OverHedged

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

noreply@blogger.com (Ben Feder) — Fri, 17 Oct 2008 20:03:00 +0000

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.

Perils of Paulson

noreply@blogger.com (Ben Feder) — Mon, 22 Sep 2008 20:57:00 +0000

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.

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

noreply@blogger.com (Ben Feder) — Thu, 19 Jun 2008 16:38:00 +0000

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.

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

noreply@blogger.com (Ben Feder) — Thu, 29 May 2008 19:10:00 +0000

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.

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

noreply@blogger.com (Ben Feder) — Thu, 01 May 2008 19:23:00 +0000

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.

A Clearing House For CDS Trades?

noreply@blogger.com (Ben Feder) — Fri, 18 Apr 2008 21:51:00 +0000

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.

Court: Fairness Opinions Are Not Insurance Policies

noreply@blogger.com (Ben Feder) — Fri, 07 Mar 2008 16:16:00 +0000

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.

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

noreply@blogger.com (Ben Feder) — Tue, 26 Feb 2008 16:43:00 +0000

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.

A Big MAC

noreply@blogger.com (Ben Feder) — Thu, 14 Feb 2008 17:47:00 +0000

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.

“The US itself looks almost like a giant hedge fund.”

noreply@blogger.com (Ben Feder) — Wed, 13 Feb 2008 16:46:00 +0000

Excellent analysis amid all the bombast that is out there.

Follow the Money?

noreply@blogger.com (Ben Feder) — Wed, 06 Feb 2008 19:26:00 +0000

Some rather eye-opening numbers on the amount of money that is currently pouring into distressed debt funds, according to The Deal:

Funds managing distressed securities held $105 billion in assets in 2007, up
from $70 billion in 2006 and, just to put the industry into perspective, only
$934 million in 1990.

Hedge Fund Seeks to Stop Countrywide Merger

noreply@blogger.com (Amir Shaikh) — Thu, 31 Jan 2008 21:03:00 +0000

SRM Global Fund, founded by Jonathon Wood, is seeking to stop the merger between Bank of America (BAC) and Countrywide Financial (CFC). In a statement released by SRM, a company spokesperson said: "We strongly believe that the terms of the proposed merger with Bank of America are contrary to the interests of the Company's shareholders."

SRM Global filed a Schedule 13-D with the SEC today. The company claims that the book value of the shares of CFC are $20.00 a share as of December 31, 2007. SRM owns 5.19% of Countrywide. They would receive 0.1822 shares of B of A for every share of CFC they own. The SEC filing indicates that the company may engage the boards of directors of the companies in discussions regarding the proposed merger.

As soon as I saw this story, I was reminded of Bob Barnard 's Post on Hedge Funds Using Litigation to Exert Influence over Companies. By filing this SEC 13D, SRM is indicating its intent to stop the deal with Bank of America. Will SRM resort to litigation?

If SRM is not satisfied by its talks with management, it may choose to resort to the courts for reprieve (this is pure speculation on my part based on Bob's earlier post). If they decide to resort to litigation, they will likely file a shareholder's derivative suit against countrywide and seek a preliminary injunction and temporary restraining order to stop the deal.

It is clearly too early to tell, but this might be a foreshadowing of a few of the hurdles B of A will have to overcome in order to complete the merger.

GAIM - Distressed Debt Funds As A Central Theme

noreply@blogger.com (Richard Heller) — Wed, 30 Jan 2008 15:26:00 +0000

Having recently attended the GAIM USA conference in Boca Raton last week, the overwhelming theme discussed by many of the panelists at the seminar involved the coming surge of distressed fund opportunities. There was a genuine enthusiasm in organizing funds to concentrate in this area. Indeed, several fund managers expressed an interest in branching out into the "distressed" arena, and plan to open with new sub-advisors to service this emerging niche.

While the organizational documents required to create these entities are similar to typical hedge fund organizational documents, the element of due dilligence on the underlying assets of the various portfolios to be acquired will require careful risk assessment which in itself will present new challenges in this area. We anticipate that there will be aggressive jockeying for the better pickings that may be left on the table throughout this year. We envision delicate negotiations with bankruptcy trustees and others. In assessing distressed portfolios, one must consider the impact a trustee may have over the value of the underlying assets.

Another Sentence Handed Down In Bayou Fiasco

noreply@blogger.com (Bob Barnard) — Wed, 30 Jan 2008 15:22:00 +0000

Following closely on the heels of the 51-month sentence handed down to James Marquez (reported below), Daniel Marino, Bayou's former CFO, was sentenced this week to 20 years in prison. Marino had entered a guilty plea to conspiracy and three counts of fraud in connection with a scheme that cost investors approximately $450 million.

U.S. District Judge Colleen McMahon had harsh words for Marino, calling him "as much a career criminal as any mobster or drug kingpin." The judge reserved a decision on how much Marino will be required to pay in restitution, but indicated that the amount would exceed $200 million.

Bayou co-founder and CEO, Samuel Israel III, still awaits sentencing.

Read the full NYTimes.com story here.

A Little Noted Case Regarding Credit Default Swaps Could Portend Major Problems for Financial Institutions

noreply@blogger.com (Ben Feder) — Wed, 30 Jan 2008 15:02:00 +0000

In response to my recent postings regarding credit default swaps (CDSs), a professional acquaintance was kind enough to refer me to a relatively recent decision. Aon Financial Products v. Societe Generale, 476 F.3d 90, issued nearly one year ago by the Second Circuit Court of Appeals, provides a fascinating insight into the risks posed by credit default swaps, and demonstrates how even financial institutions and hedge funds that have used such instruments prudently may find themselves facing unexpected damages in the coming months as default rates begin their inexorable upward climb.

The facts are unremarkable. Several years ago, a Bear Stearns affiliate provided a loan of $10 million to a Philippine entity for a construction project. Bear demanded that the borrower obtain a surety bond from a Philippine government agency, the Government Service Insurance System (GSIS), and then sought to further hedge its exposure by purchasing a credit default swap from Aon for $425,000 (CDS 1). Aon (NYSE:AOC) in turn hedged its own exposure by buying a credit default swap from SocGen (OTC:SCGLY) for $328,000 (CDS 2).

Aon acted in a textbook manner. It balanced its position, and booked a profit of nearly $100,000. So, what went wrong?

The Philippine borrower defaulted, and GSIS refused to pay on the surety bond. Bear Stearns' assignee successfully sued Aon for payment under CDS 1. Aon in turn sued SocGen under CDS 2, and moved for summary judgment. Aon argued that the court's finding in the first action, that a "Credit Event" requiring payment had occurred under CDS 1, mandated a similar result with respect to CDS 2. The district court ruled in favor of Aon, and SocGen appealed.

The Second Circuit reversed and ruled in favor of SocGen, stating that "[t]he terms of each credit swap independently define the risk being transferred." The court parsed the language of CDS 2 with precision. Simply put, it noted that "the risk transferred to Aon and the risk transferred by it were not necessarily identical." Aon had sold Bear Stearns protection that expressly included a failure to pay by GSIS as a Credit Event. However, what it bought from SocGen was slightly different. CDS 2 contained protection against "a condition . . . resulting from any act or failure to act by the government of the Republic of the Philippines . . . or any agency . . . thereof . . . that has the effect of . . . causing a failure to honour any obligation . . . issued by the government of the Republic of the Philippines." The Court of Appeals declined to interpret GSIS's claim that it was not legally obligated to pay under the surety bond as a "condition" caused by "an act or failure to act by the government of the Republic of the Philippines."

The risks for which protection was sold under CDS 1 and CDS 2 did not match up. Aon, instead of making $100,000, lost $10 million.

This case, which is now binding precedent in New York and will probably be followed elsewhere, will garner greater attention as default rates mount and payments are sought under CDSs.

As noted previously on this site, the notional amount of the CDS market has grown from less than $2 trillion in 2002 to in excess of $45 trillion today. The Office of the Comptroller of the Currency estimates that major financial institutions hold about 40% of these instruments, equally split between buyer and seller positions. As Aon vs. SocGen demonstrates, these positions might not be as precisely balanced as they may need to be for what lies ahead.

When the Music Stops-Check Your Documents

noreply@blogger.com (Martin Eisenberg) — Thu, 24 Jan 2008 15:55:00 +0000

When times are good and there is money to be made, investors are supremely motivated to “get the deal done.” The last thing they want are lawyers mucking up the process by engaging in protracted negotiations. As a consequence, in the zeal to close, the quality of the transaction documents often take a back seat to expediency. For example, rather than risk losing the deal, one party might agree to provide the other with additional protections which are not customary in the industry. Conversely, a motivated party may forego receiving standard representations and warranties from its counter party. Time is money.

However, when the music stops and these deals turn sour, investors on both sides of the aisle will look for avenues to recapture value. Now is the time to check your transaction documents. You might be surprised to learn that your anxious counter party may have provided recourse to recover your losses.

"Seems"?

noreply@blogger.com (Ben Feder) — Wed, 23 Jan 2008 19:49:00 +0000

A front page economic analysis column in today's The New York Times reflects on whether recent economic "good times" were simply a "mirage" and, referring to the so-called "great moderation" - growth without inflation, high yields without risk - blithely remarks that it "now seems to have depended - in part - on a huge speculative bubble . . . that hid the economy's rough edges."

"Seems"?

A brief sample from the list of gross market distortions over the past few years:

- Global LBO volume increased from $95 billion in 2003 to over $1.2 trillion (annualized) in the first half of 2007.

- Subprime mortgage originations increased from $120 billion in 2001 to over $1.2 trillion in 2005-06 combined.

- The notional amount of debt underlying credit default swaps has increased from less than $2 trillion in 2002 to over $45 trillion today.

"Seems, madam? Nay, it is. I know not 'seems.'" (Hamlet, I, ii).

Hedge Fund Founder Gets 51-Month Sentence

noreply@blogger.com (Bob Barnard) — Wed, 23 Jan 2008 16:17:00 +0000

James G. Marquez, the founder of several Bayou Management hedge funds, was sentenced yesterday by a federal district judge to 51 months in prison, followed by two years of supervised release. He must also pay close to $6.26 million in restitution.

In December 2006, Marquez pleaded guilty to conspiring with Bayou's CEO (Samuel Israel III) and CFO (Daniel Marino) to misrepresent the profitability and overstate the value of the Bayou funds. Investors relying on those representations lost mountains of money when Bayou collapsed in July 2005. Read the nytimes.com article here. Israel and Marino still await sentencing.

Judge Again Denies Basis Yield Alpha Fund's Request for Chapter 15 Recognition

noreply@blogger.com (Ben Feder) — Tue, 22 Jan 2008 20:49:00 +0000

The Cayman Island Joint Provisional Liquidators ("JPLs") of Basis Yield Alpha Fund (Master) (the "Fund") failed again in their effort to have Judge Robert Gerber of the U.S. Bankruptcy Court for the Southern District of New York grant recognition of the Fund's Cayman liquidation proceeding as a "foreign main proceeding" under Chapter 15 of the U.S. Bankruptcy Code. Judge Gerber's decision is consistent both with his earlier ruling in the case denying the JPLs' petition, and with a decision by Judge Burton Lifland in the Bear Stearns High-Grade Structured Credit Strategies Master Fund case, which is currently on appeal. This decision reinforces the notion, as discussed in an October 26th post on this site, that in cases involving hedge funds, bankruptcy court judges are going to be insistent on obtaining disclosures which they deem necessary to the relief being sought – regardless of how reluctant the hedge funds might be to have such information made public.

To recap – last August, in the Bear Stearns case, Judge Lifland denied the request of the Bear Stearns funds to have their Cayman Island liquidations recognized under the new Chapter 15 of the Bankruptcy Code, which essentially would have provided protection to the funds' U.S. assets while the funds' liquidation is overseen by the Cayman courts. Judge Lifland denied the relief even though no party had raised any objections, finding that the funds' Cayman presence amounted to little more than a "letter box", and making clear his view that the court was not going to "rubber stamp" the funds' petitions in order to facilitate their winddown outside of the U.S.

Shortly afterwards, in late August, the Fund commenced its own Cayman proceeding, and the JPLs filed a petition for recognition under Chapter 15 in the Southern District of New York. Again, no objections to the requested relief were made. However, Judge Gerber followed Judge Lifland's precedent in denying Chapter 15 relief to the Fund, in the 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 accept this invitation, however, the JPLs filed a motion for summary judgment. In effect, the JPLs argued that, in the absence of any objection or contrary facts presented, 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 didn't bite. The court noted that the Fund's organization as an "exempted" company under Cayman law, which prevented the Fund from conducting any business in the Cayman Islands "except in furtherance of [business] carried on outside the Islands[,]" was itself sufficient to counter the presumption regarding the Fund's COMI and to require the submission of the type of evidence that the court had previously requested. "The silence is deafening. The JPLs' conspicuous failure to try to establish, or even plead, facts supporting the existence of a main proceeding, even after . . . the Court's own questions in this regard, makes any reasonable observer wonder why." Just in case they missed the point, Judge Gerber included as an appendix to his opinion the same list of factual items he had requested from the JPLs over four months earlier, and expressly invited them to try again.

As it happens, a hearing on the appeal of Judge Lifland's ruling regarding the Bear Stearns funds is being held this week. While the JPLs of Basis Yield Alpha Fund may decide that the time has come to present the evidence that Judge Gerber has requested, it is probably more likely that they will appeal the denial of summary judgment, and hope in the meanwhile for a favorable ruling in the Bear Stearns appeal.

The struggle between the secretive nature of hedge funds and the open, public process of bankruptcy in the U.S. continues.

Not Time Yet for Third-Party Service Providers to Breath Easy

noreply@blogger.com (Bob Barnard) — Fri, 18 Jan 2008 21:06:00 +0000

This week's Stoneridge Investment Partners decision from the U.S. Supreme Court, along with the recent Seward & Kissel decision from New York's Appellate Division, First Department (both of which are noted below), are being celebrated by third-party service providers to hedge funds, among others. However, these cases should not be viewed as a blanket protection. Investor lawsuits seeking to reach into the perceived "deep pockets" of third-party service providers are not simply going to go away. They will merely come at the service providers from a different angle. Some possibilities that immediately come to mind:

Direct actions in the name of the investor

Common law fraud. While the Stoneridge decision insulated third party providers from 10(b)(5) claims for securities fraud, it does not eliminate the possibility that third party providers could be liable on a theory of common law fraud for making false or misleading statements upon which investors rely. The Seward & Kissel decision doesn't insulate service providers accused of fraud as much as some may think; the basic analysis is still whether a defendant who makes a fraudulent statement anticipated and intended that the plaintiff would rely on that statement (the discussion of the need for a fiduciary relationship in the Seward & Kissel case dealt with omissions, not affirmative statements). In certain cases, this requirement of forseeability may protect the defendant, but in others it may not.

Aiding and abetting. A defendant may be held liable for aiding and abetting a breach of fiduciary duty if that defendant is found to have had knowledge of the fiduciary duty that was owed and provided substantial assistance in the breach. Defendants can also be civilly liable for aiding and abetting fraud under a similar analysis.

RICO. An investor may bring a civil RICO action if it appears that an outside service provider acted in concert with the management of a fund to violate securities laws or other laws.

Actions in the name of the hedge fund

Derivative actions. Most funds are set up as LLCs or limited partnerships. The statutes and court decisions in most states allow minority members of LLCs and LPs to bring derivative actions (under the appropriate circumstances) on behalf of the company to enforce the rights of the company. In other words, even if the management of a fund does not want to sue its third-party providers, a minority member may be able to force the issue.

Financial pressure. Large investors, especially if they band together, may be able to pressure the fund's otherwise reluctant management to bring actions in the name of the fund against third-party service providers.

Trustees and Receivers. If a hedge fund really begins to struggle, watch out. Courts can appoint receivers, and bankruptcy courts routinely appoint trustees, to manage the financial matters of a failing business during dissolution, liquidation or reorganization. Trustees and receivers will have the ability to assert claims and bring lawsuits on behalf of the hedge fund. Thus, even though an investor may not be able to make a direct claim for securities fraud or malpractice against a third-party provider, the trustee or receiver can. Moreover, while the management of a fund may be very reluctant to sue its trusted accountants, lawyers, or business partners, a receiver or trustee will have no hesitation if it appears that those third-party providers may be liable to the fund.

While the Stoneridge and Seward & Kissel decisions will provide some measure of protection for third-party service providers, dogged investors and creative attorneys will keep coming after the deep pockets when hedge funds stumble and fall.

Hedge Fund Service Professionals Owe No Fiduciary Duty to Investors

noreply@blogger.com (Amir Shaikh) — Fri, 18 Jan 2008 18:30:00 +0000

In an action arising out of a hedge fund fraud claim, investors sought to recover damages from the fund's outside professionals including the hedge fund's legal counsel and auditor. The First Department overturned orders from the court below and dismissed the complaints against the hedge fund's legal counsel and auditor.

In a combined appeal heard in the First Appellate Division of New York State Court, the plaintiffs (Eurycleia Partners, LP) alleged that Seward & Kissel, LLP (S&K) were liable to the investors for damages because S&K knowingly made false and misleading statements. "They allege that S&K prepared the fund's offering memorandum, listed itself therein as counsel, and invited prospective investors to rely upon its legal opinions, and that therefore S & K is liable for the statements contained in the memorandum concerning the fund's investment strategy, which allegedly were false at the time that they were made."

However, plaintiffs did not allege that S&K made any statements directly to the plaintiffs. The pleadings indicated that the alleged false statements were contained in the offering document. Since the offering document is from the hedge fund to the investors, there were no false statements made by S&K to the investors.S&K never made any material representations to the investors directly. If they had, S&K might have been liable for fraud. The fiduciary analysis comes into play when discussing whether or not S&K omitted material facts which they had knowledge of.

Plaintiff's alleged that S&K knew that the Hedge Fund had deviated from the strategy described in the offering document and failed to make required filings with the SEC and had not retained TBS (RSM McGladrey) as its auditor.

In order for an omission to constitute fraud, there must be a fiduciary relationship. The court held "[a]s counsel to the fund, not to the investors, S & K's fiduciary responsibility was to the fund, not to plaintiffs." Thus, no fiduciary duty existed and S&k has no liability to the plaintiffs.

The decision in this case was based on a motion to dismiss. (For those non-lawyers reading, a motion to dismiss is granted when the plaintiffs fail, at the outset of a case, to state a claim for which relief can be granted. This decision was based purely on the initial pleadings in the case and involves no analysis of the veracity of the underlying facts. When deciding a motion to dismiss, the court gives the plaintiffs the benefit of every possible factual inference.)

This case is different than Stoneridge because Eurycleia Partners involved common law claims, not securities act claims.

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Eurycleia Partners LP et al. v. Seward & Kissell, LLP, et al.

Securities Law Getaway Driver

noreply@blogger.com (James P. Jalil) — Thu, 17 Jan 2008 20:23:00 +0000

Let's say you and three friends decide to rob a bank. One of your friends decides he will go into the bank with a gun, your other friend says he will collect the money in a bag from the tellers, but you, cleverly, say you'll drive the get away car. As you drive away with your two friends, and the money, you realize you all forgot about the silent alarm. Five blocks from the bank you are surrounded by cops. At your trial, you stand up and say, "Your honor, my two friends are the ones that actually robbed the bank, all I did was drive the car." What do you think the judge would say? Right…you're looking at some serious jail time.

On the other hand, if this crime were in the area of securities fraud, where by the way you can steal a heck of a lot more money than you can robbing a bank, the judge would say, "Yes, Sir, we apologize for having inconvenienced you, you are free to go". This is the result of the latest pearl of wisdom from the Supreme Court of the United States. In Stoneridge Investment Partners v. Scientific-Atlanta the Supreme Court held that secondary actors in securities fraud….the figurative getaway drivers, can not be held liable in private actions.

The reasoning is this…..since the essence of securities fraud is the reliance on a material misstatement (or omission), the only one an aggrieved investor can sue is the person who actually made the misstatement, or, when otherwise giving information, withheld something. You can not recover from the man behind the curtain prompting, helping, enabling, pulling the strings, but whom you never spoke to directly. Technically he made no misstatement directly to you. Those who aided and abetted, that enabled, that supported the fraud, those whose help was crucial to the execution of the fraud, but who, like the getaway driver, didn't actually rob the bank, or directly make a misstatement in this case, are not liable to investors.

What next…..well curiously, while our getaway driver, or the man behind the curtain, may not be liable to investors in a private right of action, they may be found liable in SEC enforcement actions, including facing the possibility of going to jail for securities fraud. So, under the current statutory scheme, they are culpable enough to go to jail, but not culpable enough to be sued by investors. What the Supreme Court has done is throw this back to Congress. In effect the Supreme Court is saying: "We are not going to fix your sloppy law writing skills. If you want to hold these aiders and abettors, or secondary actors, liable for securities fraud in private lawsuits, you have to write the law that says that. If you write it that way we will enforce it that way. But the way the laws are written now, we don’t see the language that would permit us to allow these private suits to go forward. " The ball is now squarely in Congress' court.

Supreme Court Limits Fraud Claims Against 3rd Parties

noreply@blogger.com (Amir Shaikh) — Tue, 15 Jan 2008 21:36:00 +0000

From the wonderful crew at the SCOTUS Blog:

"The Supreme Court, in one of the most important securities law rulings in years, decided Tuesday that fraud claims are not allowed against third parties that did not directly mislead investors but were business partners with those who did. The 5-3 ruling came in Stoneridge Investment Partners v. Scientific-Atlanta (06-43)."

SCOTUS Blog: Court Limits Securities Fraud
Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc.

This case is good news for 3rd party service providers to hedge funds. If the investor does not rely on a statement directly from 3rd parties, the 3rd party cannot be held liable for fraud.

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Basis Capital seeks Court Assistance for Redemptions

noreply@blogger.com (Amir Shaikh) — Fri, 11 Jan 2008 15:28:00 +0000

More trouble for Basis Capital. Yield Alpha Fund's Sister, Basis Aus-Rim Diversified Fund, has also lost about half its value since the credit crunch began. Basis recently announced they will be seeking help from the courts regarding redemptions.

In a letter to investors dated January 9, 2008, Basis Capital Funds Management Ltd. said "Identifying appropriate representatives of the various classes of investors and obtaining their consent" to its plan for dealing with redemption requests "has been a time-consuming process."

It assured investors that "Basis Capital and its legal advisers have been working hard to identify and reach an expeditious outcome."

Basis Capital seems to be trying to reclassify the redemptions from investors back in June (the first round of big redemptions) as creditors of the fund. Basis is trying to balance the interests of the old redemptions versus new redemptions from investors who stuck with the fund through the storm. I am not familiar with Australian Law on the issue so I cannot accurately comment on the practical difference between being a creditor and a redeemer. But the issue is that the fund is struggling defining what priority the redemptions have over each other, i.e. who gets paid first.

This highlights another important thing for hedge funds to consider. When formulating your policy on redemptions, a fund needs to have clear redemption procedures. Specific measures including defining a timeline and fund obligations will help give investors more certainty about their potential for repayment.
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Sydney Morning Herald
The Australian

Feeding Frenzy

noreply@blogger.com (Martin Eisenberg) — Wed, 09 Jan 2008 16:04:00 +0000

Hedge Funds that invest in distressed debt have been “lying in wait” for the next wave of bankruptcies to emerge. When the tsunami hits, it is likely that these investors will be the dominant players in the market place.

With the credit crunch upon us, it is doubtful that conventional financial institutions, such as banks, will have the appetite to provide debtor-in-possession or exit financing to Chapter 11 debtors. Hedge Funds, flush with newly raised capital, will likely fill the void.

In addition, the Hedge Fund market for the purchase and sale of defaulted secondary bank loans has skyrocketed in recent years. Conventional lenders who hold outstanding pre-petition loan claims no longer have the staying power to maintain their claims to the finish line. Add to this the ever growing and competitive market for the purchase and sale of bankruptcy trade claims, and you can expect a distressed debt Hedge Fund feeding frenzy where Hedge Funds purchase and hold vast tranches of creditor claims and provide post-petition financing. Since Hedge Funds are more likely to pursue aggressive strategies to increase value, things could get very spirited. But buyers beware! Those who navigate these secondary waters would be wise to have someone on board who has sailed through bankruptcy before.