Derivatives Don't Cause Massive Losses. Only People Cause Massive Losses.

Such was the thrust of testimony before a Senate committee this week by Robert Pickel, head of the International Swaps and Derivatives Association (ISDA), and Richard Lindsey, former president of Bear Stearns' brokerage unit, regarding the role of credit default swaps (CDSs) in the current economic crisis. Said Lindsey,

"[R]isks [are] not created by derivatives. They [are] created by
individuals or corporations making bad choices when using derivatives."

Given recent events, perhaps it would be churlish to point out that derivatives, particularly when combined with massive leverage, can magnify and concentrate the effect of those bad choices (as the travails of AIG have amply demonstrated). Regarding CDSs, "Black Swan" author Nassim Taleb noted this week,

"We refused to touch credit default swaps. It would be like buying
insurance on the Titanic from someone on the Titanic."

Even as TARP has morphed from an asset purchase program to a recapitalization plan, financial market turmoil and volatility remain unabated. Many observers blame the fear that continues to grip the financial world on the dawning realization of the threat posed by the $62 trillion (by some accounts) CDS market. The exponential growth of the CDS market over the past few years, its opacity and lack of regulatory control, and the fear of counterparty risk in the wake of Lehman's failure have made CDSs the latest instrument to raise the spectre of further massive losses at financial institutions and hedge funds. As investors, politicians and regulators cast about for root causes of the current crisis and steps that need to be taken going forward, a harsh light is being shone on CDSs.

CDS proponents are pushing back. Messrs. Pickel and Lindsey, while conceding the need for some changes in the market (such as a central clearing house for trades), reject the notion that direct government oversight of the market is necessary or appropriate. Similarly, The Depository Trust and Clearing Corporation issued a statement last week that strongly disputed the size and opacity of the CDS market, claiming that the $62 trillion notional value amount represents double counting (i.e., adding in both sides of a single trade), and that the real number is approximately $35 trillion. The DTCC also takes issue with the potential losses that will result from Lehman's bankruptcy. While some analysts have that predicted total losses arising from protection sold against a Lehman default could be as high as $400 billion, the DTCC contends that virtually all of the Lehman trades will net out, and that required payouts will not exceed $6 billion.

We will find out very shortly who is correct. The financial markets are now directly confronting the concerns raised months ago in this space (and many others). An auction conducted last week by ISDA produced a settlement price for Lehman debt of less than ten cents on the dollar, which means that Lehman protection sellers must pay their counterparties over 90% of the par value on the underlying bonds. Did protection sellers properly hedge their risks by buying protection coextensive with their potential exposure? If they did, will their counterparties be able to make good?

Settlements are required to be made next week, on October 21st. After that, the financial markets can begin to focus on the potential impact of the WaMu CDSs. That settlement auction is scheduled for October 23rd.

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Perils of Paulson

Henry Paulson and Ben Bernanke may be escaping from the precipice of one horrific calamity, only to be breathing a sigh of relief just as an even worse catastrophe looms. The plan to buy distressed mortgage related assets and derivative products, referred to by some as TARP (the Troubled Asset Relief Program) and by others as MOAB (the Mother of All Bailouts), may provide some short term relief to the global financial markets, which perhaps will suffice to head off greater disaster. However, putting aside the concerns raised regarding the wisdom and efficacy of the proposal, the larger question remains as to how to mitigate the threat posed by the still-completely-unregulated $62 trillion credit default swap market.

As discussed in this space before, a credit default swap (CDS) is a swap agreement whereby the holder of debt may purchase protection from a third party against the debt issuer's default. The seller thereby takes on the credit risk of the issuer, and the buyer replaces the credit risk with counterparty risk. As CDSs have evolved from hedging devices into speculative instruments (buyers making short bets without actually owning the underlying debt), the market has grown exponentially. The perils posed by such rapid growth in an unregulated over the counter market were fast becoming apparent last year. Several months ago, I wrote:

Given both the immense size of the CDS market and how poorly risk in other asset
classes was assessed and priced over the past several years, CDS counterparty
risk is accurately being called the "sword
of Damocles" hanging over the financial services industry. The term
"counterparty risk" will likely soon move alongside "subprime borrower" as a
disquieting addition to the financial lexicon.

Fear of exposure to the CDS market led to the Federal Reserve's willingness to backstop in part the JP Morgan takeover of Bear Stearns and the rescue of AIG. Lehman Brothers was permitted to fail because its CDS exposure appeared to present less of a systemic threat.

CDS market participants and the International Swaps and Derivatives Association have been working for months to increase transparency and reduce counterparty risk. As of today, there are no standardized settlement procedures, and the market has never been forced to deal with a major default. The obvious need is for the creation of a central exchange. Unfortunately, the development of such a clearing system will probably not be in place until early 2009.

In the meantime, it is anyone's guess where the major fault lines lie. The bailout of Fannie and Freddie triggered "credit events" under an unprecedented number of CDS contracts – as much as $1.4 trillion by some estimates. However, because the conservatorship effectively assures full payment of the underlying Fannie/Freddie debt, the settlement amounts on the trades (the difference between par and market value that the CDS seller owes to the CDS buyer) should be $0. Accordingly, there will be relatively little economic impact as the major market participants seek to sort this all out.

The financial markets may not be so lucky the next time a company whose debt is the subject of over $1 trillion in CDSs goes into default. If, for instance, one of the Big Three automakers were to seek bankruptcy protection, its bonds will almost certainly be worth substantially less than par, and the settlement amounts owed by CDS sellers to CDS buyers could be overwhelming. While most trades will net out, the failure of a financial institution or hedge fund to make good on its obligations as a protection seller could trigger another financial crisis equal in scope or greater to what has been faced over the past two weeks.

It also gives rise to the even more unsettling possibility that the government may be forced to step in and prevent such a major bankruptcy filing. The perils continue. TARP / MOAB may be just the beginning.

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Supreme Court Narrowly Construes State and Local Tax Exemption for Asset Sales in Chapter 11 Proceedings

On June 16, 2008, the United States Supreme Court, in Florida Dept. of Revenue v. Piccadilly Cafeterias, Inc., Case No. 07-312, held that a bankruptcy court may not exempt a debtor from state transfer taxes on the sale of its assets prior to confirmation of its Chapter 11 plan. In a 7-2 decision, the Court reversed the order of the Bankruptcy Court for the Southern District of Florida (the “Bankruptcy Court”), which applied Section 1146(a) of the U.S. Bankruptcy Code, formerly designated as 1146(c) prior to the enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, to exempt Piccadilly Cafeterias, Inc. (“Piccadilly”), from documentary stamp taxes imposed by the Florida Department of Revenue (“Florida”), on the sale of substantially all of its assets through a public auction. The holding is anticipated to affect billions of dollars in state tax revenue collection, and it will have a significant impact on creditors of corporate debtors that elect to dispose of their assets in pre-confirmation sales under Section 363 of the Bankruptcy Code.

Pre-confirmation asset sales under Section 363 of the Code are common in Chapter 11 cases, and the trend toward such sales has grown stronger over the last few years. However, the Section
1146(a) tax exemption has not been uniformly applied. Section 1146(a) provides as follows:

The issuance, transfer, or exchange of a security, or the making or delivery of
an instrument of transfer under a plan confirmed under Section 1129 of this
title, may not be taxed under any law imposing a stamp tax or similar tax.

Piccadilly sought approval from the Bankruptcy Court for the sale of its assets prior to confirmation of its Chapter 11 plan, over Florida’s objection for nonpayment of taxes. The Bankruptcy Court, following the reasoning of courts in the Second Circuit, interpreted the exemption on a “transfer under a plan confirmed,” to include asset sales preceding confirmation of a Chapter 11 plan, so long as necessary to confirmation of the plan, and held that the sale under Section 363 of the Code was exempt from the imposition of Florida’s documentary stamp tax. On appeal, both the District Court for the Southern District of Florida and the Eleventh Circuit Court of Appeals affirmed the Bankruptcy Court’s order.

Courts in the Third and Fourth Circuits had taken a different view, interpreting Section 1146(a) to apply solely to transfers effectuated through a confirmed plan. These courts have held that Congress intended to provide exemptions only for transfers “reviewed and confirmed by the court,” and thus a transfer “under a plan confirmed” contemplates only those transfers occurring after the date of confirmation.

The Supreme Court granted Florida’s petition for a writ of certiorari in order to resolve the disparity among the circuits. Florida argued in support of its appeal that the plain language of Section 1146(a) provides for a limited exemption from stamp and similar taxes on post-confirmation transfers made under the authority of a confirmed plan, and asked the Court to interpret Section 1146(a) as setting forth a simple bright-line rule.

On the other hand, Piccadilly advocated the conclusion that Section 1146(a) applies to pre-confirmation transfers that are “instrumental” to consummation of a Chapter 11plan. Piccadilly argued that the text of Section 1146(a) is ambiguous and the intent of the provision, as well as the Chapter 11 structure, is best carried out by a broader interpretation of its application.

Ultimately the Court was swayed by Florida’s argument that §1146(a) exempts only those transfers made pursuant to a Chapter 11 plan that has been confirmed. The Court held that this interpretation was “ [t]he most natural reading of §1146(a)’s text, the provision’s placement within the Code, and applicable substantive canons.” The Court particularly noted that “recognizing an exemption from state taxation that Congress has not clearly expressed” would offend fundamental principles of federalism.

This decision is unlikely to significantly deter the current trend of pre-confirmation Section 363 sales. However, while the ruling substantially benefits the tax collection efforts of state and local government authorities, it will impede the recovery efforts of unsecured creditors, who already generally receive significantly less than they bargained for when a company liquidates through Chapter 11.

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More on Hedge Funds and the U.S. Bankruptcy Process

Bear Stearns Funds

The denial of recognition under Chapter 15 of the Bankruptcy Code of the Cayman Islands liquidations of the Bear Stearns High-Grade Structured Credit Strategies Master Fund and the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Master Fund (the "Funds") was affirmed last week. Judge Robert Sweet of the U.S. District Court for the Southern District of New York affirmed the decision last September of Bankruptcy Judge Burton Lifland that the Funds' centers of main interest (COMI) were in the United States, rather than the Cayman Islands. Although there was no opposition to the requested relief, Judge Sweet strongly validated Judge Lifland's view that the Joint Official Liquidators of the Funds failed to meet their burden of establishing the Funds' COMI outside of the United States.

Many hedge funds are domiciled outside of the United States. For such a fund that fails, commencing a case in its jurisdiction of formation, and then utilizing Chapter 15 of the Bankruptcy Code to protect assets located in the U.S., can offer a flexible, lower-cost alternative to the commencement of a Chapter 11 case. However, what may be in the best interests of a fund's sponsors and managers may not coincide with the interests of its investors and creditors. Considering the substantial amounts (nearly $2 trillion) currently entrusted to hedge funds, Judge Sweet aptly noted:

The process by which the financial problems of insolvent hedge funds are resolved appears to be of transcendent importance to the investment community and perhaps even to the society at large.

For now, it is clear that the parties entrusted with the liquidation of such funds will need to establish that the fund's business is truly centered outside of the U.S. (or, at the very least, that it has significant operations outside of the U.S.). Otherwise, they will need to resort to the more burdensome requirements of a Chapter 11 case.

Rule 2019 Disclosure

Rule 2019 of the Federal Rules of Bankruptcy Procedure requires certain disclosures by "every entity or committee representing more than one creditor or equity security holder[.]" As noted in an earlier post, the question of whether Bankruptcy Rule 2019 can be used to require members of ad hoc committees (which often consist of hedge funds) in Chapter 11 cases to disclose the amount that they paid to acquire their claims or interests remains a very hot issue right now. For a hedge fund, such information can be tantamount to disclosing a proprietary trading strategy. Unquestionably, some debtors and other interested parties are requesting such disclosures as a way to seek to neutralize aggressive groups of hedge funds.

Last year, in the Northwest Airlines case, SDNY Judge Alan Gropper held that a group of hedge fund equity holders represented by common counsel constituted a "committee" for purposes of Rule 2019. The equity holders were therefore required to provide information setting forth "the amount of claims or interests owned by the members of the committee, the times acquired, the amounts paid therefor, and any sales or dispositions thereof[.]" Judge Richard Schmidt in the Pacific Lumber Chapter 11 case subsequently reached the opposite conclusion on this question, and refused to require an ad hoc group of bondholders to disclose details of their trades of Pacific Lumber debt securities.

Judge Kevin Carey in the highly influential Delaware bankruptcy court has now weighed in. Ruling on a Rule 2019 request in the Sea Containers Chapter 11 case, Judge Carey agreed that the ad hoc bondholders did constitute a "committee" for purposes of Rule 2019. However, he did not require disclosure of the amounts paid in specific trades. The outcome is probably a positive one for the Sea Containers bondholders, but will almost certain engender more Rule 2019 disclosure requests in other major Chapter 11 cases.

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The Secretive Nature of Hedge Funds vs. the Open, Public Process of Bankruptcy in the U.S. - An Update

Judge Robert Gerber of the U.S. Bankruptcy Court for the Southern District of New York signed an order yesterday dismissing the Chapter 15 case of Basis Yield Alpha Fund. The dismissal was made at the request of the Cayman Island Joint Provisional Liquidators (JPLs) of the Fund, following Judge Gerber's refusal to recognize the Fund's Cayman liquidation proceeding as a "foreign main proceeding" under Chapter 15 of the U.S. Bankruptcy Code.

As described in an earlier post on this site, the Fund commenced the Cayman liquidation proceeding in August, 2007 and the JPLs shortly afterwards filed a petition for recognition under Chapter 15 in the Southern District of New York. Although no objections to the requested relief were made, Judge Gerber denied Chapter 15 recognition to the Fund, citing an absence of evidence sufficient to convince the court that the Fund's "center of main interest" (COMI) was in fact in the Caymans. The JPLs were subsequently directed to show detailed information not only about the Fund's assets, creditors and employees, but also the number and location of the Fund's equity investors and the relative percentages of the applicable equity that investors in each locale hold. Rather than presenting the information requested, the JPLs contended in a subsequent motion that, as a matter of law, the Fund was entitled to recognition in the Caymans, citing a provision of Chapter 15 that sets forth a presumption that a petitioning debtor's COMI is based on the location of its registered office. Judge Gerber disagreed, however, and reiterated his request for the information. The JPLs instead asked to have the case dismissed.

The struggle to reconcile the often secretive nature of hedge funds with the open process mandated by the U.S. Bankruptcy Code has been building for some time. The issue of whether Bankruptcy Rule 2019 can be used to require members of ad hoc committees (which often consist of hedge funds) in Chapter 11 cases to disclose the amount that they paid to acquire their claims or interests remains highly contentious. Last year, Judge Alan Gropper in the Northwest Airlines case and Judge Richard Schmidt in the Pacific Lumber case reached opposite conclusions on this question. Now, Judge Kevin Carey in the highly influential Delaware bankruptcy court is expected shortly to issue a ruling on a Rule 2019 request in the Sea Containers Chapter 11 case.

The proliferation of credit default swaps (CDSs) will likely accelerate this controversy. For example, in an attempted out of court workout or restructuring, if certain debt holders have hedged their exposures to the borrower through the purchase of CDSs, their interests may well be better served by the failure of the negotiations and the commencement of a bankruptcy case, particularly if the CDSs were set to expire. Although it is arguable that Rule 2019 and other current disclosure requirements, under both the Bankruptcy Code and Rules and applicable non-bankruptcy laws, are inadequate to address this dynamic, as CDSs are contractual agreements with third parties and not claims against the debtor, it is unlikely that bankruptcy courts are going to stand by passively if they believe that a creditor has a greater interest in seeing a troubled enterprise fail than succeed. The battles so far over the scope and purpose of Rule 2019 will probably seem like minor skirmishes, as compared to the fights that will take place regarding disclosure with respect to CDS positions.

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A Clearing House For CDS Trades?

Deutsche Bank and other investment banks are evidently considering plans to develop a clearing house for credit default swap trades. The $62 trillion market (up from less than $2 trillion in 2002) has given rise to substantial fears of "counterparty risk," particularly in the wake of the near bankruptcy of Bear Stearns. Because these trades are unregulated, there is no way of knowing at this time how many, and to what extent, banks, funds, and other investors are going to be exposed to CDS payment demands. Of equal concern are the exposures of the CDS buyers who believe themselves to be properly hedged against specified losses (not the least of which, for many large institutions, are their positions as CDS sellers that they prudently sought to match), but who may instead find their protection to be worthless because of their counterparty's inability to pay.

Given both the immense size of the CDS market and how poorly risk in other asset classes was assessed and priced over the past several years, CDS counterparty risk is accurately being called the "sword of Damocles" hanging over the financial services industry. The term "counterparty risk" will likely soon move alongside "subprime borrower" as a disquieting addition to the financial lexicon.

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Court: Fairness Opinions Are Not Insurance Policies

Just in time for the current business cycle downturn comes an important decision, whose genesis lies at the heart of the previous one. In a recently issued opinion, the U.S. Court of Appeals for the Seventh Circuit determined that an investment bank that provided a fairness opinion in support of a disastrous merger during the height of dot-com mania had no duty or obligation to rescue a client from its own foolishness.

The facts underlying the ill-fated acquisition read almost as a parody of deal-making at the peak of the tech stock bubble. In the spring of 2000, HA-LO Industries, Inc. (the "Purchaser"), a company with real products and services, went deeply into debt to purchase an internet startup company that had no revenues and a burn rate of $3 million a month (the "Seller") for $240 million in cash and stock. Unsurprisingly, the Seller's promised technology never bore fruit, and the Purchaser was forced to file for bankruptcy. Even less surprisingly, the Purchaser's creditors (via a liquidation trust (the "Trust)) cast about for someone to blame, and (no surprise at all) focused on the investment banker that advised the Purchaser's management and provided a fairness opinion (the "Advisor").

The Trust assayed two basic lines of attack in an effort to establish that the Advisor had acted with "gross negligence." First, it argued that the Advisor should not have relied on the revenue projections provided by the Purchaser's management. (The parties stipulated that the Purchaser's CEO knew that the revenue projections based on the acquired technology were "wholly speculative" and false.) The Advisor's engagement letter and the fairness opinion itself both stated that the Advisor was relying upon the Purchaser's revenue projections and that it was not independently verifying such numbers. The court succinctly disposed of the Trust's contention:

[It is] impossible to label as "grossly negligent" [the Advisor's] decision to do what the contract required it to do: use the figures and projections furnished by its client. (emphasis in original)

As the court observed, the financial markets rely on accounting firms, rather than investment banks, to be number verifiers, and it declined to consider imposing liability for the Advisor's failure to undertake a task that it neither had contracted to undertake nor should reasonably have been expected to perform.

Next, the Trust noted the precipitous drop in the equity markets between the time that the opinion was given and the time the transaction closed. The Advisor's opinion was dated January, 17, 2000. The NASDAQ index peaked in March, 2000, and had dropped precipitously by the time that the transaction closed on May 2, 2000. The Trust argued that the Advisor should have withdrawn its opinion (or issued a new one). The court disagreed:

The Trust's assertion that [the Advisor] should have foreseen the end of the dot-com boom is an appeal to hindsight . . . Inability to see the future differs from "gross negligence."

The court again noted that the Purchaser contracted with, and paid, the Advisor to provide a single opinion as of a specific date. It declined to replace the specified contractual obligations with "a set of duties" derived from tort law.

This case should be closely considered by investors that look to purchase the debt of companies that are in financial distress or that have filed for bankruptcy. Such debt is often bought for mere pennies on the dollar with the hope that value can be extracted from the remnants of the enterprise after senior creditors are paid. Not uncommonly, the only sources of recovery are causes of action that the debtor's estate may assert against healthy third parties, such as former professional advisors. However, the mere fact of financial failure does not mean that a party (other than the debtor) can be properly blamed.

Judge Easterbrook of the Seventh Circuit neatly encapsulated the essence of the case:

This suit is nothing but an attempt to find a deep pocket to reimburse investors for the costs of managers' blunders . . . But [the Advisor] did not write an insurance policy against managers' errors of business judgment.

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A Big MAC (cont'd): Solutia and its Lenders Step Back From the Abyss

Solutia and the lenders that committed to fund its exit from Chapter 11 have reached a settlement. After making some changes to the financing terms, the lenders, led by Citigroup, have agreed to drop their contention that a material adverse change (MAC) had occurred in the loan syndication markets. As described in an earlier post, such an adverse change, under the terms of the commitment letter, would have obviated the lenders' obligation to lend.

In the end, following a three day evidentiary hearing held less than a month after the commencement of the suit, both sides stepped back from the brink before Judge Prudence Beatty of the U.S. Bankruptcy Court for the Southern District of New York issued her ruling. Judge Beatty had not appeared to be too receptive to Solutia's contention that the so-called "market MAC" provision was somehow not valid because it was mere "boilerplate" language that had never been enforced. On the other hand, she seemed skeptical of the lenders' contention that, as bad as the loan syndication market is currently, it has "materially" worsened since the commitment letter was executed in late October.

Neither side could afford to risk an adverse ruling. For Solutia and its stakeholders, a painstaking reorganization that took four years to reach hung in the balance. For the lenders, facing substantial exposures from huge commitments entered into during 2007's halcyon days that cannot be sold in the current market environment, the best outcome clearly was to obtain some concessions to make this deal less painful and to preserve their legal arguments for another day.

This interlude succinctly encapsulates the current turmoil in the financial markets. Indeed, putting aside the pure legal question of whether a "material adverse change" had in fact occurred, the plain fact that Citigroup and the other lenders, Deutsche Bank and Goldman Sachs, were willing to bear the reputational risks of invoking a rarely used provision to back out of a firm lending commitment speaks volumes about the current lending environment.

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A Big MAC

Yes, the leveraged loan market is highly troubled right now. But has it changed so dramatically from this past late October as to justify a failure to fund a loan commitment made at that time? This is the $2 billion question right now in the Chapter 11 case of Solutia, which has had its plan of reorganization confirmed but whose exit from bankruptcy is now in jeopardy.

Solutia's prospective lenders, led by Citigroup, Deutsche Bank and Goldman Sachs, provided Solutia with a commitment letter dated October 25, 2007 for loans aggregating up to $2 billion to fund Solutia's obligations under its Chapter 11 plan and provide it with post-bankruptcy working capital. The lenders expressly agreed that the commitment was not conditioned on their ability to syndicate the loans. However, the letter did contain (typically) "material adverse change" (MAC) language regarding Solutia's business and (far less typically) a so-called "market MAC", i.e., a provision that excuses the lenders from performing if there has been "any adverse change . . . in the loan syndication, financial or capital markets generally that, in the reasonable judgment of [the lenders], materially impairs syndication of the Facilities[.]"

Citigroup and the other lenders have invoked this clause and are refusing to fund the loans. Solutia has brought an action to compel their performance. The matter will be contested on an extremely expedited basis; the hearing is scheduled for February 21st.

A ruling for Solutia will force the lenders to fund a very large loan facility that they will be unable to move off of their books without incurring substantial losses. A ruling for the lenders will no doubt lead other banks that have similar "market MACs" in their commitment letters to seek to avoid funding their loan commitments. Either way, this case will further roil the leveraged loan market and further reduce liquidity.

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