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The Fed Raises Concerns about Corporate Debt

Philip R. Stein & Kenneth Duvall

We have previously written about the possible economic and litigation implications of mushrooming corporate debt. Now, the Federal Reserve has flagged some of those same concerns.

In its semi-annual monetary policy report to Congress last Friday, the Fed expressed anxiety regarding the amount of debt taken on by American companies. Even “before the outbreak of the pandemic,” business debt was “already elevated.” Now, amidst the pandemic, “business leverage now stands near historical highs.”

The Fed took a sanguine view of “near-term risks,” stating that low interest rates and other factors provide cause for optimism in the short term. But the Fed appears more worried about longer-term risks, citing “considerable” insolvency concerns at small, medium, and even some large firms. If bankruptcies do result, then the economic pain can be expected to spread to securitized corporate debt—also known as collateralized loan obligations, or CLOs—and trigger litigation over the quality of the underlying bonds.

When corporate debt has been securitized, the initial claimants are likely to be investors holding certificates in the CLO structures, especially the lower tranches with sub-investment-grade ratings. More precisely, the plaintiffs would probably be trustees acting on behalf of those investors because the “no action” clauses in many CLO indenture documents bar investors from filing suits themselves.

On behalf of the investors, the trustees might sue the managers for various types of claims. Because CLOs are actively managed, i.e., assets can be traded in and out of the CLO over time, the manager’s decisions might be called into question. For example, investors might allege that the manager did not properly diversify risk among various industries. As another example, investors might argue that the manager failed to promptly sell off underperforming assets. Or investors might contend that the manager did not properly enhance the credit features of the CLO, which can include overcollateralization, limits on the junk-grade debt, procurement of insurance policies, and excess coupon spreads. The manager might be required to take some or all of the foregoing actions based on the CLO’s governing documents or, in the absence of contractual duties, on industry custom and practice.

Beyond the managers, the trustees might also sue the entity that issued or “arranged” the CLO. (Because the issuer is typically a special purpose entity with little to no assets, plaintiffs would probably attempt to sue the “arranger,” alternately known as the underwriter, initial purchaser, or placement agent.) The most lucrative claims might be securities violations (both state and federal).[1]  But because CLOs are typically distributed to qualified institutional buyers, CLOs are often encompassed by Rule 144A of the Securities Act, meaning that some causes of action under the federal securities act are unavailable.

Accordingly, the trustees might fall back on common law claims. In the wake of the previous financial crisis, a plaintiff in Michigan tested several claims, including breach of contract, unjust enrichment, fraud, silent fraud, negligent misrepresentation, breach of fiduciary duty, and accounting.[2]  However, the court dismissed most of the claims, and even after the plaintiffs attempted to re-plead the fraud claims with the requisite level of particularity, the court again dismissed the counts.[3] The only claims that survived the pleading stage were one count for breach of contract and one count for unjust enrichment. These surviving claims are usually not as lucrative as fraud claims because the available damages are not as robust.

By contrast, a plaintiff’s fraud claim in a more recent case in New York survived not only the pleading stage, but summary judgment.[4]  In fact, New York’s intermediate appellate court affirmed the denial of summary judgment, providing precedent in the country’s leading commercial jurisdiction.[5] The appellate court granted that sophisticated investors are under “an affirmative duty . . . to protect themselves from misrepresentations made during business acquisitions by investigating the details of the transactions and the business they are acquiring.” But the court found that the information and disclosures in that case “can be interpreted in a myriad of ways,” and more broadly observed that it is the “rare” case where “the issue of reasonable reliance can be resolved at the summary judgment stage of a fraud case.”

It is also possible that the investors would turn their sights on the trustees themselves. Though a trustee is not typically involved in the active management of the funds, the trustee can take on a greater role in times of distress, such as events of default. Trustees are bound by fiduciary duties to act in the best interest of the investors, creating opportunities for claims if investors feel that the trustees fell short of their obligations to protect them and be fair to all tranches.

If the trustees, issuers, or managers suffer losses resulting from such suits, those entities might look to the entities originating the underlying loans for compensation. A study from S&P late last year found that covenant light, or “cov-lite,” terms have largely reduced recoveries, at least in the bankruptcy context. Cov-lite loans—meaning loans without financial maintenance covenants during the life of the loan—have become predominant in the leveraged loan industry, accounting for most institutional loans since 2013 and 85% of institutional loans since 2018. If CLO litigation flows down to the level of the originators, cov-lite loans will thus probably play a significant role.

[1] In re Citigroup Inc. Securities Litigation, 753 F. Supp. 2d 206 (S.D.N.Y. 2010).
[2]  General Retirement System of the City of Detroit v. UBS AG, 799 F. Supp. 2d 749, 754 (E.D. Mich. 2011).
[3]  Gen. Ret. Sys. of City of Detroit v. UBS, AG, No. 10-CV-13920, 2012 WL 1278300, at *11 (E.D. Mich. Apr. 16, 2012), on reconsideration in part, No. 10-CV-13920, 2012 WL 2803912 (E.D. Mich. July 10, 2012).
[4] Girozentrale v. Tilton, No. 651695/2015, 2019 WL 3944490, at *6 (N.Y. Sup. Ct. Aug. 20, 2019).
[5]  Norddeutsche Landesbank Girozentrale v. Tilton, 178 A.D.3d 539, 115 N.Y.S.3d 312 (2019).

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