It seems the only busy sector of the structured finance market lately is litigation.
With the dearth of liquidity, market participants ranging from banks and insurers to private investors and hedge funds are wrestling with deal terms and hoping on one end to benefit from a hefty payout, or to avoid one altogether on the other.
While participants in structured finance transactions don't have a huge appetite to litigate to begin with, particularly against one another, many are now becoming more willing by necessity, market participants agreed.
A particular focus for the industry of late has been quarrels over CDS contracts. These disputes can be divided into two categories: counterparty disputes and shareholder litigation. In counterparty disputes, usually the seller of protection is trying to get out of its obligation to pay once a credit event occurs. In shareholder litigation, company shareholders that have entered into CDS contracts and have had to make payments on that protection, incurring significant losses, have claimed that the company failed to disclose the risks posed by those CDS contracts.
Although the market has seen more counterparty disputes, recently there has been an increase in shareholder litigation, said Ed Flanders, co-leader of the financial services litigation team at Pillsbury Winthrop Shaw Pittman. He pointed out recent class action suits brought by shareholders of corporations that suffered huge CDS losses, claiming that the company did not disclose the risks posed by those transactions.
A recent example is the class action suits brought against American International Group in connection with CDS losses it incurred in the billions of dollars after it had come out and told the public it did not think that it had much exposure in that area.
Hedge Funds Bring
A common trend seen in CDS litigation has been among hedge funds that sold protection to financial institutions and are trying to renege on those obligations.
However, these cases may be a challenge for the hedge funds, which may not have understood the contracts they were getting themselves into.
"It appears that these hedge funds didn't quite understand the risk and exposure, and are trying to come up with arguments as to why they shouldn't have to pay out on their CDS agreements," Flanders said. "These will be difficult cases for the hedge funds," he said, citing a 2007 decision by the United States Court of Appeals for the Second Circuit, Aon Financial vs. Societe Generale, where the court held that CDS agreements are private contracts that should be strictly construed - meaning that as long the contract is unambiguous it should be followed. Pillsbury served as an advisor on that case.
However, hedge funds may be attempting litigation to gain bargaining leverage so that they can cut a deal with their counterparty, sources agreed, which may be the case in the Paramax Capital International suit that was settled last week.
Last Monday, Paramax Capital, a private equity and finance firm focused on the financial services industry, announced that it had settled a dispute regarding a CDS transaction entered into between UBS and one of Paramax's affiliated investment vehicles. A spokesman for Paramax would not disclose the terms of the settlement.
In 2007, Paramax agreed to insure $1.31 billion of triple-A rated super senior notes from an ABS CDO pool. The fund, which was organized as a special purpose entity of $4.6 million, made the swap agreement, and UBS said it would pay Paramax 0.155% of the $1.31 billion in notes annually for the insurance, according to reports. Paramax would deposit this money into the fund to back the agreement and would increase deposits if the underlying notes began to drop in value, reports said. By last November, UBS had called for approximately $33 million in additional collateral, and when Paramax refused to pay, UBS sued the fund. Paramax filed a counterclaim shortly after in January 2008, alleging that it was falsely led to believe that the mark-to-market risk on the trade was low.
Similar cases, such as ones filed earlier this year against Citigroup and Wachovia by hedge fund VCG Special Opportunities Master Fund, previously named CDO Plus Master Fund, are also examples of hedge funds suits. The suits allege that the banks had improperly claimed that the CDOs they had bought CDS on from the hedge fund had hit a credit default.
While it is hard to tell how much CDS-related litigation will hit the market, the losses are staggering. "Where you have counterparties who sold protection and aren't able to recoup their exposure because they didn't buy protection from someone else to hedge their exposure, they are going to look for any way possible to avoid having to pay out on their CDS," Flanders said.
Hiding the Truth
Other recent litigation in the structured finance market centers on fraud or misrepresentation of underwriting standards.
MBIA Insurance brought a suit earlier this month against Countrywide Financial, alleging that it was mislead into guaranteeing billions of dollars of Countrywide mortgage bonds, which have now cost MBIA over $459 million.
And the market could see more of these types of claims alleging fraud, misrepresentation and breach of representations and warranties, said Zachary Rosenbaum, co-chair of the capital markets litigation group at Lowenstein Sandler. One caveat in these types of cases is that a lot of those originators are out of business so you may need to be creative in who you pursue, he said.
Coughlin Stoia Geller Rudman & Robbins announced last week that it has commenced a lawsuit against Citigroup Mortgage, certain officers and directors, and the issuers and underwriters of Citigroup Mortgage Loan Trust mortgage pass-through certificates and asset-backed pass-through certificates, all of which were originated in 2007.
The suit claims that Citigroup violated the Securities Act of 1933, providing false statements and/or omissions about the supposed underwriting standards used in the origination of these mortgage loans; the maximum loan-to-value ratios used to qualify borrowers; the appraisals of properties underlying the mortgage loans; and the debt-to-income ratios permitted on the loans. As a result of rating agency downgrades and weak performance of the mortgage loans, these certificates are no longer marketable at prices comparable to those originally paid by the holders. Coughlin did not respond to repeated requests for comment.
The case was filed in the U.S. District Court for the Eastern District of New York on behalf of purchasers of the Citigroup Mortgage Loan Trust.
Klayman & Toskes, a securities litigation law firm, announced last week that it filed a claim against Wachovia and Evergreen Investment Services with the Financial Industry Regulatory Authority's office of dispute resolution. The firm said it is seeking to recover damages incurred by investors in the Evergreen Ultra Short Opportunities Fund, which experienced a decline of approximately 20% in less than three weeks.
The claim states that investors were mislead regarding the risks in the fund, as well as its exposure to the subprime mortgage market. Instead of being diversified, the fund was over-concentrated with approximately 72% of its assets invested in the mortgage industry - residential and commercial fixed and variable rate MBS, including CMOs and other types of mortgage-related securities.
Also last week, a New York judge ruled that HSH Nordbank AG will be allowed to sue UBS for least $275 million in losses on the grounds that UBS violated agreements by putting risky subprime loans into a CDO pool, jeopardizing the steady stream of income from HSH's investment, according to published reports. However, the court did dismiss allegations of fraud, negligent misrepresentation and breach of fiduciary duties, reports said.
CDO Drama Continues
The market is also continuing to see disputes between classes of investors in CDOs and other structured finance vehicles, regarding the meaning of the waterfall or other rights in the indenture. That seems to be permeating into the asset-backed securities world, in addition to CDOs, Rosenbaum said.
To add to the complication, particularly in structured finance, you have a collateral manager, a trustee and then note holders who could be anywhere.
"Just to bring the interested parties into the case is difficult. It takes more time than many one-on-one or even multi-party cases, because there, even if it is a large institutional litigation, at least you know who you are dealing with," Rosenbaum said.
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