Friday, August 16, 2013

No Cliche Left Behind in the New York Times Ridiculously Mistaken Assault on the Detroit Swap Settlement

The New York Times ran an editorial today entitled "No Banker Left Behind" about a motion in the Detroit bankruptcy for approval of a settlement and compromise between the city and some interest-rate swap counterparties.  The editorial board of the Times was outraged that the counterparties were receiving 75% of their claim when pensioners are, according to the Times, looking at a 90% haircut.  The Times thinks that this is about "protecting pensions; protecting municipalities from Wall Street; and, at long last, revoking the obscene privileges of banks that allow them to prosper on the failings of others."  But, in truth, the only thing the editorial demonstrates is the utter ignorance of the Times about basic bankruptcy law, pension funding and the utility of interest-rate swaps in finance. I wonder where in the world the Times' editorial board got its information because it's so horribly ignorant of all the relevant facts.  I put up this post so that somewhere in the world the correct understanding will exist.

First, the Times shows no awareness of interest rate risks the city faced in 2005 when it entered into the swaps.  Interest rates rose consistently throughout 2005; from CNN/Money, Sept. 20, 2005: "The Federal Reserve raised a key short-term interest rate Tuesday and suggested more rate hikes are on the way ...The central bank's policy-makers boosted their target for the federal funds rate a quarter-percentage point to 3.75 percent, the highest level in more than four years.  The rate increase was the 11th straight since June 2004 as Alan Greenspan and other central bankers seek to keep inflation under control. In its heavily scrutinized statement, the Fed said that more "measured" rate increases were likely in the coming months."   The city reasonably must have feared further rate hikes would be another drain of its already constrained cash.  So they sought to lock in those rates by entering into a swap, where they would pay a fixed rate of interest on the notional amount and receive floating rate payments from the counterparties (which two payment streams were probably netted such that the city just kept paying its floating rate interest and also paid (or was supposed to pay) the counterparties of just the difference by which the fixed rate specified in the swap exceeded those payments).

This was economically equivalent, the Times seems not to grasp, to issuing fixed rate debt to refinance the floating rate debt.  Why didn't the city just do that?  Probably two reasons:  1) the amount of debt was large enough that the market would not have been able to absorb it all efficiently and the city would have had to pay more than it wound up paying under the swap to get the market to digest the fixed rate issue; and 2) the city's credit probably had deteriorated since the floating rate debt was issued and they wanted to preserve the lower spread or at least the optics of a lower spread.

The key takeaway here is that the transaction is no less proper or common than issuing fixed rate debt. It is economically the same thing.  The Times' editorial board, and whoever fed them the story, sadly seem not to grasp that simple fact, as it insists of shoe-horning this into the narrative it clings to of greedy speculators on Wall Street taking advantage of poor ignorant municipalities.  When it is just a commonplace, plain vanilla form of risk management.

Second, the Times fails to grasp how the claim of the counterparties arose.  The Times recognizes that it reflects interest rate movements adverse to the city; rates did not rise as they thought, they fell.  What the Times fails to recognize is that this is not particularly driven by the fact the transaction was a swap.  The city would have been faced the same problem had it just issued plain vanilla fixed rate debt.  The swap claim does not represent an extra charge of some kind, it is just the accumulation of  years of differential between the fixed rate Detroit would have paid on fixed rate bonds and the floating rate on the paper it kept outstanding.  In principle, the city should have trued up the difference between floating and fixed rates every quarter or biannually.  That is how most swaps are written.  But the city was probably too cash constrained to do that, that is, to pay regularly what it would have been paying had it just issued fixed rate debt. So effectively it seems to have financed the fixed vs floating rate spread, which is economically equivalent to getting a plain vanilla loan from the swap counterparties in an amount equal to the interest payment differential.  And it appears the counterparties were not willing to make that loan unsecured, so they took collateral.  There is nothing  out of the ordinary about making a secured loan to finance a weak credit. Had the counterparties not done that, Detroit would have run out of cash sooner.  That is the key takeaway of point 2, that this transaction was economically equivalent to a secured loan from the counterparties that was just a way to stretch Detroit's cash farther.  It would have run out of cash earlier and in some other way without this financing; the swap did not make anything worse than it would otherwise have been, once the city decided to protect itself against interest rate hikes that seemed reasonably likely before September 2008.

Last, the Times falsely equates the counterparties, who were clearly secured according to the Times' narrative, with the unsecured retirees and further overstates the retirees' haircut.  Obviously, as any one with financial or legal experience knows, secured creditors are entitled to be paid in full from their collateral in bankruptcy.  They do not have to compete with unsecured creditors.  And it would be crazy to make them do so.  They are not insurers of pension benefits.  Back when ERISA was set up, a political choice was made to not cover public sector workers.  This enabled state and local politicians and public sector unions to engage in mutual back-scratching practices over the past four decades without the nuisance of a federal regulator telling them the promises were unsupportable.

The Times' presentation of a 90% haircut of the pensions is totally false.  First, recoveries are estimated to be closer to 20% but more important, the 90% figure ignores the funds already transferred to the city pension fund and the value earned thereon, which is functionally the retirees' collateral.  The haircut is only applicable to the unfunded portion, not the whole pension!

It's super-pathetic that the Times puts out such nonsense based on such fundamental ignorance of so many key aspects of the motion.  I do really wonder where they got it into their head to write an editorial about this -- was it some union, a progressive activist,  a politician with an agenda or a reporter?  In any case, the person who brought it to their attention is equally ignorant, or perhaps outright mis-representing the facts and the law to the Times' editors.

Saturday, August 3, 2013

UK Supreme Court Resolves that Contributions to Underfunded Pensions of an Affiliate Are Not "Expenses of Administration" Even Though Assessed Post-Insolvency-Proceeding

Traveling in the UK and elsewhere towards the end of July, I read in one of the UK papers a story about a decision of the Supreme Court of the UK in the insolvency proceedings of Nortel and Lehman.  The court held that pension liabilities are pari passu with general unsecured claims in insolvency proceedings. Returning home, I read the opinion online (here: scroll down to 24 July judgments).  I found it interesting how much the court's reasoning parallels US bankruptcy law (without actually mentioning so).  Here is a short summary:

1.  The Pensions Act of 1995 establishes (section 75) minimum funding requirements for pension plans ("schemes" in the UK parlance; but I will generally use American parlance throughout this post as I assume most readers of this blog are US-centric) and specifies that deficiencies in funding are "provable debts" (equivalent to the US's "general unsecured claims") in insolvencies.  Much like section 502(b) of the US Bankruptcy Code, it states that  "a section 75 debt is to be taken, for the purposes of an employer’s insolvency, to arise immediately before the occurrence of the insolvency event."  The Lehman UK and Nortel UK plans were underfunded.

2.  By the Pensions Act 2004 (30 years after ERISA!), the UK appointed a pensions regulator and set up a pension protection fund to backstop pensions, funded by taxes on pension plans themselves.  To protect the fund against corporate asset-shuffling, the law empowers the regulator, inter alia, and regardless of whether the plan sponsor is in insolvency proceedings or not, to issue "Financial Support Directions" ("FSD"), which may require a variety of actions from the target companies to support their affiliate's pension plan.  A specific form of FSD is a "Contribution Notice" ("CN") which requires the targets to pay a specific amount of money. toward the pension plan sponsor's funding deficiency. Such potential liability is similar to the liability ERISA imposes on "commonly controlled entities", although it seems to be ad hoc and discretionary, as opposed to strict and automatic under ERISA.  The CN, because it requires payment of a specific amount of money, would clearly be a "claim" in a US proceeding, whereas theoretically some forms of FSD might, under a KovacsMidlantic National Bank line of reasoning, escape "claim" characterization and be seen as a non-dischargable regulatory obligation.

3. Post the entry of Lehman and Nortel's UK companies into administration, the pensions regulator conducted an investigation into the respective pension plans' funding status and determined to issue some kind of FSD's to certain of their affiliates, which the court presumed, would "in due course" eventually take the form of CN's to contribute to the underfunding.  The actual issuance of those FSD's was "informally stayed" pending litigation of the ranking the resulting liability would have in the insolvencies.

4. The issue was a familiar one: whether the post-insolvency-proceeding FSD was an "expense of administration" in the proceedings of the companies targeted, simply because it was promulgated post-commencement of insolvency proceedings, or whether the issuance of an FSD merely crystallized a contingent liability that loomed over the targeted companies prior to the insolvency by virtue of being in a corporate group with an underfunded pension plan, such that it was merely a pre-petition claim, to use American parlance.  Similar to the US bankruptcy laws, an expense of administration is the highest priority unsecured claim in a UK insolvency proceeding (and even has priority over floating charges, but not fixed charges).  (Also, by way of clarification, there are two types of insolvency proceedings in the UK: administration and winding-up/liquidation; but the opinion explains that the issue operates identically regardless whether the company enters one or the other, or whether it begins in administration and then transitions to a winding up). Thus, the characterization determined whether the pension funding claims would be fully satisfied as admin expenses, or only partially satisfied, pari passu with other general unsecured debts.

5.  Reversing both lower courts, the high court held the FSD liability should be classified a pre-petition claim.  Its reasoning resembles very much the reasoning that US courts go through in analyzing an admin expense / general unsecured claim issue.

6.  The court's reasoning (isn't this just like one of those case summaries law students write up?) begins at paragraph 58: "on the face of it, the sensible and fair answer would appear to be that the potential liability of a target, under a FSD issued after an insolvency event, and in particular the liability under a CN issued thereafter, should be treated as a provable debt. There seems no particular sense in the rights of the pension scheme trustees to receive a sum which the legislature considers they should be entitled to receive having any greater or any lesser priority than the rights of any other unsecured creditor."

7.  Continuing: "if a CN had been issued in respect of a company before an insolvency event, it would give rise to a provable debt, and the courts below considered that, if a CN were issued after an insolvency event, it would give rise to a provable debt if it was based on a FSD issued before the insolvency event. It appears somewhat arbitrary that the characterisation and treatment of the liability under the FSD regime should turn on when the FSD or CN happens to have been issued, if it is based on a state of affairs which existed before the insolvency event."  The court noted the practical consequences of an "expense of administration" ruling: "Where the Regulator is proposing to issue a FSD in respect of a company not yet in administration or liquidation, it would be well advised to wait for the insolvency event, if the decisions below are right, because the amount recoverable under a subsequent CN would inevitably be greater than under a CN issued following a FSD issued before the insolvency event."

8. The court also noted the illogic and unsound policy of treating the debtors in a corporate group differently: "It would be strange if the employer company’s statutory obligation to make good a shortfall in its employees’ pension scheme ranked lower in its insolvency than the more indirect statutory obligation of a target to make that deficiency good ranked in the target’s insolvency."

9. The court also discusses at length whether the affiliates' liability is a "provable debt" at all, what we in the US used to call the "Frenville" issue until that case was overruled by the Third Circuit.  The reasoning is again very similar to the US analysis of whether something is a "claim" that can be discharged in a chapter 11:
"Where a liability arises after the insolvency event as a result of a contract entered into by a company, there is no real problem. The contract, in so far as it imposes any actual or contingent liabilities on the company, can fairly be said to impose the incurred obligation. Accordingly, in such a case the question whether the liability falls within para (b) will depend on whether the contract was entered into before or after the insolvency event."

10.  But, "Where the liability arises other than under a contract, the position is not necessarily so straightforward....the mere fact that a company could become under a liability pursuant to a provision in a statute which was in force before the insolvency event, cannot mean that, where the liability arises after the insolvency event, it" should be viewed as a pre-petition debt.  As a general principle, the court said, to have incurred a pre-petition "debt", the company "must have taken, or been subjected to, some step or combination of steps which (a) had some legal effect (such as putting it under some legal duty or into some legal relationship), and which (b) resulted in it being vulnerable to the specific liability in question, such that there would be a real prospect of that liability being incurred."

11.   The court then proceeds to determine that the contingent FSD liability satisfies the two conditions: "if one asks whether those potential liabilities of the Target companies in these two appeals satisfy the requirements ... the answer is yes."

"As to the first requirement, on the date they went into administration, each of the Target companies had become a member of a group of companies, and had been such a member for the whole of the preceding two years – the crucial look-back period under the 2004 [Pensions] Act. Membership of a group of companies is undoubtedly a significant relationship in terms of law: it carries with it many legal rights and obligations in revenue, company and common law.

"As to the second requirement, by the date they went into administration, the group concerned included either a service company with a pension scheme, or an insufficiently resourced company with a pension scheme, and that had been the position for more than two years. Accordingly, the Target companies were precisely the type of entities who were intended to be rendered liable under the FSD regime. Given that the group in each case was in very serious financial difficulties at the time the Target companies went into administration, this point is particularly telling. In other words, the Target companies were not in the sunlight, free of the FSD regime, but were well inside the penumbra of the regime, even though they were not in the full shadow of the receipt of a FSD, let alone in the darkness of the receipt of a CN."

In other words, the court seems to say, the day before the insolvency, there was a pretty decent prospect the regulator would issue an FSD to the affiliates, and that determines their contingent liability should be treated as a pre-petition debt.

This is, I think, a very similar result and analysis to what you would see in the US.  It is probably a good idea for management of multinational insolvencies that the US and UK take a similar approach to this kind of issue.

Friday, August 2, 2013

What Can Lawyers Learn from the Outcome of the SEC v. Tourre Trial?

I was out of the country on vacation for most of the trial of SEC v. Tourre, about which I had posted previously.  From the articles I read this week,  three things jump out at me that might be relevant to practitioners and have not, AFAIK, been covered elsewhere.

1.  Term sheets and preliminary deal discussions need to be treated as potentially career-terminating powderkegs.  The supposed misrepresentations about Paulson & Co signing up for the equity tranche only occurred in informal, preliminary deal discussions with ACA, not in the final offering and sale documentation. Multiple witnesses for the SEC who worked at ACA testified that the statements made in those preliminary contexts were "critical" to their underwriting. The jury seems to have credited those assertions, despite the fact that there seems to be no evidence that ACA ever sought to include in the deal documentation a condition to closing that the insurer receive documentation evidencing Paulson's supposedly "critical" subscription for that tranche, which I find highly suspicious since it is the basic job of a lawyer for a party to a deal to include in the closing conditions delivery of all the documentation that the client considers "critical" to its involvement in the deal.

Also, although it was undisputed that Paulson and ACA representatives met to discuss portfolio selection, I didn't see any evidence of ACA confirming Paulson would be the equity investor at those meetings.  However absurd ACA's claims may appear to me as a lawyer who worked on structured deals, the jury obviously had to credit them to find for the SEC, and thus one has to conclude that all the language that is usually put at the top of term sheets and transmittal letters about non-binding, no representations, subject to final documentation etc., don't protect one's client (or oneself) from a career-killing SEC investigation or lawsuit.  I foresee an increased use of "pre-negotiation agreements", one of those god-awful mechanisms that people began using in recent years, and many billable hours devoted to the terms thereof. But I don't even know if those would help against a rabid SEC investigation. Lawyers who advise on IPO roadshows and the like have known this for years and that is why clients spend money on lawyers in those contexts.  But it's definitely not the norm in structured deals, where a party is represented by counsel who can comment on the final document, to think that comments made in the preliminary, structuring phase need the kind of lawyering oversight that travels with IPO roadshows.

2.  The trial seems to have turned on an utterly subjective version of materiality that I find highly dubious and questionable.  Although the SEC doesn't have to prove reliance, a great deal of the testimony focused on the importance that the senior tranche's insurer, ACA, purportedly placed on the identity of the equity investor. There was no evidence reported of any other investor finding that material to its investment decision.  On cross-examination, one of the Goldman employees called as a witness by the SEC testified he would not consider that material, but obviously the jury credited ACA's subjective assertion of materiality (despite, as I note above, no evidence that ACA manifested the supposed materiality to the rest of the working group in the customary fashion, by negotiating for a closing deliverable demonstrating receipt of the desired equity investment).

Certainly I have seen deals where the identity of an equity investor is important.  Large private equity shops get better terms from lenders than smaller ones, and probably better execution, too, for instance.  Then there is the groupie phenomenon in which an investment by someone with prior successes in similar situations can, in and of itself, persuade others to co-invest in a deal they might otherwise not have paid much attention to. So it's not out of the question.  But what I don't see in the ABACUS deal (besides any customary manifestation that ACA really cared at the time) is any financial reason why it would matter, and, if the ACA witnesses were testifying truthfully, one has to question whether they understood the deal ACA was insuring at all.  ABACUS was structured so that a 100% short position could be bought against the portfolio; it was inherent in the deal that someone was 100% short.  Also, the long side of the trade was highly levered, more than 6 to 1.  So the equity long position was a small fraction of the overall money in the trade, of the panoply of views on the trade.  But you've got ACA executives on the stand claiming to have viewed the identity of the relatively small equity investor as "critical"  --  while never attaching equal,  let alone proportionate, importance to ascertaining the identity of the person who put on a much larger short position.  I find this pretty incoherent, which is why I think they either did not grasp the basic nature of the deal, or they just made up a story after the fact to divert blame from themselves for bad underwriting.  ACA was in the business of insuring structured deals, so how they could claim they were misled by someone else on such a deal is just mind-boggling.  But I imagine its executives were highly motivated to maintain that position, due to other pending or threatened litigation against them.

But what are the implications of that set of facts for documenting deals in the future? It seems that lawyers will have to really dumb down documentation, not just in registered deals that might wind up in the public markets someday, because that has already happened, but even in sophisticated deals that would not hitherto have been thought to be so closely scrutinized, to reach a level that even a really dumb investor would not be able to claim misled it.  And that certainly provides further confirmation that "big boy" letters won't be of any value in fending off an SEC investigation or proceedings, although there have been cases on that for a while now.

 3.  As Tourre is not a US native, the potential sanctions against him don't seem particularly meaningful. Banning him from the US securities industry is not all that significant as he's not in it right now anyway and, in any event, finance is global and the ban does not preclude him from working in Paris, London, etc., although a future employer would have to be careful to keep him off US-impacting deals.  And whatever fines might be imposed seem difficult to collect were he to move out of the US.  For those and other reasons that have been mentioned in the press and thus I won't bother to repeat, the trial seems to have been mostly a show trial, designed to prove to someone that the SEC can win a trial, if they only throw gazillions of resources into it, which will undoubtedly be noted frequently in its next appropriations request.