As the pandemic began unfolding about a year ago, we wrote about the risk that the high volume of corporate debt might make it the next market bubble to burst. The issuance of corporate debt only accelerated in 2020 compared to 2019, growing by 17% and setting a new record in volume. S&P Global Ratings has predicted that corporate debt issuance in 2021 will remain robust, decreasing by only 3% compared to a frenetic 2020 (which would still be up 14% over 2019 levels).
The ratio of corporate debt to GDP might be at an all-time high, registering at over 46% in the second half of 2020. Factoring in the debt of smaller companies not listed on stock exchanges drives that ratio even higher, at nearly 75% before the pandemic arrived. For those watching the relationship of credit cycles and recessions—in which the ratio of debt-to-GDP plummets immediately after a recession and then rises until the next recession—the current ratio might be ominous. The cycle peaked at about 43% on the eve of the savings and loan crisis in the early 1990s, at about 45% before the dot.com recession in the early 2000s, and again at about 45% before the financial crisis.
In light of those possible warning signs, many risk managers believe that the risk of defaults associated with corporate debt and related securitizations (collateralized loan obligations, or CLOs) has heightened since the beginning of 2020. Many managers also believe that policymakers should do more to address the risks associated with CLOs. One of the most prominent regulations of the CLO market—the federal risk-retention rule requiring CLO managers to hold 5% of their deal—was thrown out by a court several years ago, and any appeal of that decision expired in 2018. It is still too early to tell whether the Biden administration will be inclined to revive such a rule or otherwise increase regulation on CLOs.
Even absent additional regulations, though, there are already several areas of potential litigation. Some economists have focused on three such areas targeting the CLO managers. One area is overcollateralization [1] tests: junior tranche investors might sue the manager if they believe that they were denied cash flow because the manager’s decisions caused the security to fail the test. Another area of potential dispute involves conflicts of interest claims against the manager, who might be accused by investors in one tranche of favoring investors in another. Similarly, a CLO manager might face claims of breaching fiduciary duties because the manager approved amendments to CLO documents that harmed certain investors’ interests.
A high-profile case from recent years involving some of these types of claims (among other issues), Zohar v. Patriarch Partners, LLC, sought to test some of these theories in Manhattan federal court. In an aggressive move, the plaintiff attempted to frame the allegations involving conflicts of interest and valuation decisions as violations of the Racketeer Influenced and Corrupt Organizations (RICO) statute. The upside of RICO claims for the plaintiff is that treble (i.e., triple) monetary damages are available.
But in a win for the manager, the court dismissed all of the RICO claims. The court found that the RICO counts were barred by a law (in the Private Securities Litigation Reform Act, or PSLRA) prohibiting RICO claims from being based on the purchase or sale of securities. Notably, the court did indicate that the claim regarding overcollateralization could have avoided dismissal if that claim had been brought by itself. But the plaintiff’s other RICO claims regarding the misappropriation of equity interests and equity distributions were predicated on the security transactions, requiring dismissal of all of the RICO claims. Investors might take this ruling as a signal to pursue only traditional, non-RICO claims, such as contractual and common law tort actions. Alternatively, investors might still try to pursue RICO claims (perhaps in tandem with non-RICO claims), but do so more narrowly, focusing only on claims that are not predicated on the purchase/sale of securities.
[1] Overcollateralization occurs where the value of the collateral is greater than the value of the loan.
