Collateralized Loan Obligations: Emerging Litigation Risks
June 16, 2020
Financial experts are forecasting significant increases in borrower defaults on leveraged loans held in collateral loan obligations (“CLOs”). From the ashes of these defaults will arise litigation similar to the residential mortgage-backed securities cases that followed the Great Recession. Defaults in the leveraged loan market in the Covid-19-era economic downturn will give rise to losses in CLOs and a host of disputes involving CLO investors, managers, arrangers, trustees and asset valuations, among others. This article discusses these issues in detail and explores actions market participants might take to protect their investments in CLOs.
II. More outstanding CLOs exist than ever before, while a recession is looming.
CLOs are comprised of below-market grade loans, often referred to as leveraged loans, collateralized into an asset-backed security. Notwithstanding the inherent risks, the CLO market has doubled since 2009 – reaching $740 billion in collateralized loans outstanding at the end of 2018.1 Increased demand by investors in recent years has caused issuance standards to become more relaxed,2 leading arrangers and CLO managers to create riskier deals containing fewer protections.3 With financial experts calling an economic downturn over the next few years a foregone conclusion, they are now also predicting an influx of leveraged loan defaults and CLO losses. Fideres projects the default rate for leveraged loans in the U.S. to reach 15% in 2020 and 10% in 2021, with the total loss to CLO investors exceeding $106 billion.4 Fitch Ratings similarly predicts the default rate to reach 8%–9% by year-end 2021.5 At least for now, the potential CLO losses appear to be confined to the equity and junior tranches, sparing the AAA tranches. From these defaults will arise litigation involving priority of payment, breach of fiduciary duty, and fraud, among others.
III. CLO Disputes
Arrangers are responsible for structuring CLO transactions, underwriting and marketing the securities, and engaging with legal advisors regarding the transactions, among other things. In the past, disputes against arrangers have often been brought by noteholders alleging misrepresentation of risk and misleading or omitted disclosures. See e.g., General Retirement System of City of Detroit v. UBS, AG, 799 F. Supp. 2d 749, 754 (E.D. Mich. 2011) (alleging arranger “represented expected returns of 10–15%” when “they knew these representations were untrue.”). Notably, eight banks account for 76% of CLO arranger market share by loan-amount outstanding.6 These eight arrangers or underwriters are the same entities that were involved in the RMBS securitizations from the Great Recession.
CLO managers assemble and monitor loan portfolios, which is a role distinct to CLO securitizations. These managers could be subject to a multitude of contractual requirements that may give rise to liability upon breach. In as recently as March, two CLO funds filed suit against their funds’ collateral manager, alleging manipulation of investment criteria. See The Charitable Donor Advised Fund, L.P. v. U.S. Bank, N.A., No. 1:20-cv-1036 (S.D.N.Y.). However, in addition to investment criteria disputes, litigation involving managers has also arisen from failure to act upon management terms7 and manipulation of overcollateralization tests.8
CLO noteholders have varying levels of priority in the event of default. In what’s often analogized to a waterfall, the senior-most noteholder is paid first and – to the extent anything remains when the water runs out – the junior-most is paid last. Should there be insufficient funds to pay the last tranches, an investor claim may be triggered to recover their losses.
CLO noteholders may have claims against arrangers, CLO managers and rating agencies related to losses sustained by the investor. The noteholders may also seek to enforce the terms of the governing documents underlying the specific Trust through directing the Trustee to bring action on behalf of the investors.
Disputes among investors can also occur when there is disagreement as to priority of payment, or when certain events set to occur affect priority of a noteholders’ stake. For example, a case brought by intervening junior noteholders in 2015 failed to prevent an unfavorable liquidation of CDO collateral, where the governing documents were held to authorize the senior noteholders to exercise that right. Oxford University Bank v. Lansuppe Feeder, LLC, 933 F.3d 99 (2d Cir. 2019).
CLO trustees hold the loans in trust, monitor compliance with covenants, and declare default events. The Trustee may be directed to bring affirmative actions against various entities related to the quality of the loans. Trustees must carefully review the operative documents to determine if they may institute proceedings for the collection of assets or moneys, enforce judgments, sell all or portions of the assets, or exercise remedies under the U.C.C.
A final category of cases that may arise involve asset valuations. These actions can include disputes among managers, noteholders, underwriters, and warehousing providers depending on the circumstances. Often, valuation actions are brought by CLO noteholders claiming the fund manager overvalued the security assets, causing it damages upon default. See e.g., UBS Sec. LLC v. Highland Capital Mgmt., L.P., 86 A.D.3d 469, 470 (1st Dep’t 2011). Improper valuation is an angle experienced financial market litigators must consider in evaluating the potential for liability.
Mark Twain famously said, “[h]istory doesn’t repeat itself, but it often rhymes.” Industry experts have pointed to many similarities between the Great Recession of the mid-2000s and the global crisis in which we now find ourselves. While this article is not an exhaustive list of litigation that may arise from impending CLO defaults, it does highlight potential problems ahead, where resolution through litigation might be necessary.
1 Financial Stability Board, Vulnerabilities associated with leveraged loans and collateralized loan obligations (December 19, 2019), https://www.fsb.org/wp-content/uploads/P191219.pdf at 7.
2 In the mid-2000s, residential mortgage-backed securities standards were similarly relaxed due to an increase in demand. As a result, the economic fallout from related defaults was exacerbated.
3 Fideres, CLO Litigation Webinar Series (April 2020), available at https://fideres.com/videos (In 2009 and 2010, only 15% of leveraged loans contained no covenants. By 2019, 76% contained no covenants.); Id. (B rated loans have increased 23% since 2009).
5 Mayra Rodriguez Valladares, Distress In The Leveraged Loan And CLO Markets Will Significantly Hurt Lenders And Investors, Forbes (March 27, 2020) (14% of top loans of concern are due by the end of 2020, and 35% are due by the end of 2021).
6 Fideres, supra, note 3.<
7 See e.g., U.S. Bank National Association v. Triaxx Prime CDO 2006-1, Ltd. et al., No. 15cv10172, 2016 WL 3552272 (S.D.N.Y. June 23, 2016) aff’d sub nom, U.S. Bank Nat’l Ass’n v. Triaxx Asset Mgmt. LLC, 687 F. App’x 8 (2d Cir. 2017).
8 See e.g, SEC v. ICP Asset Manaement LLC, No. 10-cv-p4791 (S.D.N.Y.).
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