Monday, June 15, 2015

Judge Wheeler's Opinion in Starr, and Is There Any Read Through to FNMA?

Judge Wheeler found liability, that there was an illegal exaction under the 5th Amendment when the government insisted on taking equity in connection with the extension of the loan by the Fed to AIG, since the Fed didn't have legal authority to take equity in connection with the loan extension under section 13(3) of the Federal Reserve Act.
Judge Wheeler also found no damages, on the theory that if the government hadn't acted illegally (meaning in his view, hadn't made the loan), AIG would have been bankrupt and Starr's interest in AIG would have been worthless.
Of course, there is another view as to what damages would have been if the government hadn't acted illegally, meaning not have illegally exacted an equity interest in AIG.  This would imply that one determines damages by what plaintiff's interest would be valued at, had the government made the loan but not made the illegal exaction of equity, as opposed to simply not making the loan.
This will form the basis for an appeal by Starr on damages.  I expect the US also to appeal on determination of liability.  I like Starr's chances on appeal on damages better than US chances on appeal on liability.
Judge Wheeler held out a tantalizing thought to Starr in his opinion, namely that if Starr had plead for disgorgement of illegal profits, or restitution, he might have awarded damages:  
"Turning to the issue of damages, there are a few relevant data points that should be noted. First, the Government profited from the shares of stock that it illegally took from AIG and then sold on the open market. One could assert that the revenue from these unauthorized transactions, approximately $22.7 billion, should be returned to the rightful owners, the AIG shareholders. Starr’s claim, however, is not based upon any disgorgement of illegally obtained revenue."
Later, Wheeler stated "As the Court noted during closing arguments, a troubling feature of this outcome is that the Government is able to avoid any damages notwithstanding its plain violations of the Federal Reserve Act. Closing Arg., Tr. 69-70. Any time the Government saves a private enterprise from bankruptcy through an emergency loan, as here, it can essentially impose whatever terms it wishes without fear of reprisal. Simply put, the Government often may ignore the conditions and restrictions of Section 13(3) knowing that it will never be ordered to pay damages. With some reluctance, the Court must leave that question for another day."
I would expect that on appeal Starr would argue that the restitution argument identified by Judge Wheeler should be applied, as well to argue that one should reframe the damages inquiry into not what would have happened had no loan been made, but simply what would have happened had the illegal exaction not occurred. Damages arise from illegal conduct, and the illegal conduct by the US was the illegal exaction of equity, not the making of the loan.  It would seem that Judge Wheeler decided that he had done heavy-enough lifting in finding liability, and that he will pass on the onus of imposing a $20B damage award to judges at a "higher pay grade".
Read through to FNMA? Yes as to the psychological notion that when the US acted in connection with the financial crisis, no private party can complain....that you can't fight city hall.
You can fight city hall.
As to legal theory, FNMA is asserting no illegal exaction claim, so there is no precedential value. But in many ways, FNMA presents an easier case regarding damages than AIG, since it is clear that when the "net worth sweep" contained in the 3rd Amendment was entered into, FNMA was not only profitable but, with the prospect for the reversal of the deferred tax assets, or DTAs, that the US was well aware of, there was over $100B of equity value for the taking....which is exactly what the US did.

Monday, March 23, 2015

More Lumber Liquidators Analysis on Seeking Alpha

Lumber Liquidators Chooses Door #1; Will Lawyers Take Note?

Lumber Liquidators And Herbalife: When Does A 'Compliance With Law' Issue Become A 'Securities Law' Issue?

Tuesday, March 10, 2015

Saturday, March 7, 2015

Will Lumber Liquidators Choose Door Number #1, Number #2 or Number #3?

Lumber Liquidators (LL) cancelled an investor presentation that its management was slated to make on March 4, 2015, just two days after the punishing broadcast on 60 Minutes that alleged that LL's China-sourced laminate flooring emitted excessive formaldehyde, in violation of California regulations, and in contravention of LL's product warranties that the products were in compliance with these regulations.

Just the prior day, LL issued full-throated assertions that their products were safe (and that LL stood behind every plank they sold), criticized 60 Minutes for employing what LL claimed was a faulty "destructive" testing method, and decried short sellers of LL common stock who were out to enrich themselves at LL's expense.

After this initial defense, LL took a breath and stated that it would conduct an investor conference call on March 12, 2015 to address the matter, and placed a voice message on its investor relations telephone line saying that LL would make no disclosures about the matter until then.

So, LL displayed a normal crisis reaction: first, deny categorically the accusations and blame the motives of the accuser, and then pause to construct a carefully planned business response.  It is curious that LL requires 8 days in the midst of this crisis to prepare this response.  Curious enough that I thought I would play Monty Hall and provide you a little scorecard as to what I expect LL's alternatives might be for this momentous conference call.

Before proceeding further, let's examine just how much of a pickle LL finds itself in.  You may recall Crazy Eddies, the electronics reseller run by the Antar family whose prices were insane.  It turned out their inventory accounting was equally insane, and Crazy Eddies went into bankruptcy and liquidation because of the mounting securities fraud governmental investigations and private securities litigation.  But at least Crazy Eddies had this much going for it: its customers weren't suing Crazy Eddies, who liked the insane prices very much, thank you.

Imagine Crazy Eddies' predicament if it had to fend off governmental consumer fraud investigations and consumer class action litigation, in addition to securities fraud governmental investigations and private securities litigation!  Well, you don't have to imagine this, you would just have to gander at what's coming down the pike for LL, all this while the negative publicity negatively impacts its store sales.  Also, you can throw in a prospective federal criminal indictment under the Lacey Act for selling illegally sourced wood from Siberia.  Also, you can throw in that as of the end of 2014, LL had only $20 million of cash, and only a $47 million credit line secured by inventory that, just maybe, breaches a covenant or two about such inventory in the credit agreement.  Also, Note 10 to LL's 2014 audited financials discloses a nasty federal investigation into anti-dumping and duties regulations, ongoing since 2010, which has been decided adversely to LL but which is now on appeal in the federal circuit court, and may result in a charge of $12.7 million (which LL has not reserved for).  All this for an LL that was not cash flow positive for 2014, even without the negative publicity.

So, what will LL say on its conference call on March 12?

Let's look behind door #1,  This is the continuation of the full denial, vigorous defense mode.  LL may feel that it has already painted itself into this corner based upon its strident management denials immediately after the 60 Minutes broadcast.

In my view, choosing door #1 will only seal (and accelerate) LL's eventual demise.  LL needs to be able to clearly demonstrate the merits of its safety claims for this choice to work, and this depends upon whether it was appropriate for 60 Minutes to use the "destructive" testing method on its laminate flooring (which resulted in the excessive toxicity recorded levels).  But it is hard for LL to explain away this testing method when it is clearly set forth in the California regulations, the hardwood trade association to which LL belongs has confirmed that this is the correct test, and 60 Minutes has stated on its website that it first confirmed with the California regulator that this was the correct test for it to use in connection with the broadcast.

LL would be foolish to choose door #1 because, as Kenny Rodgers would put it, you got to know when to fold them.

Let's look behind door #2.  This is the ring-fence, we were wrongly duped mode.  LL would say that it is a victim of the unscrupulous Chinese factories (one of which LL itself owned), and that LL was voluntarily establishing a restitution program.  That program would fund the flooring replacement for any California customer who, after hiring a formaldehyde testing company to test its indoor ambient air quality, produced a test result that showed an excessive formaldehyde concentration, and who can demonstrate that the toxic level was due to LL's flooring product and not some alternative source.  LL would also decide to stop sourcing product from China, it would rename itself inasmuch as its current brand equity was now negative (maybe a name such as Great American Hardwood Floors), and reduce costs by closing underperforming stores (although none of the 10% of all LL stores that are leased from the LL CEO).

In my view, this strategy underestimates the scope of the potential liabilities that any clear-headed examination of LL's current predicament would reasonably anticipate.  It is unlikely that California regulators will let LL create a restitution program on LL's terms, and there is no reason why additional state regulators, as well as federal consumer fraud regulators (at the recent urging of Senator Nelson), will not require a stronger nationwide restitution program.

And then there is the securities litigation exposure to all of the class action plaintiffs that will use the "fraud on the market" theory to claim that LL is liable for all of its false and misleading safety and legal compliance disclosures in LL's periodic securities filings.  This liability would be measured based upon the difference between the trading value of LL common stock before and after the true facts have been disclosed.  A good proxy for this might be the trading day before and after the 60 Minutes broadcast.  Every LL common stock shareholder at the time would be entitled to be a class member.

As far as I can tell, the only way for LL to remain a viable business entity going forward is to choose door #3, and file a Chapter 11 petition in bankruptcy. This will stay all legal proceedings and provide some senior DIP financing for LL to continue in business, while the legal claims are assessed and allowed, likely through mediation.  The future shareholders of LL will likely comprise the old LL class action flooring customers and common stockholders (in such proportions as are based upon their respective damages) that will replace the legacy LL common stockholders in that newer, revitalized Great American Hardwood Floors.

NB:  this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice.  Investing is a tough game, and everyone must do and "own" their own work, because you will certainly own your investments.

Wednesday, February 25, 2015

Thinking About RESCU Claims and Damages

I have taken an introductory look at ResCap, now trading in the form of a liquidating trust (RESCU), using a top/down analysis in my last blog post.  Now I thought I would use a bottom/up analysis to ask two very elementary, but important, questions that relate to the claims that RESCU may assert in its litigation program, and the damages that it might recover from each correspondent bank pursuant to this program.

I assume the reader has some familiarity with RESCU, its litigation program and the nature of the investment opportunity, all of which is likely to leave the reader uncertain as to whether RESCU is an investment long or short.

Let me add to this uncertainty by posing the following two questions.

1.  The Piggyback Argument. Is RESCU able to use the favorable provisions of the client guide to claim that a correspondent bank's breach of loan-level representations and warranties (R/Ws) constitutes a breach of a transaction-level R/W, thereby substantially increasing the dollar amount of claims that RESCU can assert against such correspondent bank?

2.  The No-Haircut Argument. Is RESCU able to recover the full amount of damages it incurred with respect to R/W breaches from each correspondent bank without any haircut applied to such recovery resulting from the haircut that RESCU's creditors experienced in the RESCU bankruptcy (understanding that RESCU's overall recovery from all correspondent banks may not exceed the total amount of allowed claims confirmed in the bankruptcy)?

The Piggyback Argument and the No-Haircut Argument, if pursued successfully, would afford RESCU the opportunity to assert claims and recover damages in an aggregate amount well above what many investors currently contemplate to be available to RESCU.

As to the Piggyback Argument, you will recall that the client guide contains not only various R/Ws that the correspondent banks made to RESCU, but also contains the strong-arm provision that RESCU is authorized to (i) determine in RESCU's sole discretion whether any R/W has been breached, thereby resulting in an event of default, and (ii) disclaim any requirement on RESCU's part to conduct due diligence or exercise reasonable reliance with respect to the R/Ws.  The validity of this strong-arm provision was upheld by the federal circuit court of appeals in the Terrace case (discussed in my prior blog post), with the court stating that it would enforce the client guide strong-arm provision in accordance with its terms, subject only to the proviso that RESCU must proceed in good faith when using this provision as a basis for any damage claim.

This court authorization to use the client guide strong-arm provision makes RESCU's litigation program very likely to be successfully conducted, with most of the defendant correspondent bank defenses limited to pre-trial motions that are not likely to prevail.

But I wonder if investors and, indeed, RESCU itself is underestimating the potential reach of the client guide strong-arm provision.

Let's first distinguish between the following two types of R/W breaches:  loan-level R/Ws and transaction-level R/Ws.  If a loan-level R/W is breached with respect to a loan, RESCU is entitled to recover damages incurred in connection with that non-conforming loan.  If a correspondent bank sold RESCU $1 billion of loans and had a loss rate of $500 million and a loan-level R/W breach rate of 50%, recovery on loan-level R/W breaches would imply a potential recovery of $250 million (since only half of the loans that incurred a loss can be said to have also been subject to a loan-level R/W breach).

If a transaction-level R/W is breached with respect to a loan, that loan may be considered to give rise to a damage recovery even if the individual loan-level R/Ws made with respect to that loan have not been breached.  Indeed, if a transaction-level R/W can be asserted to be breached with respect to all loans, then the defect rate in respect of that transaction-level R/W can be said to be 100%.  So, in the above example, RESCU would be entitled to recovery of $500 million.

Now, there are many loan-level R/Ws contained in the client guide, with each such R/W made individually with respect to each mortgage loan.  For example, (i) “For each Loan for which an appraisal is required or obtained under this Client Guide, the appraisal was made by an appraiser who meets the minimum qualifications for appraisers as specified in this Client Guide," and (ii) “There is no default, breach, violation or event of acceleration existing under any Note or Security Instrument transferred to [RESCU], and no event exists which, with notice and the expiration of any grace or cure period, would constitute a default, breach, violation or event of acceleration, and no such default, breach, violation or event of acceleration has been waived by Client or any other entity involved in originating or servicing the Loan.”

But there is also this transaction-level R/W contained in the client guide:  “Client’s origination and servicing of the Loans have been legal, proper, prudent, and customary and have conformed to the highest standards of the residential mortgage origination and servicing business.”

So, if RESCU brings an action against a correspondent bank in its litigation program that had a high defect rate with respect to loan-level R/Ws, RESCU should be able to claim that, in addition to the losses RESCU incurred in connection with loans that breached loan-level R/Ws, it is entitled to recover for losses incurred in connection with all other loans bought from the correspondent bank, inasmuch as all loans were originated by that correspondent bank in a manner that did not conform to the highest standards of the residential mortgage origination and servicing business.

Now, you might ask, RESCU can allege breach of this transaction-level R/W, but will a court allow it to recover on this claim?  Here is where the strong-arm provision of the client guide comes to play with its full force.

RESCU need not prove in court that a correspondent bank's high loan-level R/W breach rate constitutes a breach of the high origination standard transaction-level R/W.  RESCU need only prove in court that it has made a determination that the correspondent bank's high loan-level R/W breach rate constitutes a breach of the high origination standard transaction-level R/W, and that RESCU made such determination in good faith.

The Terrace case requires a court to rule in RESCU's favor based upon a much lower standard of proof.  The court must find that the correspondent bank breached its high origination standards transaction-level R/W, whether or not the court agrees that the correspondent bank's particular loan-level R/W breach rate is not consistent with high originations standards, provided only that the court finds RESCU made this determination in good faith.

This is the Piggyback Argument that the client guide authorizes RESCU to assert, and it is not clear to me at the current complaint-stage of the litigation program whether or not RESCU is going to make it.  It seems to me that the Piggyback Argument may be worth more than a billion dollars in potential enhanced recovery for RESCU.

The No-Haircut Argument can be illustrated by the following example:  total losses experienced by RESCU creditors was reduced in the RESCU bankruptcy from approximately $47 billion to approximately $12.2 billion of allowed claims.  Now, while it is clear that RESCU can recover from correspondent banks only for losses arising from R/W breaches, I have tried to point out in my Piggyback Argument discussion that RESCU should be able to attribute losses to R/W breaches by invoking the strong-arm provisions of the client guide in an aggregate amount far in excess of what one might otherwise expect.

But assume for sake of the No-Haircut Argument that there was a 40% R/W breach rate in all of the mortgage pools that incurred the $47 billion of losses (this 40% rate is approximately the defect rate set forth in the Sillman Examination in the RESCU bankruptcy).  In the RESCU bankruptcy, a further haircut of about 40% was also applied as a settlement factor, in order to reach a fair recovery expectation, as if RESCU's creditors had been able to proceed in litigation against a solvent RESCU.

This raises the following important questions to answer: do the defect rate and settlement rate haircuts imposed by the bankruptcy court on RESCU's creditors benefit the correspondent banks? Were the correspondent banks parties to the RESCU bankruptcy?  Are the correspondent banks intended third-party beneficiaries of the RESCU bankruptcy?  Did the confirmation plan in the RESCU bankruptcy contain any provision that, by its terms, applied any haircut to the losses that could be asserted by RESCU against the correspondent banks arising out of the sale of loans by the correspondent banks to RESCU (as opposed to claims that might by asserted by RESCU's creditors against RESCU in respect of losses arising out of subsequent securitizations)? If a correspondent bank sold loans to RESCU that incurred $1 billion of losses, assuming that RESCU can prove that all of these losses arise from R/W breaches under the strong-arm provisions of the client guide, is RESCU required by any provision of law to seek less than the entire $1 billion amount as a damage recovery?

It seems to be an article of faith among followers of RESCU that I have talked to that RESCU must haircut what it seeks in recovery from each correspondent bank simply because RESCU's creditors suffered a haircut in getting their claims against RESCU allowed in the RESCU confirmation plan in bankruptcy. Under this ideology (I dare not call it a thesis, since I would think a thesis requires an underlying principle or articulable rationale), each correspondent bank's "share" of RESCU losses must be ratcheted down from the actual loss amount to a lesser amount proportionate to the haircut suffered by RESCU's creditors.

I am not aware of any legal provision that would require this result.  If one looks for an analogy to the common law, one notices that the law allows a tort victim to proceed for the full amount of its recovery against any single tortfeasor among multiple responsible tortfeasors, even if the full amount is in excess of that tortfeasor's proportionate responsibility for the tort victim's damages. The law permits the overpaying tortfeasor to proceed against the other tortfeasors for contribution, rather than requiring the tort victim to ratchet down its damage recovery to a proportionate amount against the first tortfeasor.

In terms of bankruptcy law, I am unaware of any provision which requires the bankruptcy debtor to limit its recovery, as a plaintiff in proceedings against defendants that caused the losses incurred by the debtor, in a manner that conforms to the recovery schema imposed upon the debtor's creditors. Indeed, one would think that in a post-bankruptcy collection proceeding, the shoe would be on the other foot, and bankruptcy law would seek to promote the debtor's ability to obtain full recovery in favor of the bankruptcy creditors (up to the aggregate amount of their allowed claims).

Put another way, the bankruptcy case benefits the debtor at the expense of the debtor's creditors, but I am not aware that it benefits firms, which were not parties to the bankruptcy, against which the debtor has a cause of action at the expense of the debtor.

Now, I will concede that RESCU would not be able to recover more than its full damage amount of $12.2 billion, because I do think that is the aggregate ceiling on the amount that the debtor can recover in respect of its $12.2 billion allowed claims that were confirmed in bankruptcy.  But I don't know of any legal provision that would prevent RESCU from recovering this $12.2 billion maximum amount in whatever manner that RESCU is able to obtain recovery among the correspondent banks.

Put another way, it seems to me that each correspondent bank's "share" of the RESCU losses is post-bankruptcy the same as it was pre-bankruptcy, or 100% of the pre-bankruptcy losses arising from such correspondent bank's breaching loans (subject to an overall maximum recovery cap for the RESCU litigation program of $12.2 billion).

It seems to me that the No-Haircut Argument may also be worth more than a billion dollars in potential enhanced recovery for RESCU.

NB:  this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice.  Investing is a tough game, and everyone must do and "own" their own work, because you will certainly own your investments.

Tuesday, June 10, 2014

RESCU and the MBS Litigation Circle Game


This blog has taken particular interest in investment situations where a company's value is significantly affected by litigation claims asserted by that company.  

Since the financial crash in 2008-2009, this blog has reviewed claims by monoline insurers, such as MBIA, Assured Guaranty and AMBAC, involving breach of representation and warranty (R/W) made against mortgage originators and securitization issuers, such as Countrywide and its parent Bank of America (BAC), that issued mortgage-backed securities (MBS) that were insured by the monolines.

These R/W actions had to survive various defenses, such as the purported requirement for monolines to show loss causation, the purported requirement to offer evidence of R/W breach on an individual loan basis, rather than on a pool basis using statistical sampling, and claims that monolines either were aware of the R/W breaches, or failed to exercise proper due diligence with respect to the R/Ws, or otherwise placed unjustified reliance upon the R/Ws made by the securitization issuers.  

In short, these R/W cases were hard to win. They required plaintiffs to marshall significant resources to make hotly-contested and uncertain legal arguments over a significant period of time. Notwithstanding vigilant defendant pushback, monolines have managed to do quite well on the R/W scorecard, given the sole bench trial and various settlements reached to date.  Several monoline cases, including most notably AMBC v BAC, remain ongoing.

The investment opportunity of these special situations was that, especially in the case of monolines such as MBIA and AMBAC, the incremental value to the company from a successful litigation outcome was quite large when compared to the monolines' enterprise value.

Now, suppose you are presented with an investment opportunity in which i) the outcome of R/W actions will not only significantly affect a company's enterprise value, but constitutes the only determinant of value for the company, since the company's entire enterprise value is represented by the litigation, and ii) the legal merits of this company's R/W cases may be far stronger than the legal merits of the various monoline cases to date.

That investment opportunity might be appealing to consider.  That investment opportunity is ResCap Liquidating Trust (RESCU).  

This blog post will discuss the legal issues surrounding RESCU's investment opportunity, but will also highlight the investment uncertainty created by the lack of disclosure available relating to material information that affects the litigation (and therefore the entire investment) outcome.

RESCU's R/W Posture

Your first thought may be that as a prolific issuer of MBS, ResCap was a repeat defendant, not a plaintiff, in R/W cases, and you would be entirely correct until recently.  Indeed, ResCap confirmed its bankruptcy reorganization plan in December 2013 after it was inundated with R/W claims to such an extent that unsecured claims against ResCap in the aggregate amount of over $12 billion were allowed by the bankruptcy court. These $12 billion of allowed claims were converted into liquidating trust units of RESCU, which are essentially equity interests in RESCU, although more about that later.  

The assets deposited into RESCU and to be distributed over time to unitholders consisted of tangible assets that RESCU is liquidating, with a reasonably ascertainable value, and R/W claims that RESCU may assert against correspondent banks which supplied ResCap with mortgages to securitize, whose uncertain value gives rise to the investment opportunity.

So, ResCap has been transformed from a repeat MBS R/W defendant into a phoenix named RESCU, arising from bankruptcy as a R/W plaintiff. As opposed to Countrywide, which originated substantially all of the mortgage loans that it securitized, ResCap purchased all of the mortgage loans that it securitized from an army of correspondent banks, both large (eg. PNC and Suntrust) and small (eg. Broadview Mortgage Corp. and Lyons Mortgage Services).  Just as ResCap made loan-level and transaction-level R/Ws to purchasers and insurers of MBS issued by trusts that ResCap sponsored, ResCap received loan-level R/Ws from the correspondent banks about the mortgage loans that they sold to ResCap to securitize.  

So, unlike various vertically-integrated MBS issuers like Countrywide, which had only their own origination and underwriting departments to blame for R/W breaches (and fraud, such as the Countrywide "hussl" program that is currently the subject of a BAC/Justice Department settlement negotiation that may penalize BAC in excess of $12 billion), ResCap could turn around and bring in its own name, for the benefit of ResCap's unsecured creditors cum RESCU unit holders, R/W cases against the correspondent banks that conducted all of ResCap's outsourced MBS origination and underwriting responsibilities that fed the ResCap securitization pipeline.  

What goes around comes around.

In the five months since ResCap's bankruptcy plan has been confirmed, RESCU has undertaken a massive litigation program seeking to recover on R/W breaches by correspondent banks. Substantially all of the cases are brought under Minnesota law in federal district court in Minneapolis, with Minnesota law specified in the controlling law provision of the principal ResCap mortgage origination document.  

This principal document is the rather extraordinary ResCap Client Guide.

The ResCap Client Guide is a very ResCap-favorable document that contains R/Ws and remedy provisions so pumped up on steroids that any conceivable attempt by correspondent banks to defend against RESCU's R/W actions faces great difficulty.  ResCap was prepared apparently for the possibility of "garbage in, garbage out," and prepared its documentation accordingly. 

Among other provisions, the ResCap Client Guide provides 
  • an exhaustive list of R/Ws made by the correspondent banks with respect to mortgage loans they originated; 
  • that the correspondent banks made such R/Ws irrespective of their knowledge as to whether the mortgage loan was is breach;
  • ResCap has the sole authority to determine whether a R/W has been breached and constitutes an event of default, and ResCap need not show loss causation; 
  • the correspondent banks waive any right to judicial review of ResCap's declaration of an event of default; 
  • ResCap may pursue any remedy available at law and equity, including a putback of the defective loan to the correspondent bank for repurchase, provided that no remedy selected shall bar ResCap from pursuing additional remedies; 
  • no delay in exercising any remedy, such as the right to putback loans for repurchase, shall act as a bar to the exercise of that remedy; 
  • there are no conditions precedent to the exercise of ResCap's remedies, such as showing that ResCap exercised due diligence; and 
  • most significantly, as discussed below, ResCap shall have an additional right to be indemnified by the correspondent banks for any and all of ResCap's losses, including attorneys fees, arising out of "any claim, demand, defense or assertion against or involving [ResCap] based on or resulting from such breach or a breach of any representation, warranty or obligation made by [ResCap] in reliance upon any warranty, obligation or representation made by the [correspondent bank] contained in the [documents under which the correspondent bank sold mortgage loans to ResCap]”.
It is no exaggeration to say that the ResCap Client Guide is a plaintiff R/W lawyer's dream come true.

The enforceability of the ResCap Client Guide's favorable R/W provisions has been validated by the 8th Circuit Court of Appeals in Residential Funding v Terrace Mortgage.  In Terrace Mortgage, ResCap declared a handful of mortgage loans originated by Terrace to be defective, declared an event of default and demanded that Terrace repurchase the loans under the ResCap Client Guide. Terrace defended by objecting to the terms of the Client Guide, noting that its terms were so onerous that ResCap could on a whim order Terrace to repurchase all of its originated loans, and Terrace would have no recourse to contest this demand.

The federal appeals court affirmed the district court and held that contracting parties can agree to forgo judicial review of contractually-authorized determinations, such as ResCap's determination in its sole discretion that an event of default had occurred, and the court refrained from coming to the aid of a defendant when the terms it agreed to were unambiguous. Terrace was a sophisticated business entity, and there was some evidence to the effect that ResCap was paying top dollar for the loans Terrace had for sale, so it wasn't exactly a one-way street.  

Terrace Mortgage also confirmed that ResCap was subject to an implied duty of good faith in proceeding, which the court found that ResCap had complied with in the facts of the case. The possible ramifications of this implied duty of acting in good faith will be discussed later in this blogpost.

RESCU's Statute of Limitation Posture

It is now 2014, the financial crisis came to its crescendo in 2008-2009 with respect to securitized mortgage loans that were originated in the several year period before that, and the 6 year Minnesota statute of limitations for R/W breach starts to run from the respective dates the correspondent banks sold mortgage loans to ResCap. Isn't RESCU's potential recovery substantially limited by this 6 year statute of limitations period?

Two very important points must be considered in this regard that promote ResCap's ability to maximize its recovery.

First, the federal bankruptcy code provides a trustee in bankruptcy with a two year extension of any applicable state statutes of limitations, in an effort to promote creditor recovery, and provides a debtor in possession, such as RESCU, with generally the same powers as a trustee.  So RESCU's 6 year limitations period to bring R/W actions is really an 8 year period owing to its status as a debtor in possession seeking recovery for its creditors.

Second, ResCap's Client Guide provides for a separate contractual right to be indemnified for losses arising from claims made against ResCap based upon R/W breaches made by the correspondent banks. Remember, all loan-level R/W breaches by ResCap to MBS purchasers and monolines may be asserted by ResCap to be based upon R/W breaches made to it by correspondent banks.

The statute of limitations for contractual indemnification claims also is 6 years under Minnesota law, but the very important question arises as to whether this limitations period commences when the original correspondent bank sale of the mortgage loan occurred, or does it commence when ResCap's damage claim with respect to that R/W breach is fixed and determinable (i.e. at the end of 2013, when ResCap's bankruptcy plan was confirmed)?

Either case is a possibility, and the answer turns upon a simple question of legal framing.

If ResCap's right to indemnification is understood as one of several remedies, one would think the statute of limitations should run from the time of the original R/W breach.   For example, under New York law, a breach of a MBS putback provision was not viewed (at least by the appellate court division that heard the case) as a separate contractual breach giving rise to a new limitation periods, but rather as a failed remedy exercise that leaves the plaintiff with whatever limitation period was remaining for the underlying R/W breach that occasioned the putback demand. (I thought otherwise).

If on the other hand ResCap's right to indemnification is viewed as an ongoing independent contractual covenant that is first triggered when the damage or loss arises, and stands as a cause of action apart from the underlying R/W breach, then the indemnification period should be deemed to have started to run at the time of ResCap's plan confirmation at the end of 2013.

The difference in terms of ResCap's ultimate potential recovery is hard to quantify, in the absence of detailed knowledge about when the various correspondent banks sold loans to ResCap, but it is safe to assume that if the indemnification limitations period is determined to have began only recently, there will likely be no time bar to ResCap from recovering all of its losses, given the strength of the R/W claims ResCap can allege under the ResCap Client Guide (as interpreted by Terrace Mortgage).  As one would expect, defendant correspondent banks have asserted that ResCap's right to indemnification is barred with respect to loans that were sold more than 6 years prior to commencement of suit.

In Gateway, an early federal district court case considering such a dismissal motion against a ResCap indemnification action, the federal magistrate recommended to the district court that it rule in favor of ResCap on both the 2 year bankruptcy extension for R/W claims, as well as the commencement of the indemnification 6 year period at the time the ResCap bankruptcy plan was confirmed.  This is an important ruling and, if followed in subsequent federal court decisions hearing RESCU's cases and interpreting Minnesota law, this ruling provides the pathway for RESCU to recover the full amount of its damages that are recoverable from solvent correspondent banks.

I say, "if followed in subsequent federal court decisions hearing RESCU's cases", because Gateway cited, as authority for the proposition that the limitations period starts to commence for a contractual indemnification right at the time the damage has been fixed, Hernick v Verhasselt, which relied upon Oanes v Allstate, which was a Minnesota Supreme Court decision that held that the limitations period with respect to a right to indemnification for tort damages accrued at the time the adjudication against the tortfeasor was concluded, not the earlier date when the injury occurred.  

It is not clear that a holding with respect to the commencement of the limitations period for indemnification for tort damages should be applied to indemnification for contract damages, and a recent motion to dismiss filed against ResCap by National Bank of Kansas City seeks to establish this distinction.  So, notwithstanding the favorable holding of Gateway, one might attend the disposition of National Bank of Kansas City before coming to the conclusion that ResCap has definitively established the favorable limitations period for indemnification.

Preliminary Financial Analysis 

RESCU has approximately 100 million units outstanding and currently units trade at about $17.50, yielding an enterprise valuation for RESCU of approximately $1.75 billion.  RESCU's tangible assets have a book value as of March 31, 2014 of approximately $7 per unit, implying that the market currently values ResCap's litigation claims at approximately $1 billion, or $10 per unit.

While ResCap's unsecured creditors claimed losses arising from R/W breaches in excess of $40 billion, those were losses incurred by ResCap's creditors, not by ResCap.  In order to ascertain what are the maximum amount of ResCap's losses from R/W breaches, I believe that it is appropriate to use as a proxy the $12 billion of allowed claims that were confirmed in ResCap's bankruptcy reorganization.

On the assumption that the ResCap Client Guide permits ResCap to successfully assert all of the possible R/W breaches ResCap can identify against correspondent banks, and the indemnification period is deemed to commence in December 2013 upon plan confirmation, the upper limit of ResCap's potential recoveries over time should be $12 billion, or over $120 per unit.

Now, there is very good reason to expect ResCap's ultimate recovery over time will be substantially less.

First, many of the correspondent banks ResCap dealt with are not still in existence or are judgment proof.  I am unaware of what portion of ResCap's potential recovery may be uncollectible for this reason, but one might be able to review all of ResCap's litigation against correspondent banks and perform a solvency analysis to arrive at a best guess. When you have done this, let me know where you come out.

Second, ResCap does not appear to be using the strength of the Client Guide to its absolute limit, and this is where the implied duty of good faith discussed earlier comes into play.  In the complaints that ResCap has filed to date, it has identified loan principal balances that it believes have given rise to losses specific to each correspondent bank, as opposed to simply citing (as if upon whim) a maximum recovery sought from each defendant equal to all of the mortgage loans that correspondent bank originated. In other words, ResCap is playing fair, but this also requires ResCap to be able to document for each defendant the appropriate principal balance of defective loans and, in connection with ResCap's indemnification claims, the losses arising therefrom.

So some recovery less than $12 billion, due to collectibility concerns and the requirement that ResCap identify defective loans originated by the various correspondent bank defendants, will likely be recoverable by ResCap over time.  What that time period will be is hard to estimate; this is a massive litigation project and each case brought against a creditworthy defendant can be expected to be met with a vigorous defense.

Informational Drought

RESCU's units are publicly traded, and one would normally expect that publicly traded equity securities would be subject to the reporting requirements under the Securities Exchange Act of 1934, giving rise to, among other things, quarterly and annual financial reports filed with the SEC, and management discussion and analysis and other textual disclosure.  However, it appears that RESCU has not registered the units under the Exchange Act, and information available about RESCU's ongoing strategy to maximize recoveries and liquidations to unitholders is nowhere to be found.

Now, the original distribution of RESCU units was free from registration under the Securities Act of 1933 due to an exemption for distributions arising out of a bankruptcy proceeding, but it would appear that RESCU is proceeding also under the basis that units are exempt from registration under the Securities Exchange Act of 1934, most likely because there are not enough record holders of units.  Even when the record holder requirement doesn't apply, it is not uncommon for a reorganization liquidating trust to seek only a partial exemption from certain Exchange Act reporting requirements, since the trust is not engaging in business and many of the required disclosures aren't relevant or would be too costly.  See e.g. the no action request made on behalf of Motors Liquidation, the liquidating trust for the GM unsecured creditors.

Even without requirement for SEC reporting, RESCU should consider itself to be under a duty to its equity holders, as a matter of proper trust governance, to fully inform unitholders about material information affecting the value of the units, and there is no more material information than information relating to its litigation program.  

RESCU has satisfied this duty to date with simply a list of filed actions.  So any investment in RESCU must be made with the understanding that you won't receive much informational guidance from RESCU itself.  Of course, RESCU might well point out that anything of value that it might otherwise wish to disclose about its litigation program is privileged attorney-client information.  So, perhaps hoping for more issuer disclosure is unrealistic.

A Word of Caution

In this blogpost, I have referred to RESCU as an investment opportunity.  Indeed, RESCU is the prototypical litigation-influenced investment opportunity.  This raises the question as to whether a purchase of RESCU units is really an investment after all, or rather a speculation, whether or not prudent.

This may be a distinction without a difference, as many believe that the vagaries of investment in business enterprises are no less uncertain than investment in litigation-influenced opportunities.

It is my view that while the rule of law offers investors reasonable expectations as to litigation outcomes, uncertainty as to litigation outcome is so endemic that one must consider purchases of securities that are litigation-influenced as to value, such as RESCU units, to be a speculative, as opposed to investment, activity. It may be a prudent speculation, based upon the considerations that I have tried to examine in this post, but it is a speculation nonetheless. 

The question arises whether an investment in a litigation program, such as RESCU, is qualitatively different than an investment in an operating business.  I don't believe one has sufficiently understood the characteristics of litigation risk if one doesn't consider this question, as it is certainly posed by RESCU.

NB:  this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice.  Investing is a tough game, and everyone must do and "own" their own work, because you will certainly own your investments.

Wednesday, April 9, 2014

The Detroit GO Settlement, and My Halls of Fame and Shame

The monoline insurers MBIA, Assured Guaranty and Ambac ("monolines") scored a major victory when they settled with the City of Detroit with respect to the Chapter 9 treatment of the insured Detroit unlimited tax general obligation bonds (GOs).

The term sheet for the settlement provides, among other things, the following:
  • the entire $388 million claim in respect of the GOs will be allowed in the Chapter 9, and the existing ad valorem taxes securing the GOs will be treated as "special revenues" for purposes of the Chapter 9, thereby rendering the GOs as secured for purposes of the Detroit plan of confirmation.
  • 74% of the GOs will be reinstated for the benefit of the holders (Reinstated GOs), and 24% of the GOs (Stub GOs) will be reinstated and assigned to a fund for the benefit of the poorest Detroit pensioners.
  • ad valorem taxes securing the GOs will continue to be levied in an amount sufficient to pay off all of the GOs, but such tax revenues will be applied first to pay the Reinstated GOs, and any excess will be applied thereafter to pay the Stub GOs.
  • upon plan confirmation, the Reinstated GOs will be exchanged for GOs issued by the Michigan Financing Authority, which will be secured by both the existing Detroit ad valorem taxes as well as a 4th lien on state aid provided by the State of Michigan. There are further bond protections provided.
This is a significant victory for the monolines since the Detroit Emergency Manager (EM) had proposed an allowable claim of just 15%, or $58 million, in the proposed plan of adjustment.  This settlement constitutes an incremental $229 million win for the monolines.

Readers of this blog will not find this settlement win for the monolines to be surprising.  I have previously stated in this blog and in an online debate on the Public Sector Inc. website that I thought the monolines would win this fight with the EM.  It was clear to me that the GOs were secured by ad valorem taxes which were created and levied in connection with the authorization of the GOs, such that these taxes would be treated as "special revenues" and the GOs treated as secured obligations in Chapter 9.

Why the 26% discount if it was so clear that the monolines would prevail?  There are several possible theories.  One is that the monolines perceived some risk that given the weakening of property values in Detroit, the ad valorem taxes would not be sufficient to pay the GOs in full, even if the GO claim was allowed in full. This would explain why the monolines obtained in the settlement further security for the Reinstated GOs in the form of the state aid lien.  

Additionally, remember that the GOs were double barrel bonds, secured by (i) a full faith and credit pledge, as well as (ii) a pledge of specially levied ad valorem taxes in connection with the authorization of the bonds.  The monolines might have been concerned that while Judge Rhodes would find for the monolines on the ad valorem pledge, and therefore provide the monolines an allowable claim in full, Judge Rhodes might have found against the monolines on the full faith and credit pledge, thereby creating an undesirable precedent for monolines to deal with down the road.

Moreover, let's remember, that no matter how certain a litigant may believe it will prevail, one must discount one's chances by at least 10%, given the nasty vagaries of judicial whim.  If one starts with a 90% certainty that the monolines would prevail, settling for a 74% recovery is a meager settlement discount, especially in the face of a 15% offer.

Hall of Fame

My hall of fame award goes to the monolines.  They have proven to all municpal issuers and bondholders the practical value of bond insurance.

Consider this:  suppose you were a bondholder without the benefit of insurance, and the EM just told you that he was going to shaft you by offering $.15 on the dollar, even under circumstances where you rightly believe that on the merits you are entitled to par.  Would you have have been able to contest successfully the EM's proposal in an adversary Chapter 9 proceeding?  Would you have preferred to form a committee of bondholders and commenced litigation against the EM? You would have faced a collective action problem that likely would have prevented you from mounting an effective challenge.

If there was ever a perfect illustration of the value of bond insurance, this is it.  The monolines are keeping the bondholders whole and are obtaining a recovery that is $229 million better than what the EM offered.  Bond insurers provide financing benefits to issuers in the form of reduced interest rates, but they also provide benefits to holders after issuance by assuming the risks and costs of asserting creditors remedies.

Hall of Shame

My hall of shame award goes to the EM.  This is just another example of how the EM has screwed the pooch in the Detroit Chapter 9 proceeding.
  • The EM failed to understand municipal bankruptcy law and recognize the lien underlying the GOs in respect of the pledged ad valorem taxes, and therefore failed to make the monolines a fair offer in the proposed plan of adjustment.  The EM had a good faith obligation to classify Detroit's claims in Chapter 9 properly, and the EM both failed in this regard, and then wasted Detroit resources in trying to defend its failure.  
  • The EM failed to understand municipal bankruptcy law and recognize the absence of any lien securing the swap obligations, which has led the EM to make overly generous offers to the swap banks on two occasions, with the result that each settlement has been rejected by Judge Rhodes.  A third swap settlement between the EM and the swap banks has been teed up for a possible strike three later this week. 
  • The EM stated that it was central to its plan of adjustment that Detroit lease its water and sewer facilities to the surrounding counties, and apply any lease payments in excess of payments on the bonds secured by these facilities towards Detroit's rehabilitation.  The EM has not been able to even begin to implement this proposal, because the EM has not been able to provide the counties sufficient financial information for the counties to even understand the EM proposal, much less negotiate it.
  • The EM failed to find a way to maximize proceeds from the Detroit Institute of Art fine art collection while still maintaining the cultural viability of the DIA.  Here is a meaningful DIA solution offered up by a monoline insurer.  The EM ignored the huge collateral value of the DIA art and has made Detroit pensioners suffer losses because of this EM failure. 
Of course, the EM is good at making public appearances and giving press interviews, and is now busy trying to save face.  Notice this specious explanation from the EM spokesman regarding the GO settlement with the monolines given to a columnist in today's Detroit News:

"Orr spokesman Bill Nowling said bondholders are getting a better deal now because the city previously didn't include revenue from voter-approved property taxes in its iniital offer to investors of Detroit's debt."

This makes it seem like the EM has suddenly become magnanimous in reaching settlement, as opposed to the reality of the situation, which was that the EM was abjectly wrong in excluding such tax revenues as security in the first place in making the GO offer!

One simply hopes that this buffoonery on the part of the EM doesn't dissipate Detroit resources for too much longer.

Disclosure:  Long MBI; AGO.
NB:  this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice.  Investing is a tough game, and everyone must do and "own" their own work, because you will certainly own your investments.