Some of the biggest players in the CLO industry are embroiled in a contract dispute.
Highland Capital Management is trying to block Citigroup, Babson Capital Management and Bank of New York Mellon from removing it as the portfolio manager of a CLO.
Citigroup, which underwrote Liberty CLO for Highland in 2005, approached Highland in May 2011 about liquidating the vehicle, according to a complaint Highland filed in a state court in Dallas County, Texas on April 5.
When Highland refused, Citigroup sought to remove Highland as portfolio manager and replace it with Babson, according to the complaint.
Highland said Citi’s motives are less than pure: it claims that the investment bank bought up shares in the controlling class of securities issued by Liberty CLO at a steep discount, putting it in a position to profit handsomely if the assets used as collateral for the deal are sold.
“If the CLO is wound down as Citi desires, Citi will be paid the face value of the debt, resulting in a windfall to Citi,” Highland said in the complaint.
The asset manager said it refused Citigroup’s request to liquidate the CLO because it determined that the sale of the collateral would not be sufficient to redeem all of the outstanding notes and to pay the fees, expenses and obligations, and therefore would have violated the terms of the management agreement and adversely impacted the interests of the other certificate holders.
Highland has more than management fees at stake; the firm said it will suffer “immediate and irreparable harm” to its business as a result of Citi’s and Babson’s conduct because its “reputation as a successful portfolio manager will be unjustly impugned.”
Citigroup spokeswoman Danielle Romero-Apsilos said the claims are without merit.
Highland, which was formed in 1993 by James Dondero and Mark Okada, is one of the largest CLO managers, with $20 billion in assets under management. It has structured and monitored 32 CLOs and CDOs totaling $29 billion. Liberty CLO, which was arranged in 2005, issued securities with a face value of $872 million, according to a report published by Moody’s Investors Service that year.
In the normal course of events, a CLO issues debt that is used to fund the purchase of noninvestment grade loans and other kinds of collateral, and the interest and amortization on these loans is distributed to CLO security holders.
“A cash-flow CLO doesn’t typically end its life by having its assets sold at market value to pay down security holders at less than par,” said Frank Iacono, a partner at Riverside Risk Advisers, a New York firm that analyzes derivatives and structured products transactions. Rather, “as the assets mature, the classes get paid off in sequence.”
There is an exception, according to Iacono: When the equity class exercises its option to call the CLO and liquidate it. This might take place when the assets used as collateral are trading at or close to par, credit spreads are generally tight or the less expensive senior class is amortizing and the remaining financing of the CLO looks expensive relative to what’s currently available in a new structure. But in this call scenario, all the debt is paid in full.
“Absent this benign sequence of events, a cash flow CLO is designed to end its life by having its assets pay down according to their own maturities,” Iacono said.
Liberty CLO’s terms specify that the holder of a super majority of 66 2/3% of its Class E Certificates can direct removal of the portfolio manager, and Citigroup currently has the requisite number amount, according to Highland’s complaint. Nevertheless, Highland claims that Citigroup lacks the authority to liquidate the CLO. According to the complaint, both Liberty CLO’s indenture and the portfolio manager agreement provide that the CLO cannot be liquidated unless the proceeds would be sufficient to cover the CLO’s debt.
These kinds of contractual disputes are not unusual. Iacono said that the controlling-class liquidation provisions for CLOs are “all over the map in terms of when the liquidation option triggers and how liquidation works.”
Before the credit crisis, when the majority of CLOs currently in existence were issued, “there was no industry standard as to when the controlling class can wind down a CLO,” he said. “And not only are termination provisions all over the map, a lot of the language in the indenture can be subject to interpretation.”
This may be more than a simple contract dispute, however. Highland claims that Citigroup made improper use of confidential information that it had obtained regarding the structure of the CLO and identity of the investors to purchase more than half of the outstanding debt, although the complaint does not specify how the investment bank convinced investors to sell the securities at a discount.
Highland also alleges that Citigroup “wrongfully claimed” control of 18,920 Class E Certificates from a fund managed by Highland, and that without these shares, Citigroup would not have the 66 2/3% necessary to remove the portfolio manager. The complaint does not elaborate.
Highland’s beef with Babson, another major player in the CLO world, is that it should not have accepted Citigroup’s offer to take over as manager of Liberty CLO.
And Babson initially declined to do so. According to the complaint, one of the investment funds Highland manages owns Class E Certificates in Liberty CLO, and the terms of this fund required Babson to use its best efforts to find a successor independent of Babson. Babson named three alternative mangers suitable for the job, but Citigroup did not adopt this option, according to Highland’s complaint.
In March, the investment bank sent Highland a letter saying it had been replaced by Babson as the portfolio manager of the CLO.
Highland seeks “injunctive relief and actual and exemplary damages” for what it claims are Citigroup’s and Babson’s “tortuous interference” with its management contract.
A spokesman for Babson said the firm could not comment on pending litigation.
A spokesman for Bank of New York Mellon, which is named as a defendant in its capacity as the trustee of Liberty CLO, also declined to comment.