The pending bankruptcy case involving LTV Corporation initially involved a challenge to the underlying concepts of securitization. In the early phases of the case, LTV Corporation attacked two of its own securitizations; one backed by its trade receivables and one backed by its inventory.
As the cases progressed, LTV withdrew its attack on securitization when the securitization investors (lenders) agreed to supply replacement financing through a DIP (debtor-in-possession) facility. In effect, LTV and its securitization investors reached an out-of-court settlement on the potentially troubling issues. This result has the combined effect of (1) relieving the securitization community of the small but immediate risk of an adverse finding by the Bankruptcy Court and (2) denying the securitization community of the opportunity to have received a favorable ruling.
Although LTV has withdrawn its attack on securitization, the possibility remains that others could level similar attacks in the future. The LTV case has not nor could it have put the issue to rest for all time. Rather, the LTV attack raises some tough questions about competing policy considerations within the U.S. bankruptcy system. In particular, the toughest questions will require courts or policymakers to decide whether the bankruptcy system will have plenary jurisdiction over all the claims against bankrupt entities, or whether borrowers and lenders will be able to agree in advance to "opt out" of the system by using securitization.
LTV used securitization to finance its trade receivable and its inventory. The deals were done in 1994 and 1998. Standard & Poor's assigned a rating of AAA to the trade receivables deal and Fitch assigned a rating of BBB to the inventory deal. On 29 December 2000 LTV filed for bankruptcy protection. The company immediately sought the Bankruptcy Court's permission to use the receivables and inventory that it had securitized. In seeking that permission, LTV had to attack its own securitizations.
The focus of LTV's attack was the so-called "true sale" issue. LTV asserted that the transfers of its receivables and inventory to the deals did not constitute sales sufficient to place the assets outside of LTV's bankruptcy estate and, therefore, beyond the reach of the Bankruptcy Court and LTV's general creditors.
In attacking the asset transfers, LTV went far beyond addressing the technical aspects of the transfers and launched a frontal assault against the basic concept of securitization. For example, LTV's court papers included the following material:
[T]hrough a bewildering and complex array of documents, and through the establishment of the SPVs (which have no real function), the Lenders have conjured the illusion that the Debtors do not own their inventory, do not own their accounts, and are not in the business of manufacturing and selling steel products...The Lenders' complex documents and legal constructs are designed to create the appearance of a daily "arms-length sale" of all the Debtors' current business assets (inventory and proceeds in the form of accounts) to the Inventory SPV and to the accounts SPV. The purpose of this fiction is obvious: to remove all of the Debtors' current assets from the jurisdiction of the Bank-ruptcy Court, to deprive the Debtors' unsecured creditors of the ability to real-ize any meaningful recovery from the Lenders' enormous equity cushion, and to enable the Lenders to exercise remedies without any accountability to this Court or any other parties in interest. In other words, the Lenders have at-tempted to "opt-out" of the United States Bankruptcy Code to capture the most valuable assets of the Debtors to dispose of as they see fit, at a painful cost to the debtor' employees, unsecured creditors, and shareholders. [italics added]
Without ruling on the substantive issues, the court granted LTV's request on an interim basis. The court scheduled a hearing for 7 March 2001 and set a deadline of 20 February 2001 for the parties to submit written arguments.
News of the LTV case spread rapidly through the securitization community. In fact, the LTV case was mentioned repeatedly at last month's two securitization conferences in Arizona. At the conferences, certain speakers noted that a group of securitization market participants had organized themselves to submit "friend of the court" or amicus curiae arguments in the LTV case. The law firm of Mayer Brown & Platt represented the group and submitted a twenty page memorandum arguing that the court should respect the validity of the LTV securitizations. In addition, Mayer Brown & Platt supplied the securitization community with updates on issues in the LTV case through its Securitization.Net website.
At a pre-trial conference on Thursday, 1 March 2001, the parties agreed to postpone the hearing scheduled for 7 March 2001. Then, as suddenly as it started, LTV's attack on securitization went away: the company announced on the evening of 5 March 2001 that it had arranged for the DIP financing facility with the its securitization lenders.
Even though the LTV case itself no longer poses a threat to securitization, we are not out of the woods. Other companies in the future may follow LTV's example in attacking their own deals. Such companies may press their arguments further or more tenaciously than did LTV.
The most troubling part of LTV's argument is the italicized material quoted near the top of this page. Much of the argument is true and LTV's counsel successfully colored its description of securitization activities with sinister tones. A central objective of securitization is to remove the subject assets from the potential bankruptcy estate of the company selling (financing) the assets. This necessarily diminishes the role of a bankruptcy court in handling the company's bankruptcy. If a securitization works as intended, the securitization investors (lenders) should not have to endure the bankruptcy process in order to realize the value in the underlying assets. Thus, in some sense, it is fair to view securitization investors as a special, super-protected class of creditors - creditors who have such an exalted status that they can satisfy their claims without even going to the bankruptcy court.
On the other hand, there is nothing intrinsically right or wrong about a legal/bankruptcy system that allows for enhanced creditors' rights. The traditional U.S. bankruptcy system severely restricted creditors' rights. Traditionally, secured creditors' in the U.S. have been subject to the Bankruptcy Code's automatic stay and have been prevented from realizing the value of their collateral until they received permission from a bankruptcy court.
However, over the past 20 years, the U.S. bankruptcy system has evolved, and certain classes of secured creditors now can bypass the hardship of the Bankruptcy Code's automatic stay. For example, since 1984, section 559 of the Bankruptcy Code has provided relief for creditors who lend via repurchase agreements against collateral consisting of U.S. Treasury securities. Other sections of the Bankruptcy Code provide somewhat similar relief when a financing ar-rangement is in the form of a swap agreement ( 560), commodity contract ( 556), or securities contract ( 555). All these "special provisions" allow certain claimants against a bankrupt company to avoid the bankruptcy process. Because securitization is a tool for creating similar relief for a broader class of claimants (i.e., "secured creditors" who have structured their "secured loans" as securitizations), it shares a conceptual ancestry with the Bankruptcy Code's special provisions.
It is not surprising that securitization evolved contemporaneously with the Bankruptcy Code's special provisions. Both reflect the fact that the Bankruptcy Code's traditional anti-creditor stance has been an impediment to commerce and economic growth.
One possible future for our bankruptcy system is that it will continue to evolve in its present direction. We can hope that it will eventually reach a state where all secured creditors will have the right to their collateral without having to endure the bankruptcy process. While such an outcome might be good for commerce in a larger sense, it could dampen securitization activities; one of the main motivations for use securitization would have been eliminated.
Or things might go the other way. The shrinking role of the bankruptcy system might precipitate a political backlash. After all, the purpose of the bankruptcy system supposedly is to allow for the rehabilitation of the debtor and the fair treatment of its creditors. The bankruptcy system is a continuing expression of America's response to English debtors' prisons and deportation. Maximizing commercial efficiency and promoting economic growth have not been among the system's paramount goals. On the contrary, commercial efficiency and economic growth might be maximized without having any bankruptcy system at all.
At the end of the day, it may simply boil down to a political question. Policymakers will have to decide whether the bankruptcy system should have plenary jurisdiction over all the claims against bankrupt entities or whether borrowers and lenders should be able to agree in advance to "opt out" of the system by using securitization.
The bottom line is this: Securitization as a financing tool has gained so much momentum that it should be able to withstand attacks in court of the type brought by LTV. It would require both incredible courage and outright defiance of accepted precedent for a bankruptcy court to accept LTV-type arguments and thereby kill a securitization. Thus, in the short- and medium-term, the world is safe for securitization. On the other hand, the longer-run outlook is more murky. The present system results in very different treatment of ordinary secured creditors from those who use securitization. It is unclear whether policymakers will preserve the disparate treatment when they give the bankruptcy system its next major overhaul.