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Tuesday, April 29, 2014

Castleton Plaza II

Earlier this year, I wrote a series of posts on the flawed understanding behind the extension to chapter 11 cases of Till v SCS Credit Corp.’s “prime plus-” interest rate formula for cram-ups of secured creditors in chapter 13 cases.   In one of those posts, I focused on a recent case, In re Castleton Plaza, as a particularly egregious example of the way the extension of Till to chapter 11 leads to absurd departures from sound financial analysis, decades of precedent and common sense.  At the time I wrote those posts, Castleton Plaza was on remand to the bankruptcy court after the Seventh Circuit, acting with remarkable alacrity, had vacated the order confirming the debtor’s cram-up plan because the plan’s sale of the equity in the reorganized debtor to the existing equity owner had not been subject to competitive bidding.

When I attended the ABI Caribbean Insolvency Forum in San Juan, P.R., back in February, a panel of lawyers from Indiana, where the case had taken place, delivered a presentation about it, and forecast that the debtor would lose on remand, but would appeal the result.  At the time of the conference, the bankruptcy court had sub judice a revised plan and the secured creditor’s motion to dismiss the case, which the court ultimately granted on February 11, 2014.  Whereupon, the debtor did, indeed, appeal directly, with leave, to the Seventh Circuit earlier this month (Case No. 14-1735).  Briefs are to be completed by early June.  Per order of the bankruptcy court, the secured creditor’s exercise of rights is stayed pending resolution of the appeal.

Reading the debtor’s notice of appeal and its argument against dismissal in the bankruptcy court, I thought it would be interesting, as sort of a post-script to the Till posts earlier this year, to examine the position being taken by the debtor, which depend on the extension of Till to chapter 11, although there are other fallacies as well.

The debtor’s revised plan was remarkable for its brazenness.   Notwithstanding the emphasis in Judge Easterbrook’s opinion on the need for an auction where a debtor proposes to sell new equity to an existing equity holder, the revised plan did not contemplate one.  Rather, the debtor revised the treatment of the secured creditor, the claim of which had been bifurcated under the original plan, with the deficiency being discharged at less than par, to provide that it was now fully secured (I discuss later on that this is more a matter of the debtor’s “ipse dixit” than actual economic fact).  The revised plan further proposed a repayment of the secured claim over 10 years on a 30-year amortization schedule with a “fixed market rate of seven percent” (quoting the revised plan).

The debtor then argued, first, that Judge Easterbrook’s opinion was merely an application of the absolute priority doctrine, but the absolute priority doctrine can only be invoked by a dissenting class of unsecured creditors; since the objecting creditor was fully secured, it could therefore not be heard to complain about the continuing lack of an auction.  

Second, the debtor argued, its proposed treatment of the secured claim was “payment in full” because it complied with Till; further, it argued (in one of the most ridiculous arguments I can recall seeing), because a Till-compliant cram-up is within a debtor’s legal rights,  then being crammed-up in accordance with Till is within the “legal, equitable and contractual rights to which such claim or interest entitles the holder of such claim or interest” and, presto, the secured creditor was actually “unimpaired” within the meaning of section 1124, and thus deemed to accept the plan.

The second argument is obviously wrong, regardless what one thinks of Till-in-chapter-11 in that it misreads the word “and” in § 1124(a)’s litany of “legal, equitable and contractual rights”  to mean “or”.  Unimpairment requires that all three kinds of rights be left “unaltered”, not merely one subset of them.  The secured creditor’s debt had come due by its terms and thus the creditor has, but for the automatic stay, a host of contractual, legal and equitable rights to pursue outside of bankruptcy court that the plan, by substituting an extended payout and discharging the terms of the old debt, “alters”.   Also, fairly obviously, to conclude that a cram-down/up leaves a creditor class “unimpaired” would eliminate the role of

The first argument is more competent, also I think it is also wrong, because the “cramdown” section of the Bankruptcy Code, § 1129(b)(2), does not contain the “only if there is a dissenting unsecured creditor class” logic that the debtor reads into it.  Rather, it says the bankruptcy court shall confirm the plan “if the plan … is fair and equitable with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.”  The secured claim is such a class under the revised plan, so clearly gets to invoke the “fair and equitable” standard.   The only question is whether the content of that standard is 100% different for different classes, or do overlaps exist.    

The Code then specifies that the “fair and equitable” standard “includes” – which is statutorily defined to be non-limiting – certain criteria which differ by class, but by virtue of the word “includes”, courts can impose additional requirements, and it is clear from Judge Easterbrook’s opinion that it was not tied to the deficiency claim that the original plan would have imposed on the mortgage holder.  And that makes perfect sense as a matter of economic substance because these small to midsize commercial real estate cases are generally all battles between the mortgage holder and the equity holder; there is rarely any unsecured debt to speak of.   In Castleton Plaza, it seems pretty clear that any unsecured debt that existed in the case was consciously created by the debtor’s strategic non-payment of certain trade creditors whose loyalty it could count on (subject to designation of their votes under § 1126 (e)).

But, suppose you disagree with my position on that last issue, and instead believe there are no “cram-up” criteria for secured creditors outside of the ones explicitly specified in § 1129(b)(2)(A)(i).  Then you must confront the “Till in chapter 11” issue.  The proceedings below, it is clear, never proved by way of evidence that the proposed repayment actually delivered to the secured creditor a “value, as of the effective date of the plan, of at least the value of the holder’s interest in the estate’s interest in such property…”, i.e., the foreclosure value of the collateral here.   There was no evidentiary hearing on that issue.  Rather, the debtor simply contended a payout formula compliant with Till delivers that value as a matter of law.  

The plan uses the phrase “fixed market rate of interest”, and thus one might wonder if in fact the repayment terms could be supported by expert evidence, and thus dodge the Till issue, but that phrase is frankly absurd and misleading.  The value of the collateral that was referenced in the proceedings before the bankruptcy judge earlier this year, $8.2 million, is only about 90% of the principal amount of the note to be issued under the plan to the secured creditor (approximately $9.1 million).  There is no credible “market rate of interest” for a 10-year note with a 110% loan-to-value ratio and a 30-year amortization; if there were, the debtor would have found a lender willing to provide it and dispensed with the multi-year cram-up battle.  Thus, to obtain confirmation, the debtor would ultimately have to argue for a rule of law that a note complying with Till satisfies § 1129(b)(2)(A)(i)[1].  As I explained in my posts earlier this year, I think that would be an error of law, not a rule of law, and it will be interesting to see if the Seventh Circuit seizes on the chance to explain why Till should not be applied in chapter 11 cases.



[1]           Technically speaking, the proposed rate of interest is 375 bps above the prime rate, so slightly more than the conventional Till range of 100-300 bps, but that does not seem to affect the analysis as the LTV ratio is still too high for the note to be equal in value to the secured creditor’s claim.  

Thursday, April 17, 2014

Reasoning and Ideologically-Based Reasoning

Last year I wrote a post criticizing an article by Yale Law School professor Bruce Ackerman in which he argued that a third year in law school was more or less essential to any hope one might have to function as an intelligent citizen.  In compensation, I heartily recommend this article from a different Yale Law School blog to everyone. The author is Dan M. Kahan, and if only all law school faculty were of this mind.

http://www.culturalcognition.net/blog/2014/4/9/more-on-krugmans-symmetry-proof-its-not-whether-one-gets-the.html/

It became clear to me a few years ago, as a 30+ year reader of the Times, that the Times had chosen, as a survival measure, in the secularly declining conventional media environment, to follow the Fox News strategy and make sure to forge a tight bond with its audience by consistently telling them what they want to hear and making them feel superior to the rest of the citizenry.  Getting a Nobel Prize holder to do that makes Times Nation feel smart and honorable every time they read him, because Krugman tells them pretty much daily that the people they dislike, Republicans, are stupid and mean.  That is a psychologically enjoyable sentiment, like a massage of one's ego, and makes Times Nation come back for more, which enables the Times to stay in business.  That's all that is going on, and I am not surprised an economist would be in its vanguard.  He is probably paid enormously well!

Systemic Risk of Hedge Funds?

The WSJ “Real Time Economics” blog carried a post Monday, April 14, headlined “Hedge Funds Help Fan Financial Crises: SF Fed Paper” that referred to an article in the San Francisco Fed Letter released earlier in the day.  The article is written by a visiting scholar, Reint Gropp, and summarizes a paper he and others have written that I think I found online ( I will refer to the authors collectively as “Gropp” for expediency). If that is not the actual paper, it is a draft or earlier iteration thereof.

Briefly summarized: the researchers construct their own VaR (value at risk) model for four different kinds of financial intermediaries – commercial banks; investment banks; insurance companies and hedge funds.  Using “daily data”, they derive VaR estimates for each sector (and a control group of REITs, commodities and non-financial stocks) over 2,000 trading days from 2003-2010, which they further divide into periods of tranquility, normality and financial stress.  They then run regressions showing correlations, etc., among the various sectors during these periods, to see whether risk appears to spill over in a persistent pattern from any of the sectors to any of the other ones.   They conclude that, during periods of “tranquility” or “normality,” increases in VaR of the HF universe produce very small (8-9 bps) changes in the VaR of investment banks; otherwise, not much changes.  But in periods of financial stress, they find much greater (71 bps) correlation and impact running from HFs to IB’s and also that the spillover tends to run its course over approximately a two-week period and thus is not detectable when measurements are done using less-than-daily data.

Conversely, they perceive that insurance companies play little role in transmitting risk, as their returns are found to be negatively correlated with the returns of other financial institutions.  Finally, they find very little spillover between commercial and investment banks. The conclusion that hedge funds are the  largest amplifier of risk has implications in relation to the scope of regulation for hedge funds, which are relatively lightly regulated compared to the other sectors.

Their conclusion has an intuitive appeal, in that hedge funds are commonly seen to be more risky and active that the larger institutions and conversely, insurance companies are seen to be the most conservative. As Gropp explains,

Why are the spillovers from hedge funds during financial crises so much bigger, and why do they seem to increase more than those from other financial institutions? Hedge funds are opaque and highly leveraged. If highly leveraged hedge funds are forced to liquidate assets at fire-sale prices, these asset classes may sustain heavy losses. This can lead to further defaults or threaten systemically important institutions not only directly as counterparties or creditors, but also indirectly through asset price adjustments (Bernanke 2006). One channel for this risk is the so-called loss and margin spiral. In this scenario, a hedge fund is forced to liquidate assets to raise cash to meet margin calls. The sale of those assets increases the supply on the market, which drives prices lower, especially when market liquidity is low. This in turn leads to more margin calls on other financial institutions, creating a downward spiral. Another example is investment banks that hedge their corporate bond holdings using credit default swaps. If hedge funds take the other side of the swap and fund the investment by borrowing from the same bank, the spillover risk from the hedge fund to the bank increases. These types of interconnectedness may underlie some of the spillover effects in our study.

 

The paper appears to have crunched on a very sophisticated level through massive amounts of data, producing an analysis that would take a reader a very long time to investigate thoroughly[1].  But I also have two huge reservations.   The quotation above carries the seeds of one of them.   Most of the statements in it are actually wrong to the extent they purport to describe characteristics that are unique to hedge funds; that is, they are not true “if and only if” the subject is a HF.  For example, when the paper states “hedge funds are opaque and highly leveraged”, that is only a partly true statement.  Opaque – yes, but not that much more so than the other institutions, and not as much as you think (and also, as I realized while I wrote this post, it cannot be true of the HFs whose data they rely on – that is, the HFs they analyze cannot be opaque to the extent the paper relies on information about them!

Sure, to most observers and probably regulators, most individual hedge fund trades are opaque, yes.  But there are reporting requirements concerning equity stakes in public companies that provide disclosure on the largest equity positions, and various other ways in which hedge funds’ positions become disclosed, such as shareholder activism, being a member of an ad hoc committee in a bankruptcy, or talking up a position in some conference.  As well, other informal disclosures occur: I often found that traders had a good sense of which hedge funds had been taking positions in a distressed situation.  A prime broker would normally know reasonably thoroughly the positions of its client HFs.  Similarly, when a company goes out for a “drive-by” bond offering, or an equity raise via a private placement, the investment bank(s) running the deal invariably have a very good idea who is interested and who is not, because they have teams of sales people calling on asset managers all the time and staying up to date on what their interests may lie. Finally, to take a position in a financial asset outside of the securities exchanges, an investor must often enter into a contract in which its identity is necessarily divulged:  in loan trading, for instance, when a loan passes by assignment, the admin agent will have to sign off, and the borrower in a non-default context will also, and the identity of the buyer and seller must be disclosed.  So too in derivatives, the counterparty, often a financial intermediary, knows who it is contracting with on an ISDA form.  And, just to reinforce the point, is the “opacity” of an HF portfolio all that different from the opacity of the portfolio and trading books of the largest commercial and investment banks?  From a public investor’s perspective, I don’t think it’s all that different.  An observer of the markets may well be able to name a greater proportion of the positions held by, say, Bill Ackman’s hedge fund, or Dan Loeb’s, than those held by Goldman Sachs.  At the regulatory level, there is a difference, I admit, although I question how much actual or practical insight the regulators truly have over those institutions’ books, given their failure to apprehend any of the insolvencies in 2007-09.  As I said, the statement “hedge funds are opaque…” is indeed partly true, but just partly.

Moving on, what does the statement “hedge funds are … highly leveraged” mean, especially in comparison to the other kinds of institutions Gropp studies?  Although I do recall one memorable anecdote to the contrary[2], many of the hedge funds that I have worked with did not have any permanent leverage at all, because they held leveraged loans, HY bonds, distressed securities, ABS or other debt securities as to which the risk of illiquidity was too high to get into a margin situation in the first place.  But even assuming there are a lot of hedge funds with leverage, what makes them “highly” leveraged compared to commercial banks and investment banks from 2003-2010?  I doubt there was any hedge fund that had a leverage ratio higher than the commercial and investments banks in that period.  I would be surprised if any hedge fund had more than a 4:1 debt/equity ratio, and I would expect the average among the levered funds is less than 2:1, whereas the largest commercial and investment banks have leverage ratios in the 10:1 or higher range, depending on how one counts trust preferreds and other hybrids.  Especially for HFs that are mainly taking positions in equities, Reg U and other rules make it very difficult to do so on a basis as leveraged as a money center bank’s balance sheet is leveraged.

Tying this back to their research: the hedge fund universe that Gropp works with in his paper consists, the 2013 paper says, of 47  of the largest and most liquid such funds which comprise a “Hedge Fund Equally Weighted Index” which is one of the few sources for daily data on hedge fund performance.  But the researchers do not seem to know, and probably it is not disclosed, which, if any of those, are levered and to what extent and did it differ from day to day.  So I think the description of HFs relevant to the paper as “highly leveraged” is not supported in a scientific manner.

Moving on through Gropp’s explanation of his research, the two examples he gives of ways in which hedge funds might amplify risk are loss-and-margin consequences, and hedging credit risk via CDS’s.  But note that, again, these are not at all unique to hedge funds.  As I recall, when the subprime mortgage started, a lot of hedge funds weren’t long that asset class on borrowed money, they were short subprime MBS and indices tied thereto.  This is important because the 2013 paper states unequivocally “The subprime and financial crisis of 2007-2009 spread from mortgage-backed securities and CDOs to commercial banks and on to hedge funds and investment banks.” Think of “The Big Short”, or John Paulson being short the ABACUS vehicle in the Fabrice Tourre lawsuit.  The institutions that were long subprime were investment banks (think Merrill); the GSE’s; commercial or investment banks at home and especially abroad; andinsurance companies (AIG, the various bond insurers like MBIA and FGIC, etc).   And most of all the dozens of originators themselves, like AHM and so on.   There were certainly some mortgage funds, like the Bear Stearns’ funds, that were long subprime, but was the HF universe net long subprime?  I would be skeptical (it’s also an interesting taxonomy question relative to the research, how one should classify a HF managed by an investment bank).  So, both generally and specifically with respect to the financial crisis of 07 onwards, I doubt “loss-and-margin” consequences are particularly unique to hedge funds, especially in reference to subprime-mortgage-related assets. 

The other example Gropp gives, hedging credit risk through CDS, is again, not unique to hedge funds; for example one of the biggest individual players in CDS is the mega-billion PIMCO Total Return fund.  Further, the idea of transmitting risk through CDS raises the question of how matched the intermediary’s book is – it may be the case that the value or risk of one side of a CDS position goes up in value, but whether that intermediary’s overall CDS book loses value or has increased risk exposure depends on whether there is an offsetting position, among other things. I am not even sure how accurate it is relative to the HF sample the paper studies, because the hedge fund index they study appears, as I discuss below, to be heavily weighted toward investments relating to public equity markets, not corporate credit strategies, which are a clear minority of the strategies encompassed by that index.

So that is the first reservation I have about the study, to what extent are HFs that unique in relation to the risks and characteristics identified by the researchers as compared to the other kinds of financial intermediaries studied.

The other major reservation I have is that the study is a construct of constructs with potential for measurement errors or questionable assumptions and choices at each level.  That is, value at risk, as calculated by the authors is, obviously, a construct or a model, as it is for everyone who assays such a calculation.  But on top of that, the underlying data sets their VaR model is analyzing are themselves not the actual assets and liabilities of the subcategories but proxies for those assets and liabilities and thus potentially inaccurate reporters of the underlying value at risk, especially on a daily basis.  As well, there are a variety of financial market sectors that don’t appear to be analyzed in the paper that might have been relevant.

For example, as noted above, the set of  “hedge fund” data comes from a Hedge Fund Equally Weighted Index maintained by Hedge Fund Research.  Its methodology is described here:  http://www.hedgefundresearch.com/pdf/HFRX_formulaic_methodology.pdf.  Fwiw, the “strategies” that are “equally weighted”  in the index are Equity Hedge; Event-Driven; Macro/CTA; and Relative Value Arbitrage; HFR maintains indices in each of those strategies and the HFRX is just the sum of the NAV of the four individual indices.  Each of the underlying indices is comprised, HFR says, of funds that, in the aggregate, have the highest statistical correlation the aggregate performance of all funds with that strategy.  So the index is itself a statistical representation.

I am not going to go into a lot of detail about the underlying index, as the scope of this post is just some high-level observations; plus, I am not pursuing tenure as a professor of finance, nor billing by the hour as an advocate for HFs so someone else is welcome to push the analysis deeper.  The keeper of the index does indeed report it on a daily basis, which I find a bit curious as I don’t know of any HFs that disclose daily NAVs.  I searched the index manager’s website a few times to see if I could confirm it was receiving daily NAV data and not making its own estimates, but could not find any statement one way or the other on the subject.   I have to take them at their word, but this is a cool article from professors at the University of Maryland who tried to create daily VaR measurements for HFs using the same index that Gropp appear to be working with; they have mixed results although their conclusion that intra-month volatility is much higher than month-to-month volatility is similar to the Gropp conclusion.

Mesirow Advanced Strategies put out a paper in 2011 entitled “Understanding Hedge Fund Indices” that  contains a short, user-friendly discussion of some of the issues with hedge fund indices, including the one used in Gropp’s paper.  It also has some eye-popping charts that show wide variances in performance among the various indices that amply illustrate the caution needed in drawing conclusions from them.  A venerable alternative investment firm called Pictet also has a paper available on the Web entitled “Hedge Fund Indices: How Representative Are They?” from which I culled this little quote: “less than 1 per cent of the hedge fund industry reports to all databases, highlighting the unrepresentative nature of hedge fund databases.”  I am sure the keepers of the HFRX would disagree, but the point is, there are intelligent voices suggesting that all HF databases be taken with at least a small grain of salt.

A further complicating factor is that a lot of HF assets are not valued on a Level I basis, but may be Level II or Level III valuations that contain greater human guesswork (link for an explanation of these terms: http://www.iasplus.com/en/standards/ifrs/ifrs13 ) which introduces further potential for measurement errors in the data the authors study.

Finally, the identity of the components of the index are not disclosed in the Gropp paper or on the HFR website; they are only available to subscribers.  The Gropp paper references an appendix that supposedly goes into more detail, but every time I pasted the link into my web browser, I just got a “server error” message, so I could not investigate further.  But the main point is I can’t tell how US-centric they are, which seems to be reasonably important vis a vis the paper’s overarching topic of the regulation of US financial intermediaries.  .  .

The Gropp paper compares the VaR of the HF index to three baskets of equities of various large, publicly traded US-centric commercial banks, investment banks and insurance companies. To a certain extent, I question a VaR comparison between the NAVs  of HF’s and the equity prices of these other kinds of institutions, as equity prices of financial stocks are not equal to their respective NAVs, but are determined by secondary trading.  As well, all these other types of institutions have substantial operating, income-generating businesses in addition to holding portfolios of financial assets.  So, there is something of an apples and oranges comparison here, although I don’t think too much needs to be made of it; the geographical issue I mentioned above is perhaps more worth pondering.  

The Gropp paper states that its rosters of commercial banks and insurance companies is taken from a list compiled by Viral Acharya and others in a paper called “A Tax on Systemic Risk”, but, when I checked that paper for the list, I found the description in the Gropp paper did not quite match the Acharya paper (Gropp: 26 commercial banks and 31 insurance companies; Acharya: 29 commercial banks and 36 insurance companies).  I have no idea what changes were made, or whether they were explained by the link that did  not work.

Turning to the commercial bank subset, assuming it is the Acharya set, it contains the large money center banks which had substantial capital market businesses, like JPM, Citi, B of A (Gropp acknowledges that their classification as “commercial banks” is imperfect).  But this set also has numerous regional banks with no capital market business as well. 

The insurance sector  list oddly contains Countrywide Financial. That oddity is compounded by the fact that none of the largest mortgage insurers – Fannie, Freddie, MGIC – show up on the list (MBIA, AMBAC and AIG do, though).  So how accurate a list is that?

In contrast to the large number of constituents in the insurance and commercial bank sets, it is noteworthy that the investment bank category in the Gropp paper is composed of only 8 institutions (not all of which I can identify; compare the Acharya paper which lists 10 but those 10 include NYMex, Schwab, T. Rowe Price and ETrade, yet omit Jefferies, so I just don’t know how accurate these categories are).  Further, at least two of the investment banks in the Acharya list collapsed (Bear Stearns and Lehman) and one (ML) was merged out of existence, during the period studied.  It jumped out at me that the IB sample, as best as one can understand it, seems to be a little small to confidently draw conclusions from; appears to be  much more tied to equity markets than the other sets; and also a large proportion of the constituents seem to have been the subject of one-time events during the period of study, making a very noisy sample as well. 

Another aspect of “noise” in this data is how much was unknown in real time, but came out later, in the form of fines, penalties, damages, settlements etc, about the amount of contingent liabilities that various financial institutions other than HFs had during the period in question, which leads one to wonder, how accurate were the equity prices of the underlying assets and liabilities of those institutions?

A lot of other financial entities don’t appear in any of the sets Gropp studies, to the extent the paper tracks the Acharya paper’s list.  Fannie, Freddie, MGIC, as mentioned, and also Amex, Annaly, Blackrock, Capital One, CIT, Franklin Resources, Legg Mason, TD Ameritrade.  The exclusion of the mortgage –related entities utterly baffles me since the researchers state “The subprime and financial crisis of 2007-2009 spread from mortgage-backed securities and CDOs to commercial banks and on to hedge funds and investment banks.” I would have thought it would have been essential in the context of that thesis to study correlations between mortgage-centric entities and financial institutions, but no.  Also on the subject of things not studied for correlation, it struck me as odd that whole sectors of the capital markets, like HY indices, leveraged loan indices & MBS indices that are at least as credit-driven as anything the Gropp paper studies were not examined for correlations.

A last observation on the underlying data relates to what sounds like an overstatement in regard to the period studied.  The paper covers 7 years roughly.  Recall that one of its self-described principal innovations, compared to prior analyses, is to break that period up into periods of “tranquility”, “normality” and “distress”.   While I cannot get the link to the backup data to work, so I cannot be sure of what I am about to say, I gleaned from the paper that its repeated references to “periods of financial distress” are really just references to the 2007-09 period, taken as a whole.  As I said before, that was a very noisy period with all sorts of things going on – collapses, bailouts, shotgun weddings --  that had never happened before.  And, in any event, it’s just one period!  So I wind up skeptical about the prescriptive significance of finding some correlations between HF NAV changes and a small set of financial intermediaries in a single period that was complicated by many one-time events.  I don’t see how anyone could ever determine whether this was a phenomenon capable of recurring, or just a one-time confluence of factors, or an artifact of the assumptions and choices the authors made in generating the paper.  It seems impossible to replicate the conditions of the period to test the hypothesis.. 

Often a correlation exists between two data sets because both are displaying the influence of a third variable.  For example, if Mary and Herb live in Scarsdale and work at banks in Manhattan, and Mary leaves her house every morning to catch the 7:16 from Scarsdale, and, Herb leaves his house every morning to catch the 7:34, there is a high degree of correlation between their schedules, but no causation even though Mary consistently precedes Herb.  Their schedules are determined by exogenous variables, namely the schedule people who work in the banks and take Metro North to get there have to keep. 

Here for example, the correlation between the VaR metrics for HF and IB in times of financial distress could simply show, not that one caused the other, but that both categories held assets that were more similar than they were to the portfolios of commercial banks and insurance companies.  That is, IB’s assets may have been more HF-like than CB’s or insurance companies assets were – for instance, it jumps to mind that they may have had more HY and equities as a proportion of total assets than CB’s and insurers did.  The HY part of that conjecture would help explain why the authors found the correlation greater on the downside – being a debt instrument, HY can only go up so much, so starting from a non-distress point, (which is where the Gropp study starts, in 2003, a bull year), HY tends not to provide much return beyond the coupon, while in a distress environment it can fall several multiples of the coupon.

When the authors find that negative changes in HF VaR appeared to lead changes in the VaR of a portfolio of IB equities, that could just be because the HF VaR reflects daily marking to market of the underlying assets (or the index manager’s estimation thereof), undiluted by other factors that may affect the stock prices of IB’s, such as secondary market technical factors, or the market’s evaluation of the advisory and other operating businesses of the IB’s. 

Another possibility could be that hedge funds, as they saw a broad financial deterioration sweeping the developed world, looked to hedge their exposure by finding shorts, and the hugely overleveraged balance sheets of certain brokerage firms were prime candidates, better than insurance companies or FDIC-insured banks .  They are hedge funds after all.  I know I got many calls from HF clients in 2007 asking for an explanation of how SIPC receiverships worked in reference  to a generic or hypothetical brokerage firm where they had repo’d their cash balances or otherwise had exposure from other balances. And everyone remembers David Einhorn’s very public short bet against Lehman Brothers throughout 2008.  So there was definitely worry among them about the health of some brokerage firms.  And recall that the investment banking sector of the Gropp study is only 8 firms, so it is very susceptible to one or two members of the group driving the results in a certain direction. 

All of the above seem plausible to me, yet none of the above would justify any sort of heightened regulation of HFs.  I tend to think that most HFs tend to carry less leverage than money center intermediaries do.  As always, the most appropriate financial-sector-specific regulation that needs to be in place is having enough equity capital in the system to buffer it against the level of loss that might arise from a specified level of financial distress, and to apply the capital requirements broadly throughout the financial markets so they cannot be evaded .  But again I suspect the HF universe would be broadly in compliance with the kind of capital adequacy requirements now imposed on banks and the like.  I'm not necessarily averse to the concept, as I don't work in or for HFs anymore.  All I am trying to do is use my experience to pose some hopefully intelligent questions on the topic, fwiw.

 



[1]           In part because the authors kept much of the data crunching out of the paper itself, and in a statistical abstract, the link to which unfortunately did not work the three times I tried it.
[2]           In early 2004, I had drinks with a small group that included the number 2 guy at a well-known hedge fund that was focused on below investment grade bonds. I asked him how his fund had done in 03, and he said, proudly, “up 81%” which was incredible for the billions of AUM they had.  My next question, in all innocence, was “did you have any leverage?” and he replied, “yes, 2.7 to 1”.  When I got into the office the next day, I looked up the performance of the relevant HY index, I think it was Lehman, for 03, and, amazingly, it was exactly 30%.  Of course that was unlevered, so what that meant was the brilliant hedge fund had, as far as asset class and security selection go, been just a market performer, and its entire outperformance was due to the leverage ratio.  Of course that is only one anecdote and I have others about guys running even larger amounts of AUM in the same sector with zero leverage, fwiw (but of course they weren’t getting 81% returns).

Tuesday, April 15, 2014

The Solution to Detroit's Pension WoesTurns Out to be Ipse Dixit

CNBC reports that the City of Detroit has reached agreement with its retired police and firefighters on revised pension terms.  The City apparently went in, asking for 6% cuts in annual payouts and an end to cost-of-living increases.   The retirees apparently went in, asking for no concessions.  With the assistance of mediators, they seem to have settled at: no cuts, but "reduced" cost of living increases, and "As part of the deal, Detroit has reportedly agreed to increase the projected return on its pension funds to 6.75 percent, up from 6.25 percent and 6.5 percent, according to USAToday." 

Now that is definitely not a solution anyone has ever thought of before in relation to pension shortfalls -- assume investment performance will compensate for the gap between what the employer pays in and what the retirees are promised to receive.  This is really an approach that everyone should be able take to a difficult financial situation.  For example, why didn't GM or Chrysler think of it? 

Banker: "I am worried that your cash flow is not going to be enough to enable us to meet our obligations to creditors on time."
CEO: " Yeah, I can see how our forecasts might lead you to think that. Let's fix that by just assuming we sell more cars at higher prices."
Banker: "Oh, wow! I never thought of that. I can see why you deserve to be CEO."

And then the banker can employ this solution with regulators, too. 

Regulator: "I am worried that your loans to the auto companies might be impaired; I want you to establish reserves against potential losses."
Banker: "They won't be impaired if the auto companies sell more cars at higher prices than they have been forecasting."
Regulator: "Why, yes, if that happened, indeed, your loans would be sound.  Let's use that assumption going forward."

Now, it is definitely true that in reorg negotiations, one of the things that  often helps to get deals done is to acknowledge that there is room for upside over the debtor's base case, such that, if the prospective pie is perceived to  be a little bigger, there is more to move around and placate potentially objecting constituencies.  OTOH, Judge Rhodes has stated he will focus on the feasiblity of the City's reorganization plan, it will be interesting to see how much scrutiny he gives to what is ultimately an of unprovable assumption.  Because this assumption is related to feasibility and the judge has announced he will be giving close scrutiny to that issue, I don't think the agreement is reviewed by the usual, lenient, settlement standard of "lowerst level of reasonableness" which it would seem to satisfy. How certain does the city's forecast have to be for him to call the plan feasible in his opinion, and does the plan need to contain any kind of backup protection against future default? Or does he decide to bless the mediated result, after grilling the retirees' representatives over their degree of confidence in the forecast, and getting them to acknowledge that the City is no longer responsible to make up a shortfall if the forecast is not achieved.    It will be interesting to see. 

Update on April 17th: From the website of Detroit's police and fire retirement system, I pulled the following facts: as of the latest (end of 2011), calculations, there were two retirees for every active memember covered by the plan; the average annual benefit payout was over $57,000; the plan considers itself, as of March 2014, fully funded as to all retired members, but only 47% covered as to active members, but the deficiency is mainly due to payments missed during the chapter 9 case; prior to the case, the plan was almost completely funded as to all possible participants (the news reports I read on the settlement do not say whether those missed payments will be cured upon emergence, although I think that is likely; still it would appear that the active force will bear the burden of limits to the cost of living adjustments, since they will live longer than the retirees).  From the standpoint of the health of the reorganzied entity which is what should be the main focus of a reorganization, one would rather the retirees bore the brunt of any sacrifice, so that the City can offer the maximum incentives to the police and firefighters it needs to employ.  But with a 2:1 retiree-to-active ratio, that seems politically impossible.

Wednesday, April 2, 2014

New GM's Exposure for Old GM Ignition Defect Liability

Somewhat to my surprise, I could not find, in a Google search I ran earlier today, a good online explanation of the bankruptcy law issues pertaining to the extent of "New GM's" liability, if any, "for at least 31 crashes and 13 deaths" resulting from an ignition defect that may have been concealed from the outside world until well after government-controlled New GM's purchase of the operating business of General Motors in 2009.  So I thought I would write one.

According to a helpful timeline NPR pulled together (see above link), all of the design and/or  manufacturing defects, and internal awareness of the defect, occurred long before "old GM" (now known as Motors Liquidation Company) commenced its chapter 11 case in 2009.  This means that any tort claims arising from the defect were pre-petition claims and their creditors, to the extent old GM gave them legally adequate notice of the asset transfer to new GM are bound by the Bankruptcy Court's order approving that sale.  The general rule on notice is that claimants known to old GM should have been sent actual notice in the mail, and widespread publication would bind claimants unknown to old GM (those who had sustained an injury but not yet sued or demanded a payment outside of a lawsuit). Tort claimants were very active active in the bankruptcy case and even took appeals of the Sale Order to the U.S. District Court for the Southern District of New York.  So it is unlikely any of them could show old GM failed to give adequate notice, and thus the Sale Order would, absent further proceedings, bind them.  So the next step is to look at the Sale Order's provisions on tort liabilities.

The Sale Order was extremely clear that New GM was not taking on old GM's tort liabilities.  The relevant provisions, as well as a depiction of the extensive litigation by tort claimants over those provisions, are laid out in District Judge Naomi Buchwald's April 2010 opinion dismissing certain tort claimants' appeal of the Sale Order for mootness.  As she describes it, the Sale Order distinguishes between "Existing Products Claims" i.e., crashes or losses that had already occurred, and "Future Products Claims", those that occurred post-closing of the sale, whether or not the vehicle had been manufactured before the sale.  New GM assumed the latter, but not the former.  The Sale Order also clearly bars tort claimants from suing New GM on theories of liability outside of contractual assumption, such as successor liability, "de facto" merger and so forth.  Judge Buchwald's opinion quotes the language at page 9 of her opinion and I won't repeat it here, but it's quite clear and explicit and broad. 

Judge Buchwald also recounts, at page 8 of her opinion, how government-controlled New GM very explicitly stated in the purchase agreement that it would not go through with the sale if it could be held liable for any debts of old GM outside of the limited ones it agreed to assume.  

These statements and provisions are consistent with what had been previously litigated in the context of the relatively contemporaneous Chrysler and Lehman sales that the Second Circuit Court of Appeals had upheld against somewhat similar challenges to the authority of bankruptcy courts to approves sales of entire businesses free and clear of claims under section 363 of the Bankruptcy Code.   Judge Buchwald noted in footnote 13: "We cannot rewrite the negotiated MPA and Sale Order, in which the 'free and clear' provisions were critical and nonseverable terms of the bargained-for transaction."  That ruling seems highly relevant to the extent of New GM's liability to similar claimants.

The Bankruptcy Code Makes it Very Hard to Undo a Sale Order After the Sale Closes

A bankruptcy court's sale order is especially hard to modify, owing to specific protections for buyers built into the Bankruptcy Code to maximize interest in buying assets out of bankruptcy.  Judge Buchwald's dismissal of the tort claimants' appeal was compelled by the language of section 363(m) of the Bankruptcy Code, in which Congress severely limited the scope of appellate review of section 363 sale orders.  363(m) provides that, once a sale approved by a bankruptcy court has closed, an appeal is moot except to the extent the purchaser was not "in good faith".   While some appellate courts have reasoned that appeals of ancillary or collateral terms of sale orders were not barred by section 363(m), the Second Circuit, in a 2010 decision involving an appeal from the sale order in the WestPoint Stevens case has reached the opposite conclusion, that the entire Sale Order is off limits once a sale has closed.  In any case, there was little reason to believe that the provisions protecting New GM from liability for tort claims were not integral aspects of the transaction.

Section 363(n) provides a seller grounds to vacate a sale order if it is discovered that the buyer wsa engaged in collusive bidding but that seems irrelevant to the tort claims here, even if the claimants could persuade New GM to make such a motion.

The tort claimants behind the appeal to Judge Buchwald further appealed her decision to the Second Circuit but before the year was out, withdrew it.  That left the Bankruptcy Court's sale order intact and enforceable against all parties who were given proper notice of it, unless  they can somehow convince the bankruptcy court to modify the order at this late date, or come up with a claim that falls outside of its purview. 

The Legal Methods for Trying to Undo or Modify the Sale Order

The Bankruptcy Code does not specify a substantive right or standard for that relief, so it is governed by Federal Rule of Bankruptcy Procedure 9024 which, with certain exceptions not relevant to a section 363 order, just says that the general rule on relief from federal court orders, Federal Rule of Civil Procedure 60, applies.   The relevant provision of that rule is Rule 60(b), which clearly specifies that fraud is a basis for relief from a federal court order.  A Rule 60(b) motion must be made to the court that entered the order from which relief is sought, here the bankruptcy court.  The Second Circuit showed some inclination to interpret Rule 60(b) challenges to sale orders liberally in In re Lawrence, where insiders of a company secretly bought the company's stock from a bankruptcy estate without disclosing a major product development, and the stock quadrupled in value within a few weeks.  Unfortunately, Rule 60(b) also clearly specifies that claims for relief based on fraud (and most other bases) must be brought within one year of the order being entered, as was the case in Lawrence, but here the Sale Order was entered almost 5 years ago.   I could not find any Second Circuit case approving 60(b) relief from a bankruptcy court order entered more than a year before 60(b) relief was sought.

Claims that allege "fraud on the court" are exempted from the one-year limitation, but "fraud on the court" is an extremely limited doctrine, a full discussion of which is beyond the scope of this post, and, in any case, even if one were to believe that Old GM was somehow engaged in "fraud on the court" with respect to the ignition defect (overlooking the difficulty that the bankruptcy court was not a safety regulator and there is really nothing in the bankruptcy code or logic that requires extensive disclosure in a sale context about a liability that is not moving anywhere in the sale), it is hard to see how New GM could be tagged with the assumed fraud.  New GM was just a shell entity controlled by the government prior to the sale.  It would be difficult to impute any knowledge of the ignition defect to it. 

But even more important, it is very clear from the Purchase Agreement and the proceedings around it, that no matter how much was known by the tort claimants or even New GM or the bankruptcy court about the ignition defect at the time the sale was under judicial review, it would not have led to a different result - the buyer was not assuming the tort liabilities it knew about, and the bankruptcy court knew that, so there is no reason to think New GM would have been willing to assume the ignition defect liability or the bankruptcy court would have been any more willing to disapprove the sale because of that.  The existence of these suits was known at the time and the fact that anyone learned afterwards they had a better case than perhaps was assumed at the time certainly doesn't increase the buyer's willingness to take them on.  This is the exact kind of adverse development that a buyer seeks to avoid by not taking on contingent liabilities, not a development outside of anyone's contemplation.  This is not like a lawsuit between a plaintiff and a defendant in which the defendant hid evidence to defeat the plaintiff on the merits and then the plaintiff has an argument that things would have turned out differently if the evidence had been known at trial; here, the buyer, like many 363 buyers, is actually assuming the worst -- that the lawsuits have merit -- and for that reason declining to assume liability for them.  So the alleged disclosure / nondisclosure have nothing to do with the legal act that bars the litigants from going after New GM and for that reason, "fraud on the court" or even "fraud" under Rule 60(b) should not be applied to impose any liability on New GM. 

In the National Gypsum case in Dallas in the 1990's, asbestos claimants succeeded in convincing a bankruptcy judge in Dallas to reopen a plan of reorganization that, much like the GM sale, sent legacy liabilities to a trust that held a stake in the reorganized company's equity, while that company went on free and clear of legacy liabilities, because they convinced him that the management had deliberately concealed certain profit-increasing business plans that they put in place several months later.  That case was never reviewed on appeal because the parties settled it, and its soundness as a matter of interpreting the Bankruptcy Code is questionable.  It may just be one of those "bad cases make bad law" instances.  In any case, it is meaningfully different from the New GM situation because they had a claim that the nondisclosure affected the negotiations in which they participated.  In the New GM situation, there is no reason to think that was the case.  Again, the more compelling their claim was against old GM, the less likely that New GM would take it on.  The only counterargument I could see would be that, because New GM was controlled by the federal government, the egregious nature of the ignition defect coverup would have led the government to force New GM to assume the ignition defect liabilities as a special case, for political or reputational reasons. It's very speculative and I have no idea how you test such a proposition if you're a court asked to rule on it, other than to see what Treasury did with the money it got from the sale of New GM stock over the past four years. Or to look at what Treasury did when other politically powerful constituencies,, like car dealers in Barney Frank's district, demanded special treatment....

For some time, until late 2013. there was pending in the Motors Liquidation bankruptcy case, a litigation involving Old GM, New GM, GM Canada and about a dozen hedge funds that somehow became portrayed in the business press as having the potential to "re-open" the GM bankruptcy case.  It grew out of a "lock-up agreement" entered into between Old GM and some of the hedge funds on the eve of bankruptcy, relating to over $1B in bonds issued by GM Canada that may have had the benefit of both guarantee claims against Old GM and an intercompany claim by GM Canada against Old GM, enabling the holders to "double-dip" the GM estate through the two channels and thereby double their recovery.  A collateral issue to the merits was whether the terms of the lock up agreement had been properly disclosed in the bankruptcy case, which controversy led some to speculate about the potential to "reopen" the sale.  Ultimately, the case settled for roughly 65%  allowance of aggregate "double-dip" claims after extensive pre-trial litigation and mediation.  The transcript of the hearing on the settlement (Case No. 12-09802-reg; Doc 266; Filed 10/29/13) reveals that the Judge thought the idea of "re-opening" the sale was far-fetched, even though he did not believe he had received full disclosure of the terms agreed on the eve of bankruptcy, as reflected in the following two excerpts from his remarks:

"Canvassing the issues here, there never was any possibility of the 2009 sale to New GM being undone in its entirety, as some pundits surprisingly have suggested. There is speculation in that regard demonstrated a failure to understand what the GUC Trust was asking for, and of course, a rather striking ignorance of the law in this area.  At most, we would've been talking about whether elements of the 2009 order approving the sale should be modified. But even such a request would have run head on into principles making it exceedingly difficult to selectively modify a sale and confirmation orders, as exemplified by decisions like Judge Buchwald's on the tort litigants 2009 appeal of the sale order."

"It tends to show that Old GM's management and counsel were not in any way trying to hide anything, and that they at least seemingly complied with Old GM's 34 Act reporting duties. It does not show, however, despite suggestions by some to the contrary, that I, as a judge, was on notice of it, or should've been on notice of it. The implication that a judge should have on notice of something not in the record, not called to the judge's attention, and not said to be relevant to any judicial decision then before the Court is puzzling."

Lawsuits outside of the scope of the Bankruptcy Court's orders

In general, new lawsuits that try to circumvent orders of bankruptcy courts are very hard to sustain.  In 2009, by way of example, the Supreme Court ruled that dozens of "direct actions" by alleged asbestos victims of Johns-Manville against Travelers Indemnity Company, Manville's largest insurer, were barred as collateral attacks on the bankruptcy court's order in the Manville's 1980's bankruptcy protecting Travelers from liability to third parties for Manville's asbestos exposure as part of the overall settlement where Travelers helped fund Manville's asbestos trust.  The principle re-affirmed by the court was a simple one: once orders become final and appeals are exhausted, they have to be complied with, whether they are later perceived to have been wrong or beyond the power of the court in the first instance.

Courts have been somewhat more receptive to lawsuits seeking damages from individuals who engaged in misconduct while they worked for the debtor during the bankruptcy case.   This case from 2003 allowed lawsuits against officers and directors of National Gypsum over the conduct described earlier in this post to proceed.  It also contains a thorough discussion of cases and authorities on the subject.  These cases, however, relate to officer-director wrongdoing during the bankruptcy and it is not clear that there was any during the few weeks between the bankruptcy and the sale. As noted above, I don't see a plausible basis that disclosure of the ignition defect to the bankruptcy court was required in the context of the sale to New GM, as neither New GM nor the bankrputcy court would have done anything different had the liability been clearer at the time of the sale.

In a somewhat similar vein, in the High Voltage chapter 22 case in Massachusetts a few years ago, an assortment of claims against professional advisors who worked on the company's first chapter 11 case for assisting the company to confirm a plan of reorganization that failed within the first year were rejected by the bankruptcy court and two appellate levels for several reasons, including the preclusive effect of the confirmation order and the orders approving the advisors' fee awards.  However, such provisions, when included in confirmation orders, typically have a carveout that allow claims for intentional misconduct ( for instance, fraud) to proceed; so, were a plaintiff to find an individual who had committed fraud during the bankruptcy that was responsible for some harm the plaintiff suffered, it is conceivable the claim could skirt the bankruptcy orders' protections and proceed, assuming it was otherwise viable and not barred by a statute of limitations.  The attractive feature of the carve out is that it doesn't require a motion to the bankruptcy court for relief from an order, because the order already contains the relief embedded within it.  But even if a lawsuit arising out of the ignition defects is allowed to proceed against an individual, unless that person has been indemnified by New GM for liabilities arising out of old products liability claims, I don't see how New GM can be tagged with that liability.  There is, I suppose, a conspiracy theory approach that says New GM was part of a conspiracy to screw the tort victims, but the problem, again, is that disclosure/nondisclosure to the tort victims have nothing to do with where the liabilities wound up.

A last possible route into New GM lies in the dealer network.  According to Judge Buchwald's opinion, New GM assumed liability to its dealers for any liability they might sustain for old products liability claims, so, to the extent that plaintiffs have sued the dealers of the cars that were defective, or can still sue them and not be barred by a statute of limitations, it is possible that GM could wind up ultimately writing the check.
 
Separate Exposure Under Securities Laws

A final interesting issue of potential liability is what, if any, securities law liability exists with respect to securities offerings and sales of New GM stock, including those by the Department of the Treasury, between the time the 2009 sale closed and the facts surrounding the ignition defect came to light.  Treasury was a "selling stockholder" in New GM's November 2010 IPO and thus liable on the prospectus for any damages for violations of securities law, such as material nondisclosure, therein.   Most likely, Treasury would have been indemnified by New GM for any losses thereby sustained.  Of course, even assuming a case for liability and damages could be made out concerning those offerings, it would not help the tort victims; it's just a risk to New GM.  

But Treasury's extensive involvement in regard to New GM during the period of nondisclosure about the ignition defect, and its convenient exit from the position before the worst news, does raise the question whether it should be contributing to any sort of a victims' compensation fund as opposed to leaving the current stockholders who might not have paid the purchase prices they did had they known all the facts to bear the economic consequences of the nondisclosure that occurred on Treasury's watch.