The lack of new issuance in U.S. Structured Finance CDOs does not mean the CDO market is twiddling its thumbs. Legal battles, including disputes over cash flow allocations after an event of default (EOD), have sent both buy-siders and sell-siders from the deal rooms to the courtrooms.
The number of subprime-related cases filed in 2007 already equals half of the total 559 Savings and Loan cases handled over a multiple-year period by the Resolution Trust Corp., according to a study released last month by Navigant Consulting. Resolution Trust was a government asset management company charged with liquidating insolvent S&L assets.
The firm expected that the number of subprime-related cases filed in federal courts would dramatically outpace the S&L litigation of the early 1990s, which has been seen as a "high watermark in terms of the litigation fallout of a major financial crisis," Navigant said. Of these subprime-related cases, 22% involve securities.
Much of the current litigation in the CDO market centers around breach of contract and securities law claims that encompass inadequate disclosure as well as securities fraud, said David Krohn, partner with DLA Piper.
"Interpleader suits," which would fall under the "breach of contract" umbrella, have been the most common form of litigation in the SF CDO market, according to market participants.
Since the majority of SF CDOs have gone into an EOD as a result of hitting an overcollateralization trigger and not a failure to pay interest or principal in a timely manner, complications have arisen concerning how to allocate cash flows in a default situation and what the relevant rights of the different tranche investors are.
While the language in each set of CDO indentures can differ, the documents in many of these deals have proved to be ambiguous, pushing trustees to file interpleader suits, paying all of the deal's cash flow into court until the judge decides who is entitled to the payments.
More commonly, after a CDO has hit an EOD, the controlling class will argue that the CDO is in default and push for acceleration to change the debt waterfall. This gives the most senior class the right payments coming into the deal, according to sources. Typically, the more junior classes would object to the acceleration and either argue against a default or object to the change in waterfall.
Among these cases are two fairly well publicized suits that remain pending. Mid-December, Deutsche Bank, the trustee on the Sagittarius CDO, filed an interpleader action to determine whether the CDO's investors, led by UBS, or the CDO's credit insurer, a unit of MBIA, has the right to the remaining payments under the CDO contract. Orion CDO trustee Wells Fargo also filed an interpleader action last month. Structured finance lawyers expect the rise in this type of litigation to continue as investors struggle to understand the indentures.
Tied Up in Court
However, working out the CDO in court can be very lengthy, which is a major deterrent for investors.
"There is no irreparable harm in these suits; people can be compensated when the disagreement is over money, so there is no incentive to fast-track these cases," a CDO lawyer said. As a result, market participants are increasingly trying to work out a solution short of having to go to court. "Everyone seems to be trying to work things out to not have another Sagittarius [situation]," he said.
But while there has been some discussion of settling these cases outside of court, the dollars are so large and the positions are so divergent, it is hard to avoid litigation, according to Zachary Rosenbaum, a partner at Lowenstein Sandler PC. "While legal fees may be a deterrent, they pale in comparison to the numbers in these CDO structures," he said. "You have billions of dollars at issue, I don't expect there to be lots of friendly discussions."
More litigation may also be rising against the investment banks, Rosenbaum said. Some debt investors have already sued on the grounds that they were misled into funding these structures, he said. The relief sought in this type of suit is that the investment bank must either buy the investment back, which would typically have been invested in increments upwards of $100 million or more, or pay the investor damages.
Late last month, HSH Nordback filed a suit against UBS (see cover story on p. 10) to win back the $500 million portfolio of CDOs linked to U.S. MBS that were structured and sold by UBS in the North Street 2002-4 CDO.
To Liquidate or Not to Liquidate?
In the case of market value CDOs, there is a lot of incentive to restructure these transactions into a cash flow CDO before a default, according to Lucien White, of counsel with DLA Piper. "In order to keep CDOs alive and stay away from the litigation scenario, it makes sense to convert the transaction," he said. "If you liquidate a CDO, you have to go out and sell the collateral. But when there is no market for the collateral, it does not make a whole lot of sense to go down that path."
Rosenbaum agreed that he has not seen much of a push by investors for liquidation of subprime CDOs due to the depressed prices of the underlying assets. "Why sell into this type of market if you are only going to get pennies on the dollar? And many of these defaults are still technical defaults, meaning that the CDO assets are still continuing to throw off cash."
But regulatory pressures or the absence of cash flow or principal payments to investors might force liquidations, despite depressed conditions, market participants said. Furthermore, it is not always up to the most senior party to decide whether to liquidate. Depending on the indentures, the CDO might need the majority or two-thirds of the other classes to support the liquidation. "[CDO workouts] vary on a deal-by-deal basis," the CDO lawyer said.
As of Feb. 28, 107 U.S. structured finance CDOs out of the 761 Moody's Investors Service-rated SF CDOs originated in 2006 and 2007 were in default due to loss of overcollateralization. The rating agency said that 59 out of 107 have accelerated, 21 are currently at some point in the liquidation process and three have completely liquidated.
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