(This article appears courtesy of International Financial Law Review, sign up for a free trial on their site)
Rachel Evans
Staff writer
"When markets go down hill, it's a lawyer's waking nightmare and a wet dream at the same time," says one structured finance partner in London. "You're terrified that your documentation won't hold up but you're also secretly thrilled that all that backroom drafting will finally get some attention."
Unfortunately some of that backroom drafting, particularly in structured finance, is rather unclear. Investors, issuers, insurers, trustees and receivers need help interpreting it. In the first three months of 2008, 170 claims relating to sub-prime were filed in the US at federal level, according to Navigant Consulting. To put this in perspective, only slightly more cases – 181 – were filed in the whole second half of 2007. The rate of filings is clearly accelerating. The number of cases related to sub-prime has already surpassed half that of the savings and loans crisis in the late eighties and early nineties. Then, the Resolution Trust Corporation viewed 559 cases over several years. From January 2007 to March 2008, the US federal courts saw 448 sub-prime cases.
Plaintiffs want clarity on matters such as priority of payment – the waterfall – and events of default. Swap counterparties want to exit expensive obligations. But the documents that should deal with these issues are not specific enough. As Calum Burnett, a litigation partner at Allen & Overy, says: "Some of the documentation has gaps. People drew up these documents under time pressure in a fairly benign economic environment and perhaps didn't think that they would be subject to this type of scrutiny."
Over the waterfall
Collateralised debt obligations have suffered most scrutiny. Sub-prime CDOs were downgraded as homeowners defaulted on their loan repayments, casting doubt on the value of the assets backing structured products. By the end of 2007, Moody's ratings agency calculated that 537 CDO tranches were "materially impaired" – effectively in default – as a result of principal losses or shortfalls in interest. In comparison, fewer than 25 CDO tranches defaulted the previous year. The market, and fate of CDOs, has not improved in 2008.
Morgan Stanley calculated in January 2008 that 63 CDO products worth approximately $70 billion had experienced events of default. By July's market update, the investment bank calculates that the number of defaults had increased to 209 CDOs worth $218 billion. Morgan Stanley believes 30 of these are in liquidation, with a further 31 on notice. But documentation of how the waterfall should work in the event of a default is not clear. As a result, creditors are in dispute with the security trustee about how the remaining capital should flow down the structure.
One such case concerns a defaulted CDO known as Sagittarius. When the product defaulted, LaCrosse, the super senior counterparty and controlling class, demanded an acceleration and the immediate payment of principal on secured notes. Crucially, it argued that it should receive the proceeds before noteholders. At the monthly distribution date in November 2007, noteholders clashed with LaCrosse over "the proper interpretation" of the subordination and waterfall provisions. As Deutsche Bank – the security trustee – states in its December complaint to the New York courts: "Defendants now claim different rights in how the limited fund of interest proceeds and principal proceeds should be applied". Deutsche argued that LaCrosse should settle its claims on the interest and principal proceeds directly with Cede & Co, with which all classes of notes were registered on behalf of numerous beneficial owners.
The dispute between LaCrosse and the noteholders suggests that there are two plausible interpretations of the subordination provisions. However, while the court case is pending and the indenture remains confidential, it is hard to establish how ambiguous these documents are. Deutsche placed the principal and interest in escrow when the dispute arose and initiated legal proceedings to push the counterparty and noteholders into negotiation. But Deutsche's legal action also seeks to prevent LaCrosse or the noteholders "commencing or prosecuting any separate litigation" against the bank, as trustee, regarding the distribution of payments. This case may therefore reflect Deutsche's caution, rather than a lack of clarity in the documents.
However, Deutsche's complaint also highlights the potential for tranche warfare between creditor classes. As William Fenrich, a litigation partner at Davis Polk & Wardwell's New York office says: "Significant litigation involving competing CDO noteholders is a real possibility. Parties of substantial true economic interest are asserting claims, often in interpleader actions, over whether events of default have occurred and the allocation of cash flows and losses through the waterfall." Paragraph 33 of Deutsche's complaint warns of future disagreement as to "the portion" of the interest and principal proceeds that Cede & Co will distribute to those with beneficial interest in class S secured notes and those with beneficial interest in the other classes of secured notes. Deutsche's comments on this potential inter-creditor litigation suggest that the documentation dealing with priority of payments is genuinely unclear.
Siv-ing through the wreckage
Priority of payment is even more complicated and controversial in the case of insolvent structured investment vehicles. In July 2007, the ratings agencies were aware of 31 operational Sivs. But by June 2008, several Sivs – Orion Finance, Victoria Finance, Cheyne Finance, Axon Financial Funding, Rhinebridge and Whistlejacket being the most prominent – were facing liquidation or restructuring. Many others have been wound-up while some, such as Citigroup's stable of seven Sivs, have been taken back on balance sheet. Like CDOs, Sivs are structured with senior and subordinated creditors. But while CDOs use a special purpose vehicle to acquire assets and issue tranches of asset-backed notes, Sivs are vehicles that rely on short-term funding, in varying degrees of subordination, to finance longer-term investments. The differing maturity dates of this short-term funding, primarily commercial paper, adds an extra layer of complexity for receivers interpreting subordination provisions.
As recent court cases show, the documentation is not clear about how creditors with early and late maturing paper – but of the same class – should be treated. Whistlejacket's receivers sought advice on this matter in May after claims by two parties. Party A claimed that, as its notes matured early on the day that an insolvency event was announced, it should be paid as if the insolvency event had not happened. Party B meanwhile sought payment on notes maturing in the month following the insolvency event, ahead of other creditors whose paper had not yet matured. The receivers wanted guidance on whether either of these parties should be paid and whether money should be put aside for creditors with later maturing paper.