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.