 years, and wants an 18% annual return to compensate for the uncertainty in both the recovery estimate and the timeline.

1. Expected payout. 0.40 \times \800{,}000 = $320{,}000$.
2. Discount factor. $(1.18)^{2.5} \approx 1.51$.
3. Fair price today. \320{,}000 / 1.51 \approx $212{,}000$, i.e. about 26.5 cents on the dollar of face value.

The vendor might accept 22 cents ($176,000) for immediate cash and no risk, letting the fund buy in with room for the recovery estimate to be somewhat wrong and still hit its return target.

What this means in practice

Claims trading rewards deep knowledge of the specific bankruptcy's asset values and the priority waterfall — where a given claim sits relative to secured lenders, other unsecured creditors, and administrative expenses — more than general market views. It's a business built on case-by-case legal and financial diligence, not a diversified factor bet.