Voidable preference
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What happens if you create a security interest over existing indebtedness, and then go bust within a period specified by statute ( usually 6 months of thereabouts). The law will set aside such a security interest, supposing that in creating it a debtor was acting with base motives: preferring one of his buddies, to whom he owed money, over his legion other creditors, when the writing on the wall or his solvency made itself suddenly all too painfully clear.
Most jurisdictions have some kind of “anti-deprivation” principle in their insolvency regime which stops a struggling company from preferring some of its creditors over other ones.
In the UK, it is 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 is wide and loose, and gives an insolvency administrator power to stop companies preferring, you know, the director’s brother in law’s firm which supplies the copier paper. It gives those extending credit to struggling companies pause for thought, at any rate. But it goes wider than just setting aside security interests. If you have five trade creditors and you pay off one of them a week before you go insolvent, expect the administrator to have a good hard look at that payment.
Limited recourse
Now elsewhere in the wonderful world of structured finance is the secured limited recourse espievie.
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.
Why mention this in an article about voidable preferences? Well, as long as you are doing secured, single-issuance deals where every creditor is represented by the security trustee and has a place reserved at the Restaurant Cascade de Sécurité, no reason at all. But latterly limited recourse has slipped its moorings and drifted into the shipping lanes through which the asset management tankers thunder. An investment fund espievie doesn’t usually grant security and has a much more dispersed, antagonistic bunch of creditors and, usually, equity holders too. There’s a weak reason for requiring limited recourse — to preserve the livelihoods of espievie directors who might otherwise be barred from helming companies due to their reckless trading — but this is a weak reason, and removing it might incentivise the director to actually, you know, supervise the company’s agents to make sure they are conducting themselves with probity. Which is actually what they are paid to do.
And there’s a rather pressing reason to resist limited recourse: creditors, who might otherwise be at each others’ throats, get certain protections from each other should a company go into receivership. Such as protection against voidable preferences granted to other creditors just before it went seins en l’air.
How might this happen? Well, imagine a fund that has put on aggressively levered positions with several brokers, without mentioning to any of them that it has doubled down on the trade elsewhere. And imagine that trade suddenly goes, tango uniform, sending the fund auguring into the side of a hill, and sending dozens of broker legal eagles scurrying for their close-out manuals. But — oh! — too late. There’s no market for a stock that heavily overshot — that’s what caused the margin call int he first place — Then it transpires the fund had worked with one of the prime brokers to