managing credit risk in a post-lehman world...loans, repos, securities lending) is usually subject...

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Managing Credit Risk in a Post-Lehman World October 2, 2015

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Skanthan Vivekananda Partner, Investment Management, Hedge Funds and Alternative Investments +1.617.951.9074

[email protected]

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Chad Dale Partner, Restructuring & Insolvency

+1.617.261.3112

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Robert Honeywell Counsel, Restructuring & Insolvency

+1.212.536.4863

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Anthony Nolan Partner and Practice Area Leader, Finance

+1.212.536.4843

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Stephen Moller Partner, Banking & Asset Finance

+44.(0)20.7360.8212

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Today’s Presenters

1 klgates.com

Introduction

Viewing Business Transactions Through the Bankruptcy Lens

Even the best deal can fall apart. The unexpected happens: in one word,

“Lehman.”* *or other words: “Enron,” “Bear Stearns.” “AIG.” “MF Global.” etc. etc.

The most thoroughly negotiated contract is only as good as its enforcement remedies.

Assume you’ll have to use them.

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The Unique Context of a Potential Bankruptcy (1) Your remedies are frozen: the “automatic stay.” (2) Your number of counterparties has multiplied: not just your

contract counterparty (the debtor),

but also a host of others: Its pre-bankruptcy lenders (usually secured). Its bankruptcy lender (the “DIP lender”). Its unsecured creditors (led by the “Committee”). Its potential purchasers. Potentially, its regulators. Its professional advisors.

All of whom have an interest in the same assets you want.

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(3) Your forum is strange and highly technical: Chapter 7 or 11 in U.S. bankruptcy court (for U.S. non-brokers); Foreign insolvency proceeding (for foreign counterparties); SIPA proceeding in federal court (for registered U.S. brokers); “Commodity broker liquidation” in bankruptcy court (for U.S. FCMs); “Stockbroker liquidation” in bankruptcy court (for unregistered brokers); Federal or state receivership (for financial institutions); State court resolution proceeding (for insurance companies); The new FDIC “Orderly Liquidation Authority” (OLA) for “too big to fail”

SIFIs (“systemically important financial institutions”), or similar foreign proceedings for SIFIs (“special resolution regimes” (SRRs));

or A hybrid of all of the above.

The Unique Context of a Potential Bankruptcy cont’d

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(4) Your outcomes are highly unpredictable – anywhere from: Full recovery (100%); to Cents-on-the-dollar (0+%).

How do you maximize your recovery chances and minimize your credit exposure?

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The Unique Context of a Potential Bankruptcy cont’d

Affected Business Transactions

Investment Transactions: The “Safe Harbors”: Swaps, Repos, etc. Brokerage Assets: Securities & Collateral Custody

A Case Study: State Law “Series” Entities. Structured Finance: using SPEs in Securitizations & Project Finance. Corporate Restructurings: Spinoffs, LBOs & Debt Restructurings.

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Investment Transactions

The U.S. Bankruptcy “Safe Harbors”: How “safe” are they?

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The U.S. Bankruptcy “Safe Harbors”: How “Safe” Are They?

The Automatic Stay Imposes a standstill on creditors’ termination, liquidation, collection and

enforcement rights. Goal is to preserve the status quo ante. Also designed to prevent a rush to the courthouse. U.S.C. §§ 362(a)

Subject to certain exceptions, filing of a petition operates as a stay, among other things, of: acts to collect, assess or recover a pre-petition claim against the

debtor; acts to obtain possession or control of property of the estate; acts to create, perfect or enforce any lien against property of the

estate; the setoff of any pre-petition debt owing to the debtor against any

claim against the debtor; enforcement of judgments against the debtor/property of the estate;

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The Automatic Stay cont’d

“ipso facto” clauses are generally not enforceable. U.S.C. §§ 365(e)(1)

“Notwithstanding a provision in an executory contract. . . an executory contract . . . may not be terminated or modified . . . at any time after the commencement of the case solely because of a provision in such contract . . that is conditioned on (A) the insolvency of financial condition of the debtor at any time before the closing of the case; (B) the commencement of a case under this title; or (C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement.

The U.S. Bankruptcy “Safe Harbors”: How “Safe” Are They? cont’d

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Safe Harbors for certain categories of contracts If the requirements of the safe harbors are met, an eligible counterparty

may exercise permitted contractual rights with respect to a permitted contract type, notwithstanding the automatic stay.

Why? Prevent a domino effect - purpose is to prevent insolvency of a large player from spreading to other financial institutions or clearing houses.

U.S. Bankruptcy Code: 11 U.S.C. §§ 555-556, 559-562; §§ 362(b)(6),(7), (17) & (27).

Other bankruptcy regimes include concepts similar to the automatic stay and similar safe harbors. Federal Deposit Insurance Act (for banks): 12 U.S.C. §1821(e)(8). Securities Investor Protection Act (for broker-dealers): 15 U.S.C. §

78eee(b)(2)(C).

The U.S. Bankruptcy “Safe Harbors”: How “Safe” Are They? cont’d

Statutory and Regulatory Limits: What The Safe Harbor Protects Only permitted contractual rights may be exercised (termination,

acceleration, liquidation, setoff, foreclosure). **The remedy must be in the contract.** Foreclosure rights apply only to collateral held by counterparty. Broker-dealers: any securities collateral pledged by the BD (e.g., for

loans, repos, securities lending) is usually subject to an initial temporary stay (e.g., 21 days).

Banks: safe harbors are subject to an initial 1 business day stay. ISDA Resolution Stay Protocol may impose additional conditions

and limitations on certain types of contracts.

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The Bankruptcy Code safe harbors only apply to certain types of contracts: Swap agreements. Repurchase agreements: only short-term (1 year or less) repos of

mortgage loans, mortgage-backed securities, CDs, bankers’ acceptances, and U.S. & OECD member securities.

Securities contracts. Commodity contracts. Forward contracts. Master netting agreements.

Statutory and Regulatory Limits: What The Safe Harbor Protects cont’d

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Only certain eligible parties for securities and commodity contracts: Banks & other financial institutions (including custodians). 1940 Act funds (as to securities contracts). Stockbrokers, clearing agencies, commodity brokers & forward contract

merchants. “Financial participants” meeting certain market exposure thresholds ($1

BN in notional or principal amount or $100 M in gross mark-to-market).


Example: 11 U.S.C. § 555 The exercise of a contractual right of a stockbroker, financial institution, financial participant, or securities clearing agency to cause the liquidation, termination, or acceleration of a securities contract, as defined in section 741 of this title, because of a condition of the kind specified in section 365(e)(1) of this title shall not be stayed, avoided, or otherwise limited by operation of any provision of this title or by order of a court or administrative agency in any proceeding under this title unless such order is authorized under the provisions of the Securities Investor Protection Act of 1970 or any statute administered by the Securities and Exchange Commission. As used in this section, the term ‘‘contractual right’’ includes a right set forth in a rule or bylaw of a derivatives clearing organization (as defined in the Commodity Exchange Act), a multilateral clearing organization (as defined in the Federal Deposit Insurance Corporation Improvement Act of 1991), a national securities exchange, a national securities association, a securities clearing agency, a contract market designated under the Commodity Exchange Act, a derivatives transaction execution facility registered under the Commodity Exchange Act, or a board of trade (as defined in the Commodity Exchange Act), or in a resolution of the governing board thereof, and a right, whether or not in writing, arising under common law, under law merchant, or by reason of normal business practice.

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Litigation over what contracts qualify What is a “repurchase agreement”? (American Home Mortgage) What is a “swap agreement”? (Lehman/Perpetual) What is a “securities contract”? (Madoff, MCK Millenium)

Timing of exercise Lehman (Metavante) – non-defaulting party must exercise safe

harbor rights “fairly contemporaneously” with the bankruptcy filing; cannot “time the market” by waiting to exercise safe harbor rights (e.g., to improve position).

Compare the UK approach: Firth Rixson and Carlton cases – can “time the market” and suspend performance until the contract expires.

Court Imposed Limits

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Setoff SemCrude – Triangular setoff (i.e., among multiple affiliates) is prohibited.

Only bilateral (debtor-counterparty) obligations may be set off. Swedbank – Prohibits setoff of pre-bankruptcy obligations against and

post-bankruptcy filing obligations.

“Flip clauses”

Lehman (Perpetual, Ballyrock) – Subordination of swap termination payments in indenture waterfall triggered by bankruptcy of swap counterparties is not enforceable.

Compare UK approach (Perpetual) – Enforceable.

Court Imposed Limits cont’d

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Measuring termination damages Lehman (Fifth Third) – Termination damages must be measured as of the

bankruptcy filing date, not the date the safe harbor termination rights are exercised.

Lehman (Michigan State Housing) – Safe harbor protects the agreed contractual method for measuring damages.

Clawback litigation “safe harbors” Bankruptcy cases routinely result in litigation to “claw back” prior payments

in LBOs, dividends, corporate restructurings, etc. (to be discussed later today).

Some courts have expansively interpreted a “settlement payment” safe harbor (11 U.S.C. § 546(e)) to protect a wide variety of payments on tradeable debt securities (Enron), securitized loans (MCK Millenium), and even Ponzi scheme payments (Madoff).

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Court Imposed Limits cont’d

Current Developments in U.S. and EU “Safe Harbors”

Broad regulatory themes of derivative regulation following GFC: Financial stability; Transparency; Clearing, execution, margin and capital for swaps and SFTs.

Regulatory Framework: United States:

Dodd-Frank Title VII and regulations of CFTC, SEC and bank regulators; Volcker Rule; Dodd-Frank Title I Orderly Liquidation Authority.

European Union: Regulation on OTC Derivatives, Central Counterparties and Trade Repositories

(“EMIR”); Bank Resolution and Recovery Directive (“BRRD”).

G20 focus: cross-border harmonization of resolution regimes.

Current Developments in U.S. and EU “Safe Harbors”

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Special Resolution Regimes A lesson of the global financial crisis was the need to address orderly

resolution of systemically important financial institutions. Many countries enacted special “special resolution regimes” (SRRs) to

permit relevant regulators to address imminent failures of “systemically important financial institutions” (SIFIs) without a taxpayer-funded bail-out.

Examples of Special Resolution Regimes EU: SRRs are being established in various member states under the EU

Bank Recovery and Resolution Directive (BRRD). US: Dodd-Frank Title I established the Orderly Liquidation Authority

(OLA) as an SRR for bank holding company and SIFIs. Elsewhere: SRRs are being established more generally pursuant to

recommendations of the Financial Stability Board.

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Current Developments in U.S. and EU “Safe Harbors” cont’d

The ISDA Resolution Stay Protocol Cross-border recognition of SRRs. Prevents adherents from immediately terminating covered master

agreements with affiliates of SIFIs in resolution, thus giving regulators time to resolve the troubled institution in an orderly way.

Section 1 provides for opt-in to SRRs of France, Germany, Japan, Switzerland, the UK and the US and certain other eligible jurisdictions.

Section 2 limits cross-default rights if a counterparty affiliate becomes subject to “ordinary” US insolvency proceedings other than an SRR.

“Hybrid modular” adherence model for non-dealers. Timeline

November 25, 2015 January 2016

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Current Developments in U.S. and EU “Safe Harbors” cont’d

Brokerage Assets: Securities & Collateral Custody

In prime brokerage, customers place their securities and cash in the custody of their prime broker.

Customers also post securities and cash collateral to their dealer counterparties. Examples: prime brokerage futures and options swaps securities lending repos (technically not “collateral”)

Brokerage Assets: Securities & Collateral Custody

What happens to these assets and how are they held? How do you protect their treatment in bankruptcy?

Answer: It depends. Key questions:

Who is your counterparty and what is its regulatory status in relation to the subject transaction?

What does the contract say?

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Brokerage Assets: Securities & Collateral Custody cont’d

Rehypothecation and Commingling Rehypothecation – the re-pledge of collateral (i.e., a party who receives

collateral re-pledges the same collateral to a third party) In prime brokerage context, permits the broker to lend out the collateral or

post as collateral for other purposes. Benefit: Broker can pass on lower funding costs to the customer. Drawback: In the absence of specific law or regulation, upon

rehypothecation, customer loses title to the asset and only has an unsecured claim for a return of the fungible equivalent of the asset (or fair market value thereof).

Commingling The commingling of customer funds and securities with assets of other

customers of the dealer or proprietary assets of the dealer.

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Prime Brokerage and Rule 15c3-3 Only applies to U.S. registered broker-dealers that have responsibility for

custody of funds or securities of customers. Requires broker-dealer to obtain and maintain physical possession or

control of all fully paid and excess margin securities. “fully paid securities” – securities that are purchased in transactions for

which the customer has made full payment. “excess margin securities” – Margin securities in a customer account are

those securities with a market value equal to or less than 140% of the customer’s debit balance (i.e., the amount the customer owes the broker-dealer). Excess margin securities are those securities with a market value greater than 140%.

Example: Customer buys $100,000 of securities on 50% margin (broker-dealer lends $50,000). The broker-dealer is permitted to re-rehypothecate 140% of $50,000 = $70,000. The remaining $30,000 must be segregated and held in safekeeping by the broker-dealer.

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Prime Brokerage and Rule 15c3-3 cont’d

Rule also restricts use of customer cash credit balances. Broker-dealer must maintain a reserve account for the exclusive benefit

of customers at a bank. Excess cash (the difference between cash provided by customers and

total amount extended by broker-dealer to finance customer transactions) must be on deposit in cash (or cash equivalents) in the reserve account. Failure to do so is a criminal violation.

The broker must periodically (usually weekly) re-compute this excess amount.

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Futures Collateral and FCMs When entering into a futures contract, the futures commission

merchant (or “FCM”) acts as merely the intermediary between the customer and the futures exchange/clearing house.

FCM may require customers to post collateral to secure their obligations under futures contracts.

Such requirements will be based on clearing house requirements. The FCM may also charge extra collateral based on house margin rules.

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Futures Collateral and FCMs cont’d

Clearing house mandated collateral is passed on to the clearing house. Excess collateral charged per house rules stays at the FCM.

For futures traded on U.S. futures exchanges: FCM must treat and deal with all collateral provided by a customer as being

the property of such customer. FCM must hold customer property in an account segregated from its own

assets. However, customer property may be held in an omnibus account holding assets of other futures customers of the FCM.

Such an account may be held at a bank or trust company, a clearing house or another FCM.

Customer property may not be used to margin or guarantee, or extend credit for the benefit of, any other person, including the FCM or another customer.

Customer property may be invested in cash equivalents. See Section 4d(a)(2) of the Commodity Exchange Act and Rule 1.20

thereunder.

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Swap Collateral Prior to passage of the Dodd Frank Wall Street Reform and Consumer

Protection Act, all swap agreements were bilateral and privately negotiated over-the-counter (OTC) transactions.

Post Dodd-Frank, many swaps are now executed on multilateral swap execution facilities and subject to central clearing.

However, a large portion of the swaps market is still un-cleared. Currently, there are no limitations on constraints on what your

counterparty may do with variation margin provided under an un-cleared swap—can be freely rehypothecated, commingled, etc. if the contract permits it.

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Swap Collateral cont’d

With respect to initial margin, any end-user has the right to request a swap dealer counterparty to segregate initial margin at a tri-party custodian.

Right does not apply to variation margin. Proposed rules by the prudential regulators, the SEC and the CFTC

would mandate certain required terms for un-cleared swaps. For uncleared swaps between swap dealers and certain “financial end users” with “material swaps exposure” (more than $3 BN in notional), swap dealers would be required to collect initial margin and such initial margin would be required to be posted at a tri-party custodian.

Cleared swaps: For cleared swaps, the collateral regime is substantially different and based on a model similar, but not identical, to the futures regime.

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What do the contracts actually say? Rehypothecation

Does the contract expressly permit rehypothecation? Are you consenting to it? Who is permitted to rehypothecate (who is “we”)? Which collateral is permitted to be rehypothecated? Is right to rehypothecate subject to compliance with applicable law?

Inter-affiliate transfers & cross-collateralization What obligations are being secured? Who are the secured parties? Does the contract permit the dealer to transfer your collateral to affiliates? Are

there any limitations on their ability to do so? Will you be notified in advance? Does the contract expressly stipulate that collateral may be moved overseas?

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Collateral Account Control Agreements General purpose of account control agreements: Perfection under

Articles 8 and 9 of the UCC. Custodial liens and set off rights. What happens if the secured party goes bankrupt?

Lehman and pledgor access provisions. Are the assets in the controlled account customer property? Are the assets property of the bankruptcy estate?

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What happens in a counterparty bankruptcy? Which Bankruptcy Regime Governs

U.S. non-brokers: U.S. Bankruptcy Code (Chapter 7 or 11). Foreign non-brokers: Parallel insolvency proceeding (e.g., UK or Caymans

– Joint Administration proceeding). U.S.-registered broker-dealers: Securities Investor Protection Act (SIPA)

liquidation. U.S.-registered FCMs: Commodity broker liquidation under U.S.

Bankruptcy Code (Subchapter IV). Non-registered brokers in a U.S. case; Stockbroker liquidation under U.S.

Bankruptcy Code (Subchapter III). Financial institution: Receivership in federal or state court. The new FDIC-led “Orderly Liquidation Authority” (OLA) for large financial

companies (“SIFIs”) under the Dodd-Frank Act. Foreign “Special Resolution Regimes” (SRRs) similar to OLA.

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Counterparty bankruptcy cont’d

U.S. non-broker bankruptcies Claims for collateral are unsecured. Exception: perfected liens under UCC Articles 8 & 9 (e.g., control accounts with

3rd party custodians). Foreign non-brokers

Depends on the foreign jurisdiction bankruptcy treatment. Broker-dealer SIPA liquidation

Main goal is prompt transfer of customer accounts to solvent broker-dealer. For untransferred accounts, the net balances in securities accounts have

“customer” priority, paid pro rata out of pool of recovered customer assets. All other claims are general unsecured claims. Any contract terms expressly subordinating one’s right to custodial assets results

in an unsecured claim. Claims for account balances that are not related to securities trades are

unsecured: e.g., OTC repos, securities lendings, TBAs, uncleared swaps, foreign currency, etc.).

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Broker-dealer SIPA liquidation cont’d

Who is a “customer” has been heavily litigated. Lehman: TBAs, repos, swap collateral

FCM bankruptcies Main goal is prompt transfer of customer accounts to a solvent FCM. Similar to SIPA treatment: “customers” take priority over general unsecured

claims. With a twist: “customer” assets for different FCM products are pooled in

different buckets (“account classes”): futures accounts, foreign futures accounts, leverage accounts, delivery accounts and cleared swap accounts.

If “account classes” were commingled pre-bankruptcy, they remain commingled for bankruptcy purposes. MF Global: two pools of customer property: (1) domestic (U.S.) trades (the “4(d)

Estate”); and (2) foreign trades (the “30.7 Estate”).

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Non-registered brokers in a U.S. bankruptcy Relatively rare: e.g., Refco offshore prime broker affiliate filed for bankruptcy

in the U.S. Similar to SIPA treatment: “customers” take priority over general unsecured

claims. U.S. financial institutions

Federal or state court receivership or conservatorship. FDIC-led for any FDIC-insured financial institutions. Main goal is prompt transfer of accounts to a stable financial institution. Any remaining assets are distributed under FDIC supervision.

“SIFIs” under an FDIC Orderly Liquidation Authority (OLA) proceeding FDIC-led receivership; shared with SIPA if the SIFI is a broker-dealer. Bank subsidiaries are subject to a standard FDIC receivership. Main goal is a quick sale to a third party or bridge financial company. FDIC administers claims against untransferred assets (similar to Chapter 7).

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Treatment of State Law “Series” Entities in Bankruptcy

What is a “Series” LLC?

A single legal entity with separate classes or “series” of assets, liabilities, managers, investors (members). See DEL. Code Ann. Tit. 6, Section 18-215.

Each series can have common or separate investors, managers, and business purpose.

Assuming that record keeping, accounting and governance are correctly handled to maintain the objectively separate nature of each series, liabilities incurred by one series will not be imposed on any other series or asset.

Delaware series LLC statute brings DE law into line with other jurisdictions that have segregated portfolio companies, e.g. Luxemburg and Cayman Islands.

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Flexible Structure

Very flexible. Can be used to: Protect the operations of one unincorporated division of the same

business from the liabilities and business risks of other divisions (e.g. segregating the manufacturing division from the service and sales division of a single business).

Segregate, raise capital for and warehouse different pools of assets. Examples include registered and unregistered funds, real estate

businesses and securitization transactions.

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What Are the Risks of Doing Business With a Series LLC?

Using a Delaware series LLC as an example, the risk for lenders and investors should be no greater than doing business with any other LLC that operates as one member of a corporate family. However, because the DE statute is permissive, allowing a series LLC

to own assets in its own name, rather than at the individual series level, there is room for “mischief” in the administration of the business.

Is an individual series eligible for bankruptcy relief? Maybe.

Will the separation of series within a series LLC be respected in bankruptcy or will they be consolidated?

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Structured Finance Transactions

Securitizations: The Formalities Matter, Deeply

Overview of Securitization

Securitization is a financing technique whereby a company transfers rights in receivables to a special purpose vehicle, which issues securities to capital market investors and uses the proceeds of the issuance to pay for the financial assets.

Highly rated fixed income securities are issued that are backed by and paid from payments received on the asset pool.

Credit enhancement is provided by overcollateralization, subordination and third party guarantees.

De-linked from most credit risk of originator or sponsor: Bankruptcy-remote structure. Nonconsolidation and true sale legal opinions. Accounting sale / deconsolidation under FAS 166 and 167.

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Originator

Overview of Securitization

Bank lender

Depositors Capital Markets SPV

Bankruptcy remote

Payment obligation

Funding

Payment obligation

Disintermediated Funding

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Current Developments in the U.S. and EU

Enhancements to disclosure and structures EU: Proposed EU Securitization Regulation. Simple, Transparent Securitization Standards. Risk Retention. U.S.: Regulation AB amendments.

Due Diligence Requirements Rule 193 and Section 15E. Risk Retention – Rule 15G effective 24 December 2015.

Credit Risk Retention Majority-owned affiliates vs. originators. Asset classes. Interplay of accounting and legal considerations.

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Special Purpose Entities (SPEs): “Bankruptcy-remote" is not “Bankruptcy-proof”

Special Purpose Entities: Why so special?

Special Purpose Entities defined: A legal entity whose operations are limited to the acquisition or

financing of specific assets or gaining exposure to specific liabilities. Not an “operating company.” Typically created at the direction of a sponsoring firm (a “sponsor,”

“originator” or “seller”). Common SPE Structures

Project Finance. Synthetic Leases. Securitization SPEs.

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Special Purpose Entities: Why so special? cont’d

Motivations From the perspective of investors:

Legal isolation of assets held by the SPE from the assets of the originator/sponsor - returns are linked solely to asset/pool of assets in the SPE, and not to anything else.

Ability to create structured credit - repackaging of risks and returns on one or more instruments into a single instrument.

Creditors of the sponsor cannot reach the SPE’s assets. Bankruptcy or insolvency of sponsor won’t affect SPE.

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Motivations cont’d

From the perspective of sponsors: Creditors of the SPE cannot reach the sponsor’s assets. Performance of SPE will have no financial effect upon sponsor. Off balance sheet accounting treatment.

Removal of liabilities e.g., operating leases. Rather than borrow (and incur a balance sheet liability), lease the asset from an SPE.

Removal of assets and capital relief - by selling risk-weighted assets to the SPE, a financial institution such as a bank can improve its capital or leverage ratio.

Funding source - e.g. ABCP conduits, SIVs and the like. Risk management - transfer of risks associated with assets sold to the SPE,

in whole or in part.

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Structuring Limit by covenant the business of the SPE to its essential functions. Prevent incurrence of other debt or liabilities. Insert corporate separateness covenants into organizational

documents. Observe corporate formalities. Limited recourse provisions. Non-petition provisions. Retain independent directors and officers. Obtain true sale and non-consolidation opinions—more on that to

come.

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“Bankruptcy-Remote” is not “Bankruptcy-Proof”

General Growth Properties and the use of independent directors.

ZING VII and the role of non-petition provisions.

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Legal Opinions: Why the Bankruptcy Lawyers are such Pains-in-the-A**

Bankruptcy Legal Opinions (“True sale” and “Non-consolidation”): Why are they needed?

Accounting protection: Ensuring “off-balance-sheet” treatment for sold receivables or other

securitized assets. U.S. accounting standards (FASB 140/ASC 860) require “legal isolation”

of the assets. (International standards (IFRS) are somewhat different.) Transaction protection:

Additional third-party “insurance” (from a law firm) to ensure “bankruptcy remoteness” has been vetted.

This is why law firms write 30-plus page opinions with a few sentences of opinion.

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Bankruptcy Legal Opinions (“True sale” and “Non-consolidation”): Why are they needed? cont’d

Bankruptcy risks: The transferring entities (i.e., that sold the assets to the SPEs) may go

into bankruptcy. Their underwater creditors – especially the Unsecured Creditors

Committee – may investigate any prior SPE transfers, and may try to either: (1) Recharacterize them as secured loans; or (2) “Substantively consolidate” an SPE – i.e., pool the SPE’s assets and

liabilities with those of the debtor companies.

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Bankruptcy risks cont’d

If recharacterized as secured loans: The automatic stay applies, freezing SPE transfers. SPE assets are considered collateral pledged by the transferring debtor entity

– i.e., effectively pooled with the debtor’s bankruptcy estate. SPE beneficiaries are treated as secured creditors, with their collateral claims

valued as of the bankruptcy filing. Any deficiency claims are unsecured bankruptcy claims.

Their secured claims will have to await bankruptcy plan treatment.

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Bankruptcy risks cont’d

If an SPE is “substantively consolidated”: All of the SPE’s assets and liabilities are pooled with those of the debtor

companies. SPE beneficiaries become creditors of the pooled bankruptcy estate. Since substantively consolidation is rarely granted and usually based on

failure to observe formalities, the status of SPE beneficiaries as secured creditors is possibly at risk.

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“True sale” Opinions – The Elements

Based on lawyers’ review of all transaction docs. Backed by fact certificates of corporate officers of the transferor and

the SPE (if related). Main factors:

Intent of parties to effect a sale. Transfer of the risk of loss. Transfer of the benefits of ownership. Adequacy of price. Retention of control over transferred assets.

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“True sale” Opinions – Problem Areas

Buyer’s recourse rights Generally limited to breached reps & warranties. Cannot recover for post-sale credit events: i.e., an underlying obligor’s

later payment default . Seller’s residual interest.

Seller should not retain any direct economic interest in the sold assets – including any option (“call right”) to buy assets back other than in SPE’s discretion at FMV.

Retained servicing Servicing at market-rate compensation is acceptable. Commingling with seller or servicer cash is dangerous.

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“Non-consolidation” Opinions – The Elements

Based on lawyers’ review of all transaction docs. Particular focus on organizational documents of transferring entities and

SPE. Also backed by fact certificates of corporate officers of the transferor

and the SPE (if related). Main factors:

Org doc restrictions on SPE’s permitted business. Standard SPE separateness covenants. No evidence of commingled assets or liabilities. No evidence of SPE guarantees of company debt.

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“Non-consolidation” Opinions – Problem Areas

No protection against subsequent events Legal opinions carefully limit themselves to the transaction and

organizational docs, and to the facts certified to them as of closing. Corporate practices

Substantive consolidation, relatively rare, results when companies ignore formalities required by the docs.

Examples: Failure to observe corporate formalities (e.g. minute books). Commingled or centralized cash. Poor record-keeping: failure to mark assets as SPE-owned. Blurred branding: failure to distinguish SPEs to “the public”.

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Corporate Restructurings: Spinoffs, LBOs & Debt Restructuring

Fraudulent Transfers: Why the Bankruptcy Lawyers are such Pains-in-the-A**

Leveraged Transactions: Fraudulent Transfer and Other Risks

Highly leveraged transactions can be unwound, “clawed back” or avoided as a fraudulent transfer, ordinarily for a period 4 or 6 years after the transaction occurs (depending on the state in which the transaction is deemed to occur).

Other risks include claims against officers and directors for breach of fiduciary duty, or for making illegal dividends.

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Fraudulent Transfer Risk

Two types of fraudulent transfers 1. Transfers done with the actual intent to hinder, delay or defraud

creditors; 2. Transfers done for less than reasonably equivalent value at a time

when the transferor was insolvent or was rendered insolvent or undercapitalized.

These are known as “constructively fraudulent” transfers.

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Real World “Clawbacks”

Dividend Recapitalizations (Asarco, Renco)

Spin-Offs (Tronox/Anadarko)

LBO’s (Tribune and Lyondell)

Debt Restructurings (Global Crossing, Caesar’s Entertainment, Dynegy)

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Practical Approaches

Practical Lessons

Governance of highly levered corporate families Independent Directors and Special Committees.

Separate counsel for insolvent affiliates. All subsidiaries must be evaluated as separate businesses. Document the adequacy of consideration given in exchange for

property transferred or contractual undertakings. Evidence of solvency or adequate capitalization.

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Skanthan Vivekananda Partner, Investment Management, Hedge Funds and Alternative Investments +1.617.951.9074

[email protected]

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Chad Dale Partner, Restructuring & Insolvency

+1.617.261.3112

[email protected]

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Robert Honeywell Counsel, Restructuring & Insolvency

+1.212.536.4863

[email protected]

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Anthony Nolan Partner and Practice Area Leader, Finance

+1.212.536.4843

[email protected]

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Stephen Moller Partner, Banking & Asset Finance

+44.(0)20.7360.8212

[email protected]

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