Voidable preference

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Voidable preference
/ˈvɔɪdəbl ˈprɛfərəns/ (n.)

What happens if you suddenly, a propos nothing, create a security interest in favour of your buddy, or generally prefer one creditor to others and then go tetas arriba within a short period.

Depending on where you are, local insolvency laws may let an insolvency administrator set aside such a “preference”, if it supposes that, in creating it, you acted with base motives — i.e., you preferred your buddies over your legion of other creditors — when you both knew things were turning to crème anglaise.

Most sophisticated jurisdictions have some kind of “anti-deprivation” principle in their insolvency regime which stops a company from preferring some of its creditors over others at its time of tango uniform.

There is often an exception for desperate rear-guard actions taken in good faith with a genuine aspiration to stave off calamity, notwithstanding that they might have inadvertently caused it. This is the joy of cross-border finance: the rules will be utterly different in each jurisdiction where your counterparty is resident or holds assets. So you will need lots of legal advice.

United Kingdom

In the UK, when we last looked it was section 239 of the Insolvency Act 1986, and it goes something like this:

For the purposes of this section and section 241, a company enters into a transaction with a person at an undervalue if—

(a) the company makes a gift to that person or otherwise enters into a transaction with that person on terms that provide for the company to receive no consideration, or

(b) the company enters into a transaction with that person for a consideration the value of which, in money or money’s worth, is significantly less than the value, in money or money’s worth, of the consideration provided by the company.

This gives an insolvency administrator a wide discretion, and should give those extending credit to struggling companies pause for thought. But, in any case, it is a well understood part of the corporate credit landscape. Except when it comes to special purpose vehicles.

Limited recourse, voidable preferences and ... Archegos

Now, in the wonderful world of structured finance, there is a sort of anti-preference gambit: the secured, limited recourse SPV.

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.

Repackaging SPVs: an honourable exception

Repackaging SPVs are designed to have a strictly limited, identifiable set of creditors all of whom agree that the vehicle should never to go seins en l’air, and contractually agree not to put it into bankruptcy, so questions of voidable preference do not arise.

So: as long as you are doing secured, ring-fenced deals where every creditor is represented by the same security trustee and has its place pre-booked at La Restaurant Cascade de Sécurité, no reason at all.

Why mention this in an article about voidable preferences? Well, because limited recourse has slipped its moorings and drifted into the shipping lanes and intercontinental canals through which ordinary, unsecured asset management vehicles make their stately passage. Hedge funds. UCITS. SICAVs.

Investment fund vehicles should not be limited recourse

Many other types of investment fund are also incorporated as orphan SPVs. But these “normal” investment funds don’t usually grant security interests over their assets, and they have a much more dispersed, antagonistic bunch of creditors and equity holders — who are assuredly not on the same page as each other.

They are no different from ordinary LLCs — they are ordinary LLCs — only with an odd ownership structure.

There’s a weak justification to have limited recourse here: to preserve the livelihoods of the passive SPV directors who might otherwise be barred from holding directorships if the vehicles they nominally manage go βυζιά πάνω. They have delegated away most of their executive function to the investment manager: they just sit in the Cayman Islands snorkelling, cheating on each others’ spouses and holding the odd board meeting but otherwise having nothing to do with the day-to-day management of the fund.

But this is a weak reason. Removing it might incentivise the fund directors to, you know, do their jobs and properly supervise the company’s agents to make sure they are conducting themselves with probity and competence, so that the fund doesn’t go bankrupt.

Voldemorchegos

Now, all this might seem an arid — even petulant — objection, but the repackaging vehicles whence the limited recourse idea came are a special case, and it doesn’t really do to confuse them with regular fund vehicles.

Normal funds can go bust — our roll of honour refers — and when they do, insolvency rules such as those against voidable preferences ensure fair treatment for everyone.

Now. Could such a voidable preference happen with a harmless, peace-loving fund management vehicle?

Yes.

Imagine a fund that has put on aggressively levered positions in the same stocks with several brokers, without telling any of them that it has doubled down elsewhere. And imagine those trades suddenly turn to vanillesoße together, prompting a margin call bonanza and sending the cream of each broker’s legal eaglery scurrying for their close-out manuals.

But — oh! — too late! The brokers all try to sell the same stocks at once, into a market which suddenly has zero appetite for that stock (except not “suddenly”, really, since the only person who ever had the appetite for the stock is the one whose udders are currently pointing skyward, and they are pointing that way precisely because of the fund manager’s ravenous appetite for a crappy stock).

In that very instant the stocks — and the margin position of every one of the brokers — falls through the floor, and that of several apartments in storeys immediately below.

Anyway, said fund is now a smoking hole in the ground, and five of its prime brokers are staring uncomprehendingly at billion dollar holes in their balance sheets.

But the sixth one — who was buddies with the PM at the investment manager — seems somehow to be okay.

If — this is purely hypothetical, but let’s just imagine for a minute — it then transpires that our now titten hoch investment fund got together with its favourite broker last week and quietly closed out the positions it held with that broker, while all the other brokers were being good eggs and holding off in the vain hope of an orderly unwind, then what?

Well, suddenly those voidable preference rules start to look quite appealing to the disappointed brokers. Why should the favourite broker get preferential treatment? This is not so much a claim versus the كاسترد fund itself — it’s currently on the dessert menu — but against that pally broker who got out at par a couple of days before the fund started swimming with the fishes

The brokers consult with their legal eagles, who stumble across a “limited recourse” provision, by which those brokers kindly agreed not to put the fund into bankruptcy should it go tette in alto, for the sake of its poor little directors.

But if you can’t bankrupt the fund, it can’t have made a voidable preference, because voidable preferences only exist in situations of insolvency. The fund is cleaned out, but it isn’t insolvent. The brokers’ debts are extinguished. They have no further claim. They have no way of alleging that there has been a voidable preference, because they can’t put the fund into bankruptcy to establish one.

Suddenly this little concession to preserve the livelihoods of SPV directors looks like quite the unfortunate legal term. Could our jokey broker have got away with it?

In the investment world at the moment, limited recourse is almost de rigueur. It remains to be seen whether it stays that way, or whether some kind of evolution of the clause to allow voidable preference claims to be made even without an actual insolvency.

See also

• Bankruptcy
• Carve-in
• Slavenburg