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Of a {{tag|contract}}, that | {{a|repack|{{image|Fidgety phillip|jpg|What happens if you do not concentrate on your debt extinction language}}}}Of a {{tag|contract}}, that a debtor’s obligations under it are limited to a defined pool of assets. You see this a lot in [[repackaging]]s, [[securitisation]]s and other structured transactions involving [[espievie]]s. [[Security]] and [[limited recourse]] are fundamental structural aspects of contracts with [[special purpose vehicle]]s and [[investment fund]]s. | ||
===The basic idea=== | |||
[[Investment fund]]s and [[Repackaging|structured note issuance vehicles]] tend to be purpose-built single corporations with no other role in life. They issue [[shares]] or [[Unit trust|unit]]s, or [[Secured, limited recourse obligation|secured note]]s, to investors and with the proceeds, buy securities, make investments and enter swaps, loans and other transactions with their counterparties. | |||
These counterparties will generally be [[Capital structure|structurally senior]] to the fund’s investors (either as unsecured [[creditor]]s, where the investors are [[Shareholder|shareholders]], or as higher-ranking [[secured creditor]]s, where the investors are also [[noteholder|secured noteholders]]). | |||
=== | ====Why?==== | ||
The main reason for limiting a [[swap dealer]]’s recourse to the [[espievie]]’s assets is ''not'' to prevent the [[swap dealer]] being paid what it is rightly owed. It is to stop an empty [[SPV]] going into formal [[bankruptcy]] ''once all its assets have been liquidated and distributed, according to their contractual [[Capital structure|priority]], to investors''. At this point, the [[espievie]] has nothing left to pay anyone, so launching a [[Bankruptcy|bankruptcy petition]] is kinda — ''academic'', but sometimes academic stuff is important if you’re a director of an [[SPV]]. | |||
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 personal 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 to ''other'' countries. 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 [[SPV]]s. Unlike normal commercial undertakings, [[espievie]]s 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. ''Those'' assets might blow up, but that’s hardly the [[espievie]]’s fault. How is it supposed to know? It is a harmless little [[Open-ended investment company|otter-like creature from Guernsey]]. The directors are really nominal figures, and are also rather like otters: 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, and build little dams out of twigs and rushes.<ref>''That is a beaver, not an otter''. Ed.</ref> They are not responsible for the trading strategy that drove the [[espievie]] into the wall.<ref>The [[investment manager]] is. So should ''she'' be barred from managing assets? THIS IS NOT THE TIME OR THE PLACE TO DISCUSS.</ref> | |||
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 manager]]s can be a malign influence, and try to further limit this. | |||
==Multi-issuance [[repackaging]] vehicles: secured, limited recourse== | |||
{{Repackaging limited recourse capsule}} | |||
{{limited value of security in repack}} | |||
===“[[Extinction]]” versus “[[no debt due]]”?=== | |||
{{extinction vs no debt due}} | |||
==[[Investment fund]]s== | |||
Where you are facing an [[investment fund]] held by equity investors it is slightly — but not very — different. Generally, there is no [[Security interest|security]], since there’s no question of [[ring-fencing]] separate pools of assets. (But [[investment manager]]s 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”, ''looks'' 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. But there’s a subtle cast on this. With no security, and no co-ordination of creditors that is typical of a structured finance deal, with security, a priority of creditors, covenants not to create any other indebtedness and so on, the ecosystem is very much mapped and controlled. In an investment fund, it isn’t. The creditors (competing brokers, prime brokers, swap counterparties, futures clearers and so on) have no idea what each is doing, and there are real benefits to them in the insolvency rules ensuring fair and equitable treatment of creditors in insolvency. The Archegos situation (which as far as I know didn’t involved limited recourse, by the way) illustrates this dynamic pretty well. | |||
==Limiting recourse to a pool managed by an [[agent]]== | |||
On the other hand, limiting recourse to a pool of assets ''within'' a single [[Legal entity|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''. | |||
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]] has waxed long and hard enough about that [[Agent|elsewhere]]; suffice to say the concept of [[agency]] is one of those things we feel [[Legal concepts all bankers should know|''everyone'' in financial services should know]]; this is not one to drop-kick to your [[legal eagle]]s: 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 city types, with your [[Sharpe ratio]]s and your [[intelligent beta]]. If I am not careful you could put on some [[Amaranth Advisors LLC|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. So 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]]. She is saying, “swap dudes: to stop my agent, against whom you are trading, going properly postal and blowing up my whole operation I am limiting it, and therefore ''you'', to, ''this'' bucket of assets. Cut your cloth accordingly.” | |||
And that would be fine, if it ''were'' like a ring-fenced repack. But it is not ''quite'': for one thing, poor swap dealer has no [[Security interest|security]] over the pool. It gets no “quid” for its “quo”. It is ''limited'' to that pool of assets, but it has no ''priority'' over them, as against other general creditors of the fund, as it would if it had security. It 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, so every creditor has its own dedicated bucket — but that is messy and unreliable. Are there really no other creditors? What about people claiming under a tort?<ref>Okay, I know, I am reaching here a bit. But still, the principle.</ref> Granting security is much cleaner and neater — but you’ll never get it. Somehow, asset managers have won this battle. Swap dealers the world over run this structural risk. One day this might come back to nip them on their bottoms, like an angry [[black swan]]. Who can say? | |||
Note that the [[principal]] — or more likely the [[agent]] — is engaged in some dissembling here. So the [[principal]] wants its agent on a short leash. Fine; understood. Fair. But whose problem should ''that'' be? Who should carry the can when an [[asset manager]] exceeds its mandate, goes [[crazy-ape bonkers]], or just ''royally messes up''? Not, we would submit, an arm’s length swap dealer trading [[in good faith]], for value and without notice of turpitude. The incentives are all wrong. Isn’t the [[principal]] going to be inclined to keep a tight rein on ''the value of that pool'', rather than, as it should, on its ''[[agent]]''? | |||
The general principles of agency, we submit, say this should be the [[principal]]’s problem. ''Choose your [[agent]]s wisely, and monitor them''. If not the [[principal]] (“I did! I even conducted [[due dilly]]! I monitored! Daily!”), then the ''[[agent]]''’. For if the agent’s own [[principal]] can’t be expected to have rooted out this canker, what chance did a poor old swap dealer have? | |||
The one person whose problem it should ''not'' be is the poor, weather-beaten old swap dealer. ''Yet this is what agent-pool recourse limitation does''. It transfers ''[[agent]]'' screw-up risk — perhaps a [[second-loss]] risk, but still a material risk, since you have unreasonably limited the [[first-loss]] to an arbitrary number — to the swap dealer. It is hard to understand why a swap dealer would ever agree to this. 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 its [[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, for the period between when your [[Rotary Mazda]] begins to slide sideways and when, at its current vector, it will hit that oncoming truck. | |||
===This is liability cap, not a credit mitigant=== | |||
Thirdly, and critically: here is where your [[investment manager]] might be stealing a [[put option]]. A limitation to “a specified pool of assets under management” is, make no mistake, a limitation on the ''numeric value'' of your claim. Your exposure is “the greater of the [[net]] [[mark-to-market]] value to you of your portfolio of [[transaction]]s and the net market value of this bucket of assets.” This is a sort of [[put option]]. A cynical agent could exercise it, it if got in a hole, by failing to pay. ''That is not what [[limited recourse]] is meant to do''. Accepting this kind of limitation ought to be ''trading'' decision, not a ''credit'' decision. Ask yourself why your [[credit]] team, rather than [[trading]], are being asked to approve this. | |||
==[[Limited recourse]] formulations== | |||
The following, rendered in the linguistic mush you can expect from [[Mediocre lawyer|securities lawyers]], are the sorts of things you can expect the [[limited recourse]] provision to say without material complaint: | |||
*'''Recourse limited to segregated assets''': your [[Limited recourse|recourse]] against the [[SPV]] will be strictly limited to those assets that are ring-fenced for the particular deal you are trading against. This ring-fencing might take the form of: | |||
**'''[[Security]] and limited recourse''': {{tag|security}} and {{tag|contract}} (in an old-style [[repackaging]] with a regular [[LLC]]) — there there is a subtle trade off between [[security]] over your assets (preferring your claim against all other comers) and limitation of that claim to those [[secured asset|secured assets]]; or | |||
**'''Corporate structure''': by means of a specialist corporate structure providing for segregation of the [[corporate personality]] into little cells which may<ref>such a company and [[incorporated cell company]].</ref> or may not<ref>Such a company a [[segregated portfolio company]].</ref> have their own [[legal personality]] (if the [[SPV]] is a [[segregated portfolio company]] or an [[incorporated cell company]]); | |||
*'''No set-off or netting between cells''': [[Netting]] and [[set-off]] will be limited to the specific [[cell]] you are facing: this means if your deal goes down, others issued from the same [[SPV]] can continue unaffected — boo — ''and vice versa'' — hooray. | |||
*'''Extinction (or non-existence) of outstanding debt''': Following total exhaustion of all assets after enforcement, appropriation, liquidation and distribution, and realisation of all claims subsequently arising form those assets, your outstanding unpaid debt will be “[[Extinction|extinguished]]” — or (sigh) will [[No debt due|not be due]]. Here the intention is that you will never have legal grounds for seeking judgment, and thereafter commencing bankruptcy proceedings, for that unpaid amount once your own cell is fully unwound and its proceeds distributed. | |||
*'''A proceedings covenant''': You must solemnly promise never to set to put the [[SPV]] into [[insolvency]] proceedings. If you agree to all the foregoing, you should have concluded you have no literal right to do so, so this shouldn’t tax your conscience too greatly. | |||
{{sa}} | |||
*[[Bankruptcy remoteness]] | *[[Bankruptcy remoteness]] | ||
*[[Special purpose vehicle]] | |||
*[[Voidable preference]] | |||
{{ref}} | |||
{{Technical Tuesday|October 20}} | |||