Structured Finance in Brief

Updates and Analysis on current structured finance issues, upcoming events and activities of Reed Smith’s structured finance group

Back(loading) to the Future – the Nuances of EMIR Transaction Reporting Requirements

It’s been barely six weeks since the EMIR trade reporting obligations came into effect on 12 February and, as the regulatory dust begins to settle, parties to derivative transactions are still in the process of assessing their duties under the new regime.  In the lead up to the February deadline, bank and securities firms were busy implementing their client outreach programmes whilst we were busy putting out client alerts and blogging about the new requirements under EMIR.  We continue to help clients with their questions on this significant change to the EU regulatory landscape.

Two aspects of the new trade reporting regime in particular repay some close attention to avoid potential trip-ups.  First, the rules relating to what has been termed ‘backloading’, or, in other words, the requirement to transaction report historic trades.  After some uncertainty in the lead up to implementation, the requirements are now clearer.  Broadly, counterparties need to ensure that all historic trades that were either ‘live’ on 12 August 2012 (the date EMIR came into force), or subsequently became live prior to 12 February 2014 (the date the reporting requirements came into force), are reported.  For these trades, the deadline for reporting will range from just one day to a period of three years after the reporting obligations became effective, depending on the date of the trade and, if applicable, its termination date.  Our client alert sets out these timeframes in more detail.

The second aspect worth paying attention to is how the transaction reporting regime applies to modifications of existing derivative contracts.  In outline, EMIR makes any amendment or variation to an existing trade potentially reportable and the time frame to do so is stringent, requiring reporting within 1 working day.  Precisely what a ‘modification’ looks like has not been spelled out in the regulation and will vary between transactions.  However, it is possible that changes made to any of the reportable information for a transaction, which can be up to 80 data items, could be caught.  As many existing structured finance and securitisation deals continue through the restructuring process, changes to hedging swaps can easily be caught by this requirement and transaction reporting can easily be forgotten in the excitement of the signing and closing process.  A place holder in the signing and closing agenda can be a useful aide memoire.

After the initial rush to meet the February deadline, the questions about the new reporting rules will continue for a while longer.  ESMA have, for example, just confirmed in their latest set of Q&As issued on 20 March that the ‘backloading’ obligations will still apply to transaction counterparties that have been liquidated or become insolvent, albeit the obligation rolls to any entity that assumes their obligations.  Expect the questions to continue!

NPLs – Car Boot Sale!

Time for a spring clean?

Institutions holding non-performing loans (“NPLs”) have been and continue to be, under increasing pressure to divest these and “clean up” their balance sheets in order to free up capital, de-risk and preserve market reputation. Usually, a loan facility becomes non-performing when either payments of principal and interest are past due by 90 days or more, or where payments are less than 90 days overdue, it is expected that payments will not be made in full. Alternatively, other loans can also be regarded as non-performing if they are value impaired (e.g. if the borrower has breached key covenants in its facility or if repayment terms have been altered).

Where a borrower is in financial trouble, it may first look to a lender for restructuring options such as extending its facility, foregoing interest payments or deferring repayments. From a bank’s point of view, holding on to NPLs causes a real issue since they increase a bank’s management costs, with frequent analysis required to monitor the financial position of the borrower and its underlying assets. There are also broader repercussions to consider given that NPLs may tend to limit a bank’s ability to lend. It also potentially drives up interest rate margins thereby creating uncertainty. Divesting NPL portfolios at a discount benefits banks who recoup some value, gain liquidity and distance themselves from the risk factors associated with holding onto distressed assets, such as a potential downgrades in its credit rating or a greater chance of bank insolvency.

Why take on a bad apple?

The reasons for investing into NPL portfolios are varied and divergent. Some may look to sell the loans on the secondary market for a quick profit, others, with management expertise who see potential for improvement in the portfolios and/or future economic factors may hold out for a recovery in its value. There are also some institutions who will buy enough distressed debt to have an influence in the borrower’s restructuring options or insolvency so as to be well placed to acquire control of the company thereby benefiting from profits and value in the business itself.

Buying and selling the loan portfolio

The process of selling a loan portfolio is not always straightforward and is often an expensive exercise (but well worth it if the intention is to gain real risk transfer and capital release). The transaction starts with what may be a lengthy due diligence process on the loans and its underlying security (often replete with incomplete documentation, spread across multiple jurisdictions and involving multiple counsels).

There may also be various loan level issues to tackle which provide impediments to transfer. Potential issues include:

  1. a borrower’s consent may be required to transfer;
  2. security packages may include collateral which is not supported by adequate registration evidence required to show that the seller has a right over the collateral and the subsequent right to transfer it; or
  3. a transfer may only be permissible to a “financial institution” – which can be problematic for sales to private equity firms, hedge funds, pension funds or SPVs.

Potential solutions to these issues include sellers holding the loans on trust with beneficial interest lying with the buyer, efficient and thorough due diligence which flags up issues as early as possible at the outset of the transaction (which can also be instrumental in influencing the price of the portfolio itself, at the bidding stage), amendments to loan documentation or perfecting registration of security to ensure the buyer holds a robust package of collateral.

The seller will almost certainly prefer a transfer by novation wherever possible, creating a direct standalone legal relationship between the new buyer and the borrowers. Transfer by way of assignment (where only the rights and not the obligations are transferred) may not have the effect of removing the loan from the seller’s balance sheet. However, transfer by way of assignment can be useful where the seller’s interest in underlying collateral cannot be novated. Moreover, an assignment can be achieved without notifying the borrower, although this will merely result in an equitable assignment.

What lies ahead for distressed debt?

Following the credit crisis, many institutions in the UK have undergone high profile divestment operations – instigated by the need to comply with stringent capital adequacy requirements. Currently, the ECB is implementing key stress tests amongst the top euro zone banks to ensure balance sheets are looking healthy – with a particular focus on non-performing loans. The distressed debt market is certainly growing and the UK appears to be a popular investment destination in this area together with Greece, Italy, Spain and Ireland. There appears to be a great deal of opportunity for many institutions to recoup distressed debt and estimates suggest that European banks have approximately EUR2.5 trillion of non-core assets available to sell.

So, it’s certainly very true for the NPL market that one person’s trash is another person’s treasure!

Unlocking the Supply Chain: challenges to widening the investor base for supply chain finance and some solutions

Investors in crowded sectors may look on the opportunities created by the supply chain as medieval adventurers once looked on the fabled kingdom of Prester John.  Huge volumes of illiquid credit are created in sale transactions every day as goods and services are sold.  This credit locks up working capital for sellers and limits their appetite to supply their customers.  The effective yield on this form of financing is tied up in price negotiations.

This market is already supplied with credit by third parties through trade receivables securitisation, factoring and other variations on the theme of using trade debts as collateral on a recourse or non-recourse basis.  In some cases this financing (for the right, usually larger corporate borrowers in the right sectors and locations) can be extremely cost effective.  There are also many ways of transferring credit risk on sale transactions which may be paid for by the buyer or the seller.  But a high proportion of trade transactions are not financed or protected in this way and the availability of credit in many sectors can be volatile or non-existent and pricing is inefficient. This all adds up to create opportunities for new capital.

If this is the opportunity, what are the challenges?

Challenge #1: Duration

Receivables tend to be short dated whereas many investors want to put capital to work for longer periods.

The obvious solution to this problem is to find a sufficient ongoing supply of receivables so that collections are quickly reinvested in new receivables.  This can be structured in the form of a programme with one or more sellers selling receivables into an SPV structure.  While this is the basis for trade receivables securitisation it is also used for more simple financing structures.  The programme must be sized so that sufficient receivables are purchased to create the yield needed for the investors to achieve their expected return.  The seller may be expected to pay a commitment fee to the extent the programme isn’t fully drawn or fund some kind of equity contribution which earns a return when the programme is used but funds payments to the senior investor when it is not.  Alternatively, the programme may be entirely uncommitted in which case the seller choses whether or not to sell and the financier whether or not to purchase the receivables but both are incentivised to maintain the relationship as long as it works economically and have a framework under which they can transact quickly.  

The solutions leave investors with the need to administer some relatively complex processes as receivables are collected and new ones are purchased.  In particular, in the context of a programme the investor must ensure that the quality and collectability of receivables are maintained.  These challenges are unavoidable and as trade receivables tend to be relatively granular require material ongoing work.  However, it may be possible to delegate these roles to a servicer.

In the next instalment of this blog, we will consider challenges which arise in relation to credit risk on receivables.

This and other challenges and opportunities to new investors wishing to provide supply chain finance will be addressed during a Reed Smith after work seminar in London on 11 March 2014.  If you are interested in attending please click on the above link to register.

Clash of the Titan 2007-1

So it’s been just over a year since Fitch issued their press release confirming that as a matter of policy it would not provide rating agency confirmations (RACs) during the replacement of special servicers on EMEA CMBS transactions and indeed, just over a year since our last blog on the matter, entitled “What the Fitch??!”.

At the end of that blog we observed that it was going to be a fun year for CMBS – and wasn’t it just.

We have seen some interesting CMBS restructurings including the £238m LORDS 2 CMBS and the €480m Rivoli Pan Europe CMBS, which included the restructuring of the €105m loan secured on IBM’s headquarters in Madrid.

We also saw the resurgence of German multifamily transactions including the €1.07bn TAURUS 2013 (GMF1) PLC and the €2 billion German Residential Funding 2013-1 PLC transaction but also in new deals in UK with the £380m Deco 2013 Chiswick Park and the £263m Debussy “Toys R Us” transactions; that is, if you can see past the fact that much of the value of the new issuance involved refinanced debt.  Hopefully the bullish researchers at the banks are right in their predictions for 2014.  At this stage, it’s perhaps too early to tell.

What’s therefore perhaps equally, if not, more interesting is how the issue of servicer and special servicer replacements has evolved over the last year.  If you remember we had the three-part blockbuster ‘Windermere XIV saga’; part 1, part 2 and part 3.

It also seems that Fitch’s reluctance to provide RACs continues to cause havoc for junior noteholders seeking to exercise their rights to replace special servicers.  However, it might all be coming to a head with the Controlling Party’s proposed replacement of Capita with Mount Street as Special Servicer of the only loan in the £610m Titan 2007-1 (NHP) care home CMBS following the announcement that due to lack of support from senior noteholders for the replacement on the one hand – and because of the threat of legal action from the Controlling Party on the other – the Trustee has applied to the court for directions “as to matters of contractual interpretation relating to the applicability and satisfaction of the Appointment Conditions”.

We very much hope the issue of whether or not as a result of Fitch’s unwillingness to provide RACs, the rights of controlling parties in CMBS transactions to replace special servicers have been effectively frustrated (until Fitch decides to reconsider its position!) or whether the requirement for a Fitch RAC can now ever be an applicable pre-condition to replacement – can be finally determined through this court action.  I think market participants and particularly incumbent special servicers, controlling parties and trustees will be anxious to see the outcome.

Will the court deal a final blow to the special servicer replacement process and will that lead to re-evaluation of the value attributable to junior notes with special servicer replacement rights or will the court pave the way for a less contentious and more efficient replacement process but which might risk upsetting existing special servicers?  Either way, some clarity for the Trustees and Issuers would be nice.  Watch this space.

Indian Bond Defaults and Bond Restructurings: More Scheming Ahead?

With yet another foreign convertible bond default hitting our desk, we cannot help but wonder what the future has in store for Asian convertible bonds and debt capital markets restructurings.  This is particularly relevant when you consider that Indian companies and banks issued foreign currency bonds aggregating up to approximately $6.3 billion in the first quarter of 2013.  This momentum continued throughout 2013 with Indian companies expected to raise another $10 billion by the beginning of 2014 by issuing foreign currency bonds in the international capital markets.

The Story so far

The convertible bond has always been a favourite of corporate India.  Turning back the clock, one would recall that, particularly between 2005 and 2008, several companies across multiple industries used a variety of structures to access the international debt capital markets by issuing foreign currency convertible bonds (FCCBs) to investors. Such issuers included National Thermal Power Corporation, Indian Oil Corporation, Bharat Petroleum Corporation, Power Finance Corporation, Tata Steel, Tata Communications, Vedanta, Bharti Airtel, Amtek Auto and Rural Electrification Corporation (just a few names amongst an endless list of issuers back in the day).

Fast forward to 2014 and FCCB defaults have dominated recent headlines (think major companies like Sterling Biotech, KSL and Industries and Suzlon Energy).

The double whammy!

To cut to the chase this is what happened.  Firstly, Stock prices of most FCCB issuers fell sharply post-2008, due to the global financial crisis as well as Indian macro issues.  FCCBs worth more than $7 billion were due for redemption.  Many companies faced a severe funding crunch, since most FCCBs did not get converted as a result of the conversion price being higher than the market price (with the conversion option out, of course, no lender wanted equity!), and consequently required refinancing at higher prevailing interest rates.  Secondly, the depreciation in the value of the rupee coupled with the fact that most of the foreign currency exposures were unhedged, exacerbated the issue and ballooned the principal repayment due in rupee terms, consequently complicating the refinancing challenges.

From a legal perspective, the process is often a messy one: in addition to the usual steps which a Trustee would take of confirming the occurrence of an event of default, providing default notices to the issuer and the noteholders, receiving pre-funding from the issuer, obtaining an indemnity and instructions from noteholders, a “Section 434 Notice” is often delivered too.  A Section 434 Notice  is a statutory demand (or “winding-up notice” – not to be confused with a “winding-up petition”) requiring the issuer to make payment of the full outstanding amount due under the bonds within 21 days.  Assuming such amount is not paid a winding-up petition may then be lodged – whilst unlikely that the issuer will actually be wound up it is a useful tactic to apply pressure on the issuer often leading to a restructuring of the bonds or a buy-back by the issuer.  The key in this situation is to find an experienced Indian law firm to assist with this process.  In addition to the winding-up process in India, an aggressive noteholder may also consider bringing proceedings in England in addition to a winding-up in India.  Although the volume of FCCB defaults decreased in 2013 compared to the previous year, there are a few big ones due for redemption in the second half of this year – so better to be prepared!

Then we have restructurings.  You will sometimes see a “Scheme of Arrangement” being used to implement a restructuring.  A Scheme of Arrangement is a court-approved, binding arrangement between creditors.  It is often used where there are multiple types of creditors (not just bondholders).  But it can be useful where there are only bondholder creditors to circumvent the requirement to obtain 100% noteholder consent generally required for amendments under a New York law governed indenture (a Scheme would typically require approval by a majority of – but not all – bondholders).  In our experience, these can be tricky to navigate from the Trustee’s point of view (particularly in view of Trustee’s fees and indemnity arrangements) – consider for example the role of the Trustee in the voting process (ideally the Court should direct the Trustee not to vote).  Is the Trustee protected in other jurisdictions other than that of the jurisdiction of the Scheme – for example, if the Scheme is under Singapore law and the Notes are governed by New York law and there are US noteholders, could the Trustee have potential liability in the US?  In such a situation there are often ways for the Trustee to protect itself.  The Trustee will also need to ensure that all Noteholders have the opportunity to vote in the Scheme and that none are disenfranchised.  These and other issues are critical to be aware of – the next Scheme may be right around the corner.

Winds of change

FCCBs and depository receipts rules are administered by the government of India (the Government of India).  The Issue Of Foreign Currency Convertible Bonds and Ordinary Shares (through the depository receipt mechanism) Scheme, 1993, has undergone several piecemeal amendments to meet the emerging needs of the economy.  Particularly, in view of the new Companies Act in India (the Companies Act), the Government of India is now looking into a comprehensive review of the FCCB  rules.  Therefore, along with the ongoing restructuring of numerous historic transactions, market participants are also keeping a close watch on the regulatory developments and the impact that such regulations will have on legal documentation, transaction structures and issuers.

Whilst there are positive signs for greater international investor confidence in the Indian capital markets, as witnessed from the recent increase in international transactions, there may be further opportunities for investors and borrowers (particularly in view of the Reserve Bank of India’s (RBI’s) permissions to refinance FCCBs (subject to certain criteria) through external commercial borrowings (ECBs) and debt capital market transactions).  International investors may have a greater role to play in 2014 with a flurry of transactions expected to hit the international debt capital markets this year.

New Year, New Troubles for US regulators: Volcker Rule challenged before federal courts

It’s been a busy Christmas and New Year’s season for US regulators. After three years of work, the Federal Reserve Board announced in mid-December that five federal agencies have issued final rules to implement section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Volcker Rule”), which is intended to limit proprietary trading by banks. But their job was hardly done.

US regulators came back to work after the holiday to find that portions of the final version of the Volcker Rule have been challenged in a lawsuit over claims that requiring small banks to divest their holdings in certain collateralized debt obligations known as trust-preferred securities or TruPs C.D.O.s will cause 275 small banks about $600 million in losses and impact their ability to lend to consumers and businesses.

The American Bankers Association, an industry lobby that represents several community banks, objects to the portion of the rule that will force banks to sell TruPs C.D.O.s, and has filed a complaint before the U.S. Court of Appeals for the District of Columbia Circuit seeking a court order blocking the rule from taking effect before the end of the year (source: New York Times). The group claims that the regulators did not properly analyze the economic cost of this portion of the rule on small community banks and the impact on their capital levels.

Then, on 14 January 2014, the regulators released a final interim rule to permit banks to retain interests in TruPs C.D.O.s under the following conditions:

  • The TruPs C.D.O. must have been established and the interest issued prior to 19 May 2010;
  • The bank must have acquired its interest in the TruPs C.D.O. on or before 10 December 2013; and
  • The bank must reasonably believe that the offering proceeds of the TruPs C.D.O. were invested primarily in Qualifying TruPs Collateral which is defined as any trust preferred security or subordinated debt instrument that was issued prior to 19 May 2010 by:
    • a depository institution holding company that as of the end of any reporting period within 12 months immediately preceding the issuance of such trust preferred security or subordinated debt instrument had total consolidated assets of less than $15 billion; or
    • a mutual holding company.

In order to reduce the burden of determining if a particular TruPs C.D.O. satisfies the requirements of the interim final rule, the banking regulators have issued a non-exhaustive list of qualifying TruPs C.D.O.s.

The interim final rule becomes effective on 1 April 2014. The regulators also solicited comments on whether the interim final rule is consistent with the Volcker Rule and the portion of Dodd Frank governing TruPs C.D.O.s treatment with respect to bank regulatory capital. Comments are due 30 days after the interim final rule is published in the Federal Register (which should be in the next few days).

This is considered a ‘win’ for the market in the prolonged Volcker Rule saga. It remains to be seen whether the regulators will also ‘yield’ to similar requests made by the market with regard to non exempt securities and other flaws of the Volcker Rule identified by industry lobbies.

One unintended consequence down, how many more to go?

You Don’t Need EMIRacle – Trade Reporting for SPVs Made Easy

EMIR’s trade reporting obligations come into effect on 12 February and counterparties to derivative transactions are currently scrambling to ensure they have all the appropriate systems in place to ensure compliance. For large financial institutions, this has already involved many months of hard work and, even still, many are not optimistic about meeting next month’s deadline. At the other end of the spectrum, the administrative burden on one-off or low volume commercial counterparties should be relatively light, and ensuring that the reporting obligations are covered not therefore too taxing.

What then of SPVs – which are neither operational goliaths like their derivative counterparties nor autonomous commercial entities capable of assessing the implications on cost, resources and time of each option open to them?

Well, the good news is that Article 9 of EMIR – which enshrines the trade reporting obligation – permits SPVs, like any other counterparty, to delegate their reporting function (but not its obligation) either to its bank counterparty or to a third party.

Our latest client alert explores all this in more depth, setting out in practical terms what steps SPVs should be taking now in order to ensure they comply with all their obligations.

So if you don’t yet know your pre-LEI from your LEI, your LOU from your GLEIS or your UTI from your UPI, we are here to help.

Sunshine backed bonds – time to look on the sunny side?

So called ‘sunshine backed bonds’ are one of the newest and most exciting asset classes to enter the asset-backed securities market since the financial crisis. The resurgence of the market has led to a number of esoteric ABS issuances in recent months but it was solar energy that seemed most ripe for applying securitisation techniques (which provide an especially powerful financing tool). Indeed, given how this financing technique revolutionised the mortgage finance market 30 years ago, it now seems poised to play a role in transforming the renewable energy markets across Europe.

The case for securitising solar

In essence, securitisation allows companies to access the capital markets and in so doing to bring down their cost of capital and improve liquidity. Pools of illiquid assets are sold to bankruptcy-remote vehicles which then issue bonds to investors which are backed by the pool of assets. The originator of the assets is able to turn illiquid assets into saleable securities and in so doing shift those assets, and the risk of ownership, off its balance sheet in return for new finance.

Solar energy in many ways is a good fit for this model. Solar photovoltaic technology has improved dramatically and the income stream that can be produced from selling solar generated energy is now reasonably stable. Many European countries are giving a boost to the renewable energy market and choosing to provide financial support for the generation of solar and other forms of renewable energy and this has further brought down costs and made investment in solar assets more attractive. In the UK, the Energy Act 2008 introduced a tariff regime (the Feed-in Tariff scheme, or FIT Scheme) which was intended to reward small generators of renewable energy and which supplemented the existing Renewables Obligation scheme for larger projects. Under the FIT scheme, a qualifying generator of renewable energy is entitled to a set inflation-linked payment for every unit of electricity generated for a guaranteed period of up to 25 years. A smaller payment is available for each unit of electricity that is exported back to the grid but the larger subsidies are available for generation itself.

A look at the market

The FIT Scheme paved the way for the first publicly listed solar securitisations and over the past 12 months the Reed Smith structured finance team has advised issuers and trustees on a number of such ground-breaking deals in Europe and the UK. These first deals have demonstrated the huge potential for the solar energy market.  As the FIT has progressively reduced for new solar photovoltaic energy projects, more and more developers have moved to larger schemes in order to take advantage of the Renewables Obligation Scheme and economics of scale; there is no reason why these larger schemes are any less suitable for securitisation.

That said, the deals to date have also shone a light on some of the unique challenges that will need to be overcome if the market is to continue to develop. These challenges include:

  • Structuring the cashflows - cash flows from solar energy are fundamentally different to those from mortgage payments and modelling them can be tricky. There are, for example, more aspects that lie outside the borrower’s control such as the technology of the solar equipment and the intensity and levels of sunlight.
  • Rating of projects - the credit assessment of a project also presents new challenges compared to modelling a traditional mortgage portfolio. A baseline case needs to take into account the technology risks as well as suitable default rates and recoveries if solar bonds are to be rated appropriately.
  • Records - there is nowhere near as much data available for assessing the credit risk of solar projects as there was when the mortgage market was developing; there, participants had years of data to draw upon.
  • Standardisation  - developing a standardised approach, which was key to commoditising the mortgage-backed security market in the eighties, will be a big challenge for the solar industry. The regulatory environment for the solar industry is also complex and constantly changing and the industry will need to ensure investors understand the risks of entering the market.
  • The transaction parties - an important challenge will be harnessing the servicing expertise of energy utilities to administer solar projects, manage the risks of an obligor default and ultimately, to convince financiers and the ratings agencies that the assets are less risky. We are already seeing backup service agreements being put in place in some US deals (for example in the recent SolarCity deal). The role of trustees will also be important for decision making between investors and borrowers and the challenge will be to strike the right balance so that trustee duties don’t go beyond the normal fiduciary obligations of a trustee under typical securitisations.
  • Long-term contract risk - particularly in solar lease receivable securitisations, there are contractual arrangements which need to be struck with the land owners to ensure that the underlying leases are not terminated during the life of the transaction. Similar risks apply to the underlying solar equipment which may have been leased.

The road ahead

The signs are very promising for development of the solar energy bond market. The trickle of deals coming to the market show that securitisation techniques can be applied successfully to solar energy. However, most deals are still privately placed and unrated and there are real challenges that will need to be overcome if the market is to develop liquidity. As we have seen, these challenges include a need for standardisation and scaleability if larger public securitisations are to be brought to market.

At a time when bank lending is being squeezed by Basel III and other capital adequacy regulations, the need for the solar energy industry to access capital from alternative sources is only likely to grow. The capital markets could provide a deep source of finance to fill this need which, if some of the challenges outlined above can be successfully met, could ultimately reduce both the cost of capital to the industry and the costs of energy to end consumers. Thirty years from the transformation of the mortgage industry by securitisation techniques, we may be seeing the beginnings of a similar financing revolution in the renewable energy market.  Let’s hope the sun keeps on shining on this new asset class!

Victoria Funding (EMC-III) PLC: (I can’t get no) Satisfaction

Another day, another CMBS transaction declares an insolvency related event of default (after the REC6 default), this time based on the ‘balance sheet’ event of default. The notice posted by the issuer clearly states that after the sale of property securing the Brisk loan, the issuer will not have sufficient assets to repay the Class D Notes and the Class E Notes. Its assets are less than its liabilities. Hence, an insolvency event of default must occur. Simple, right? Well, maybe…

The event of default as listed in condition 10(c) of the notes issued by EMC-III occurs if, amongst other things, the Issuer is “unable to pay its debts as and when they fall due within the meaning of Section 123(1)(e) or (2) of the Insolvency Act 1986 (as amended)”.

Ignoring for a moment the fact that Section 123(2) of the Insolvency Act doesn’t actually deal with paying debts “as and when they fall due”, if we look at the wording of the section, it states that:

A company is also deemed unable to pay its debts if it is proved to the satisfaction of the court that the value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities”.

As the event of default in condition 10(c) did not modify the wording in the statue (as other securitisations have done in their events of default e.g. see Eurosail-UK 2007-3BL plc ), it seems to me that no one (as far as I know) has proved to satisfaction of the court that the value of the issuer’s assets is less than the amount of its liabilities (incidentally, section 123(1)(e) contains the same wording highlighted above). But, hey that’s what I say. On the face of it, such a test would most likely be satisfied in court but does it mean that the issuer should not have called an event of default (as no court proceedings were initiated) or do wider director’s duties at law mean that the issuer was right to call an event of default in the circumstances? Answers on a postcard (or in the comments section below).

Am not sure I’ve come to a clear view either way even though I try and I try and I try…

The Operating Engineers Pension Trust Fund Lawsuit: The time is now (or has it already passed?)

They say that the early bird catches the worm and it seems that courts in the US definitely agree. A recent decision by a court of appeals in Philadelphia could serve as a wakeup call for any noteholders or issuers and servicers that might have claims to bring in relation to, respectively, the disclosure of risks in offering materials or the valuation of underlying assets that they need to be diligent with regard to their filings. The facts of the case highlight why interested noteholders, issuers and servicers should scrutinise the relevant materials on which they have relied and investigate any claims in order to take relevant action in a timely manner.

Two weeks ago, the Court of Appeals for the Third Circuit (Philadelphia) (the “Court”) affirmed the dismissal, as time barred, of a class action led by the Operating Engineers Pension Trust Fund (the “Operating Engineers”) against UBS over $ 2.5 billion worth of losses in crisis-hit RMBS securities (Pension Trust Fund for Operating Engineers, 12-03454, U.S. Court of Appeals for the Third Circuit (Philadelphia)). The mortgage backed securities in this case, known as the MASTR Pass-Through Certificates, Series 2007-3, were offered to the public on 14 May 2007, towards the end of the real estate bubble. The transaction, sponsored by UBS Real Estate Securities, was backed by underlying loans originated by, amongst others, Countrywide Home Loans, Inc. and IndyMac Bank, FSB. According to the plaintiffs, disclosure by UBS in the offering materials had been “materially false and misleading” and, as a result, the certificates were substantially more risky than disclosed in the offering documents. Applying a one year statute of limitations under federal law, the Court found that the plaintiffs should have investigated their losses in the relevant securities as early as 2008, and should not have waited until 22 February 2010 (one year after Moody’s downgraded the rating of the relevant certificates) to file the original complaint.

This is but only one among the increasing number of lawsuits that have emerged in recent years in the US and Europe driven by noteholders alleging inadequate disclosure of risks or issuers and services similarly alleging improper valuation of underlying portfolios. Even though some of these claims are bound to have merit, they could be dismissed due to statutory time limitations, as was the lawsuit in this case. Certainly, the statute of limitation applicable in this case was exceedingly short at one year (15 U.S.C. § 77m which requires actions to be brought “within one year after the discovery of the untrue statement or the omission, or after such discovery should have been made by the exercise of reasonable diligence”) and other jurisdictions might not be so punitive. Nonetheless, comparable claims in European based RMBS and CMBS transactions might date back to the pre-July 2007 period and the real estate bubble. Which means that, for example, the relevant limitation period on professional negligence claims against valuers in the UK for issuers, noteholders and servicers willing to take enforcement action (at six years) is likely to expire soon, in many cases before the end of 2013.

The case also serves to prove how a diligent defendant can use the investigation of previous court filings against a plaintiff to prove that the relevant statute of limitations has run out. Indeed, the Court looked into a separate complaint which had been filed in 2008 by a class of plaintiffs including the Operating Engineers in the California Superior Court against both Countrywide and UBS Securities, asserting claims under Sections 11, 12(a)(2), and 15 of the U.S. Securities Act that were substantially similar to those in this case. This led the Court in the instant case to hold that “a reasonably diligent plaintiff who had purchased mortgage-backed securities from UBS Securities based on loans that were largely originated by Countrywide would have noticed [the California] complaint” and dismiss the claim. In other words, the Court held that a reasonable plaintiff would have inquired about its certificates at or around the date of the California complaint (9 September 2008) thus discovering the untrue statements or omissions underlying its claim at that time.

The lessons here are clear: plaintiffs, don’t assume courts will be sympathetic to complaints that aren’t timely brought (even if they have merit) and don’t ignore your claims for too long as time limitation statutes are often shorter than one would assume and might bar your relief. Equally, underwriters and service providers, you should audit your exposures carefully to ensure you understand the risks related to your disclosures and/or valuations so as to be better prepared to fight off such claims.