Sonia Tolaney and Sandy Phipps, 3 Verulam Buildings, Gray’s Inn, London
Sonia Tolaney and Sandy Phipps on lessons learned from recent ‘credit crunch’ litigation.
Introduction – A Recovery with a Caveat
It hardly bears repeating that the past two years has been an exceptionally trying time for the alternative investment industry. It is heartening to learn that, as recently reported in an earlier edition of this journal, signs of a ‘New Dawn’ for the industry are now appearing. However, as that report observes, this is a recovery with a caveat; there is now an ‘increased focus on counterparty and prime broker risk’, coupled with ‘much greater stress testing of business plans in the event of counterparty or prime brokerage failures.’
An increased focus on risk (and risk-prevention) can only be welcomed. The recent past has shown that events such as prime broker or other counterparty failure, or the close-out of asset portfolios in other circumstances, can give rise to a wide range of both difficult and potentially contentious legal issues. And so taking steps to avoid such issues at an earlier stage is undoubtedly preferable.
With that introduction, we examine below some of the lessons to be learned from recent ‘credit crunch’ litigation. It is hoped that an analysis of these issues will be of use to industry participants in identifying, planning for and devising contingency measures against their potential re-occurrence in the future.
As a matter of basic insolvency law, the failure of a counterparty will result in its assets being pooled, realised, and then distributed to its creditors on an equal-share basis. If, however, a creditor can establish some form of ownership interest (or ‘proprietary’ interest) in the counterparty’s assets, then, to that extent, the assets will fall outside the collective insolvency process and can be reclaimed by the creditor.
The routine passing of assets between counterparties in accordance with short-term arrangements has meant that this principle has played a prominent role in the wake of several prime broker and other counterparty insolvencies triggered by, and of course including, the Lehman Brothers insolvency in September 2008. Depending on the circumstances, transactions such as collateral transfers, repos or stock loans may all fall short of outright ownership transfers. Upon the insolvency of one party (the insolvent party), therefore, it will be critical for the other (the trading party), first, to identify any assets held by the insolvent party pursuant to such arrangements and, second and insofar as possible, to assert a proprietary interest in those assets. This second step is discussed in the next section.
In relation to the first step, experience has shown that, despite its apparently straightforward nature, it can give rise to difficulties. This is because, in the immediate aftermath of a counterparty insolvency, the recently appointed liquidators or administrators may well struggle to locate assets, to match failed trades, or to investigate the cause of breaks. In such circumstances, they may well be unwilling to follow up on individual queries from trading parties regarding the location or status of assets. This was the experience of a number of funds in the immediate aftermath of the Lehman Brothers’ collapse, four of whom applied to the English High Court for an order that the bank’s administrators provide them with information regarding the location of their margined securities. The funds’ evidence was that, without this information, their consequent inability to exercise their shareholder voting rights or to value their portfolios would jeopardise their continued existence. Despite this, and while it expressed sympathy for the funds’ position, the court nevertheless deferred to the administrator’s counter-argument that obtaining the information sought would unduly distract from the general business of the administration and would, thereby, be to the detriment of the creditors as a whole.
Trading parties would therefore be well-advised to treat post-insolvency uncertainty of this nature as a latent form of counterparty risk, and to plan accordingly. Risk- mitigation measures might include seeking greater and more frequent reports from counterparties as to the location and status of assets, or making provision in fund instruments for the suspension or altered calculation of reported net asset values for the duration of the uncertainty.
Laying Claim to Assets
Assuming that at least some assets can be identified, this second step is crucial. In order to assert a proprietary interest in the assets, it will be necessary for the trading party, first, to identify a proper legal basis for a proprietary interest and, second, to establish that this interest has not been extinguished by any post-transfer dealings with the assets by the insolvent party. We will address each of these points in turn.
The first requires analysis of the precise basis upon which the assets were transferred to and held by the insolvent party. In some cases, regulatory rules will have required the insolvent party to have held assets on the basis that they continued to belong to the trading party, the most obvious of which are the Financial Sevices Authority’s ‘client money’ rules. Similarly, contractual documentation may provide for the trading party’s retention of a proprietary interest in transferred assets, such as certain of the International Swap and Derivatives Association standard credit support documents or an applicable prime brokerage agreement. But this is by no means the default position; it is equally common for assets to be passed on a full title-transfer basis, so that the transferee party is itself free to hypothecate the assets. For obvious reasons, the issue of which side of the line a particular instrument falls on may be, and has recently proven to be, a significant area of contention, with each case turning on its own circumstances.
Turning to the second point, sometimes after a trading party has been able to establish a continued proprietary interest in its transferred assets, it may then discover that these assets have been mixed in a common account with other identical assets belonging to the insolvent party itself, to other clients, or to both. The difficulty here is both obvious and acute; how can the trading party continue to assert ownership of assets when it can no longer distinguish them from assets belonging to other parties? And the difficulty becomes almost intractable when, as is invariably the case, the common account contains insufficient assets to satisfy all claims. Owing to the inherently interchangeable nature of cash and financial assets, this issue has been heavily litigated in the recent past. The key points to have emerged are, in summary, as follows:
If a trading party is able both to identify and to claim assets, the next issue which often arises relates to valuation of the assets. In addition to counterparty failures, this issue can often arise in the context of portfolio close-outs following an event of default under an ongoing trading relationship.
The principal point of contention in this area relates to the extent to which the valuing party is entitled to take its own subjective views or its own interests into account in valuing the assets. In some situations, such as where the applicable valuation methodology is strictly prescribed, there will be little scope for this issue to arise. But it is equally common for shorter-form or more general contractual language to be used, and it is in such cases that disputes have the greatest potential to arise.
This was the case in a recent English Court of Appeal decision, in which the relevant agreement stated simply that the close-out value of assets ‘shall be determined’ by the non-defaulting party. The defaulting party argued that this seemingly unfettered discretion was subject to an implied obligation on the non-defaulting party to value the assets in an objectively reasonable manner. But the court disagreed, holding that, provided that the non-defaulting party did not act irrationally or in bad faith, it was entitled to value the assets by reference to whatever factors, subjective or objective, it considered relevant. Importantly, this meant that it was also ‘entitled primarily to consult its own interests’ in doing so.
This is a welcome decision. Where a party is forced to carry out a portfolio close-out as a result of its counterparty’s default, there is little (if any) justification for imposing an objective duty of reasonableness on that party. However, it should be emphasised that a different result may be reached in different circumstances, in particular where there is a highly liquid market – and therefore a readily identifiable market price – for the assets in question.
In summary, the legal issues to which a counterparty failure or portfolio close-out can give rise are difficult and, as recent cases have shown, can often lead to unfortunate outcomes for trading parties. They therefore serve as a salutary reminder of the importance of identifying and making contingency plans against risks of this nature at an earlier stage.
Sonia Tolaney and Sandy Phipps, 3 Verulam Buildings, Gray’s Inn, London