Limited recourse

The basic principles of contract

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Of a contract, that a debtor’s obligations under it are limited to a defined pool of assets. You see this a lot in repackagings, securitisations and other structured transactions involving espievies. Security and limited recourse are fundamental structural aspects of contracts with Special purpose vehicles and investment funds.

The basic idea

Investment funds and structured note issuance vehivles tend to be purpose-built single corporations with no other role in life. They issue shares or units to investors and with the proceeds, buy securities, make investments and enter swaps, loans and other transactions with their brokers. The brokers will generally be structurally senior to the fund’s investors (either as unsecured creditors, where the investors are shareholders, or as higher-ranking secured creditors, where the investors are also secured creditors).

So the main reason for limiting the broker’s recourse to the espievie’s assets is not to prevent the broker being paid what it is owed. It is to stop the SPV going into formal bankruptcy procedures once all its assets have been liquidated and distributed pari passu to creditors. At this point, there is nothing left to pay anyone, so launching a bankruptcy petition is kinda — academic.

Now, why would any creditor want to put an empty espievie — one which has already handed over all its worldly goods — into liquidation? What good would it do? Search me.

Why, on the other hand, would the directors of that empty espievie, bereft as it is of worldly goods, be anxious for it not to go into liquidation? Because their livelihoods depend on it: being directors of a bankrupt company opens them to allegations of reckless trading, which may bar them from acting as directors. Since that’s their day job, that’d be a bummer.

But if the espievie’s bankrupt, doesn’t that mean they have been reckless? No. Remember, we are in the parallel universe of SPVs. Unlike normal commercial undertakings, espievies run on autopilot. They are designed to give exposure, exactly, to the pools of assets and liabilities they hold. That’s the deal. Everyone trades with that understanding. The directors are really nominal figures: they outsource trading decisions (if any — in a repackaging, there most likely won’t be any) to an investment manager. The directors are really there to ensure accounts are prepared and a return filed each year. They are not responsible for the trading strategy that drove the espievie into the wall.^[1]

So all an investment fund’s limited recourse clause really needs to say is:

creditors’ recourse against the Fund will be limited to its assets, rights and claims. Once they have been finally realised and their net proceeds applied to creditors, the Fund will owe no further debt and creditors may not take any further steps against it to recover any further sum.

But, as we shall see, sometimes asset managers can be a malign influence, and try to further limit this.

Multi-issuance repackaging vehicles: secured, limited recourse

Secured, limited recourse obligations are de rigueur for multi-issue repackaging SPVs. They save the cost of creating a whole new vehicle for each trade, and really only do by contract what establishing a brand new espievie each time would do through the exigencies of corporation law and the corporate veil. The point is to completely isolate each set of Noteholders from each other. This is a surprisingly narrow point, as we will see, so we should not get carried away for the formalities of security.

With secured, limited recourse obligations there is a quid pro quo: all creditors are known; they are yoked to the same ladder of priorities; they all have agreed to limit their claims to the liquidated value of the secured assets underlying the deal. In return, the espievie grants them a first-ranking security over those assets — mediated between them by the agreed priority structure — and this stopping any interloper happening by and getting its mitts on the espievie’s assets.

The key point to absorb here: this is not a material economic modification to the deal. The line it draws, it draws around all the assets underlying the deal: the underlying securities, cashflows deriving from them, the espievie’s rights against custodians and bankers holding them, and its rights against the swap counterparty — everything, tangible or otherwise, of financial value in the transaction is locked down and pledged to secured parties, and the intercreditor arrangements, too, are fully mapped out. This kind of limited recourse, in fact, doesn’t limit recourse: it maps practical recourse, exactly to the totality of assets that the issuer has available for the purpose: all it saves is the unnecessary process of bankrupting a shell company with nothing left in it in any case. Secured limited recourse is like a nomological machine; a model; it is a simplified account where everything works as it should do, there are no unforeseen contingencies, and all outcomes are planned.

We shouldn’t get too hung up about the whys and wherefores of the security structure of a repackaging as long as it is there, it covers all the rights and assets it is meant to cover, and all necessary perfections and execution formalities are observed. For in a repackaging, the security just sits there and will almost certainly never be exercised.

All that tedious business about automatically releasing it to make payments, powers to appointing receivers, calling and collecting in, the trustee’s rights and obligations under the Law of Property Act 1925 and so on — look it is all good stuff; let your trustee lawyer have his day — but as long as it is there, none of it really matters.

Why? Because — unless you have negligently buggered up your ring-fencing and your Trustee has let you: both of these are quite hard to do — the SPV cannot go insolvent. Any repack redemption will be triggered by an external event: a non-payment on an underlying asset or by a failing counterparty or agent. None relate to the solvency or ability to meet its debts of the Issuer itself.

That being the case, once it exists, the security package will never actually do anything: any diminution in value to of the secured assets — will happen regardless of how strong the security is. The security is a formal belt and brace there to fully isolate from each other the noteholders of different series, and even that only matters only when the SPV is bankrupt. Which is, never.

The limited purpose of the security package in a repackaging is widely misunderstood – all it does is defend against unexpected holes in the ring-fencing.

This is why it is de rigueur to accelerate, liquidate and distribute the proceeds of a repackaged note without enforcement of the security.

Investment funds

Where you are facing an investment fund held by equity investors it is slightly — but not very — different. Generally, there is no security, since there’s no question of ring-fencing separate pools of assets. (But investment managers can get in the way and steal options, so be on your guard — see below). Limiting recourse to the fund’s entire pool of assets: A provision which says “once all the fund’s assets are gone, you can’t put it into bankruptcy”, is essentially harmless, seeing as once all the fund’s assets are gone there’s no point putting it into bankruptcy. This is the same place you would be with a single-issue repackaging vehicle: the corporate veil does the work anyway. This provision just keeps the directors of the fund in paid employment.

Limiting recourse to assets managed by an agent

On the other hand, limiting recourse to a pool of assets within a single fund entity — say to those managed by a single investment manager (some funds subcontract out the management of their portfolios to multiple asset managers) — being a subset of the total number of assets owned by the fund — is a different story altogether. This, by sleepy market convention, has become a standard part of the furniture, but to the JC and his friends and relations, seems batshit insane.

The manager is an agent

So firstly, the investment manager is an agent. An agent isn’t liable at all for any of its principal’s obligations. It is a mere intermediary: the JC have waxed long and hard enough about that elsewhere; suffice to say the concept of agency is one of those things we feel everyone in financial services should know; this is not one to drop-kick to your legal eagles: it is fundamental to the workings of all finance.

So why would an agent seek to limit its principal’s liability to the particular pool of assets that principal has allocated to that agent? Probably because the principal has said, I don’t trust you flash fund manager types, with your Sharpe ratios and your intelligent beta. If I am not careful you could put on some insanely cavalier spread play on the seasonal convergence of natural gas futures and blow up my whole fund. I don’t want you to do that. I am only prepared to risk the assets I give to you, and that is the end of it.

What the principal is doing here is broadly of a piece with segregated, ring-fenced repackaging. “Swap dudes: you are trading against, and limited in recourse to, this bucket of assets. Cut your cloth accordingly.” But not quite: for one thing, poor swap counterparty has no security over the pool, and so gets no “quid” for its generously afforded “quo”. The swap counterparty may be limited to that pool of assets, but it has no priority over them as against other general creditors of the fund: should (heaven forfend) the fund blow up our intrepid swap dealer may find itself not only limited to the pool of assets, but even then only recovering cents in the dollar on them. Double whammy. You could fix that by having the fund represent that all other creditors are similarly limited to other pools of assets, but that is messy and unreliable. Security is much cleaner and neater, but you’ll never get it.

You might also say that the principal — or more likely the agent — is engaged in some dissembling here. Whose problem should it be, if, in its dealings with an innocent, arm’s length counterparty trading for value and without notice of turpitude, an agent exceeds its mandate, goes crazy-ape bonkers, or just, in the vernacular, royally fucks up? The general principles of agency, we submit, say this is firstly the principal’s problem, and to the extent it is not the principal’s problem, it is the agent’s problem. The one person whose problem it should not be is an innocent counterparty’s. Yet this is what agent-pool recourse limitation effectively imposes. It transfers agent risk — perhaps a second-loss risk, but still a material risk, since the first loss is unreasonably limited to an arbitrary number — to the counterparty. It is really hard to understand why a principal’s swap dealer shiould agree to underwrite the risk of misperfoamcne by that principal’s agent.

The answer likely to come: “Well, all our other counterparties have agreed this.” Alas, in this particular case, the agent is probably right.

The asset pool is indeterminate

Secondly, a pool of assets for the time being allocated to an investment manager is kind of nebulous. What the client giveth, the client can taketh away. If the client’s asset manager has gone rogue, that is exactly the time at which it will be anxiously raking its assets back. So the swap dealer facing that pool of assets — who has been faithfully handling and executing all orders competently and in good faith, of course — may find that nice big juicy bucket of assets to which it has limited its recourse, suddenly has a hole in it.

Now you might extract a covenant from your asset manager — even better, from your principal — not to precipitously whip the rug away just as things are getting jiggy — but don’t bet on it. They are likely to appeal to the commercial imperative — fair enough, the JC has a healthy respect for that — but bear in mind it is rather predicated on the iterated prisoner’s dilemma — that there will be another time, there will be more business to do; that the revenue opportunities from cooperating into the infinite & unknowable future far outweigh the value of assassinating the bird sitting in the bush this very instant. But that calculus changes, mightily, in the period between the moment your porsche spyder begins to slide sideways and the point where at its current vector, it will hit the oncoming truck.

This is liability cap, not a credit mitigant

Thirdly, and most critically: This is a limitation on the value of your claim against a counterparty who does have available assets. You are leaving money on the table. This is a trading decision, not a credit decision. It is as if you have sold your counterparty a put option, limiting its exposure under your contract. Ask yourself why your credit team, rather than trading, are being asked to approve this. Ask yourself, too, how trading might feel, if the counterparty should fail whilst out of the money when you are perfectly delta-hedged, and the