Fed raises concerns about corporate debt
In its biannual monetary policy report to Congress last Friday, the The Fed expressed concern about the amount of debt incurred by US companies. Even “before the outbreak of the pandemic”, corporate debt was “already high”. Today, in the midst of the pandemic, “corporate leverage is now near historic highs.”
The Fed has taken an optimistic view of “short-term risks,” saying low interest rates and other factors give rise to short-term optimism. But the Fed seems more concerned about longer-term risks, citing “significant” insolvency problems in small, medium and even some large companies. If bankruptcies do occur, the economic pain can be expected to spread to securitized corporate debt – also known as secured loan bonds, or CLOs – and trigger a quality dispute. of the underlying bonds.
When corporate debt has been securitized, the initial applicants are likely to be investors holding certificates in CLO structures, especially lower tranches with ratings lower than investment grade. Specifically, the plaintiffs would likely be trustees acting on behalf of these investors, as “no action” clauses in many CLO deed documents prohibit investors from suing themselves.
On behalf of investors, trustees could sue managers for various types of claims. Since CLOs are actively managed, i.e. assets can be traded in and out of the CLO over time, the manager’s decisions can be called into question. For example, investors might claim that the manager has not properly diversified risk across various industries. As another example, investors could argue that the manager did not quickly sell underperforming assets. Or investors could claim that the manager did not properly improve the credit characteristics of the CLO, which may include over-collateralization, limits on poor quality debt, purchasing insurance policies and excessive coupon spreads. . The manager may be required to take all or part of the aforementioned actions on the basis of the founding documents of the CLO or, in the absence of contractual obligations, customs and practices of the industry.
Beyond managers, trustees can also sue the entity that issued or “arranged” the CLO. (Because the issuer is typically a special purpose entity with little or no assets, plaintiffs would likely attempt to sue the “arranger,” alternatively known as the underwriter, original buyer, or placement agent.) The claims the most lucrative could be securities violations (state and federal). But since CLOs are typically distributed to qualified institutional buyers, CLO are often covered by Rule 144A of the Securities Act, which means that some causes of action under federal securities law are not available.
Consequently, the trustees could fall back on common law claims. Following the previous financial crisis, a Michigan plaintiff tested several claims including breach of contract, unjust enrichment, fraud, silent fraud, negligent misrepresentation, breach of fiduciary duty and accounting. However, the court dismissed most of the complaints, and even after the plaintiffs attempted to re-plead the fraud allegations with the required level of specificity, the court again dismissed the charges. The only claims that survived the pleading stage were one count of breach of contract and one count of unjust enrichment. These surviving claims are generally not as lucrative as fraud claims because the damages available are not as robust.
In contrast, a plaintiff’s fraud claim in a more recent New York case survived not only the plea stage, but summary judgment as well. In fact, the New York Intermediate Court of Appeals upheld the denial of the summary judgment, setting a precedent in the country’s leading commercial jurisdiction. The court of appeal recognized that informed investors are subject to “an affirmative duty. . . to protect against misrepresentation made in business acquisitions by investigating the details of the transactions and the business they are acquiring. But the court concluded that the information and disclosures in this case “can be interpreted in a multitude of ways” and more widely observed that this is the “rare” case where “the question of reasonable confidence may be resolved at the summary judgment stage of a fraud case.
It is also possible that investors will turn to the trustees themselves. Although a trustee is usually not involved in the active management of funds, the trustee may play a more important role in times of distress, such as cases of default. Trustees are bound by fiduciary duties to act in the best interests of investors, creating opportunities for claims if investors believe that the trustees have not fulfilled their obligations to protect them and to be fair to all tranches.
If the trustees, issuers or managers incur losses as a result of such lawsuits, these entities could turn to the entities that originate the underlying loans for compensation. An S&P study late last year found that covenant light terms, or “cov-lite”, have significantly reduced collections, at least in the context of bankruptcy. Cov-lite loans, that is, loans without financial sustaining covenants over the life of the loan, have become predominant in the leveraged lending industry, accounting for most institutional lending since 2013 and 85% of institutional loans since 2018. Originator level, cov-lite loans are therefore likely to play an important role.