The Hedge Fund Law Report

The definitive source of actionable intelligence on hedge fund law and regulation

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By Topic: Collateralized Loan Obligations

  • From Vol. 9 No.30 (Jul. 28, 2016)

    Implications of Lehman Brothers Decision on Hedge Fund Managers Trading CDOs

    On June 28, 2016, Judge Shelley Chapman of the U.S. Bankruptcy Court for the Southern District of New York authored an opinion in the case of Lehman Brothers Special Financing Inc. v. Bank of America National Association. This decision, which holds that certain market-standard provisions in structured finance transactions are enforceable when the swap counterparty’s default is due to the bankruptcy of that counterparty, provides hedge fund managers and others trading collateralized debt obligations (CDOs) and other structured products with greater certainty than prior rulings relating to the collapse of Lehman Brothers. The Hedge Fund Law Report recently interviewed Schulte Roth & Zabel partner Paul Watterson about Judge Chapman’s decision and its ramifications for hedge fund managers. Specifically, Watterson addressed the significance of the decision in light of prior case law, the implications of the decisions for hedge fund managers trading CDOs and the specific provisions managers should include in CDO documentation to take advantage of this holding. For more on the Lehman Brothers collapse, see “Lesson From Lehman Brothers for Hedge Fund Managers: The Effect of a Bankruptcy Filing on the Value of the Debtor’s Derivative Book” (Jul. 12, 2012); and “How Can Hedge Funds Get Their Money Out of Lehman Brothers International Europe?” (Aug. 5, 2009).

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  • From Vol. 8 No.40 (Oct. 15, 2015)

    Investor Lawsuit Against Lynn Tilton Alleges Misrepresentations and Excessive Fees

    A German bank and its affiliate that invested in two collateralized debt obligations (CDOs) sponsored and managed by Lynn Tilton’s firm, Patriarch Partners, have sued Tilton and the collateral managers of those CDOs in New York State Supreme Court for fraud and negligent misrepresentation.  The investors allege that the defendants improperly invested the CDOs’ assets in controlling equity positions in portfolio companies, enabling them to extract “excessive management fees” from those companies and benefit themselves at the expense of their investors.  The plaintiffs, who are seeking damages of more than $45 million, claim that the CDOs were in fact “poorly run and incredibly risky private equity ventures,” rather than traditional CDOs that invested in portfolios of debt.  This article summarizes the factual background of the dispute, the defendants’ alleged misconduct and the investors’ specific claims.  The suit follows the March 2015 SEC enforcement action against Tilton and the collateral managers of three CDOs sponsored by Patriarch Partners.  See “SEC Fraud Charges Against Lynn Tilton, So-Called ‘Diva of Distressed,’ Confirm the Agency’s Focus on Valuation and Conflicts of Interest,” The Hedge Fund Law Report, Vol. 8, No. 14 (Apr. 9, 2015).

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  • From Vol. 8 No.14 (Apr. 9, 2015)

    SEC Fraud Charges Against Lynn Tilton, So-Called “Diva of Distressed,” Confirm the Agency’s Focus on Valuation and Conflicts of Interest

    On March 30, 2015, the SEC announced the commencement of an enforcement action against Lynn Tilton, the so-called “Diva of Distressed,” and several entities she controls, arising out of the alleged overvaluation of distressed debt in the collateralized loan obligations (CLOs) they advise.  The SEC charges that Tilton improperly valued the loans owned by those CLOs, resulting in her receipt of nearly $200 million in compensation that she was not entitled to receive.  She also allegedly certified false and misleading financial statements for those CLOs and failed to disclose and obtain investor consent to the conflict of interest posed by her discretionary valuation method.  This article summarizes the SEC’s allegations and its specific charges.  For more on CLOs, see “Private Investment Funds Investing in CLO Equity and CLO Warehouse Facilities,” The Hedge Fund Law Report, Vol. 7, No. 18 (May 8, 2014).

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  • From Vol. 7 No.37 (Oct. 2, 2014)

    Industry Experts Discuss SEC’s Newly Adopted Revisions to Regulation AB

    SEC Regulation AB governs the offering, reporting and disclosures relating to the sale of asset-backed securities.  On August 27, 2014, the SEC approved a set of sweeping changes to Regulation AB, commonly referred to as Regulation AB II.  A panel of industry experts recently discussed the key provisions of Regulation AB II.  The program was hosted by the Asset Securitization Report and sponsored by Bingham McCutchen, LLP.  Elliott M. Kass, of SourceMedia, moderated the discussion.  The speakers were Steven Glynn, a Vice President and Counsel at Barclays; Ryan O’Connor, a Director and Counsel of Citigroup Global Markets Inc.; Ian W. Sterling, an Executive Director and Assistant General Counsel of J.P. Morgan; John Arnholz, a Partner at Bingham; and Charles Sweet, a Managing Director at Bingham.  See also “CLO 2.0: How Can Hedge Fund Managers Navigate the Practical and Legal Challenges of Establishing and Managing Collateralized Loan Obligations? (Part Two of Two),” The Hedge Fund Law Report, Vol. 6, No. 26 (Jun. 27, 2013).

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  • From Vol. 7 No.18 (May 8, 2014)

    Private Investment Funds Investing in CLO Equity and CLO Warehouse Facilities

    Collateralized loan obligation (CLO) issuance totaled approximately $82 billion in 2013, outpacing 2012 total issuance by more than 50%.  The establishment of private investment funds to invest specifically in CLO securities is likewise on the rise.  This guest article provides a brief overview of CLO transactions, while also outlining certain key issues that funds may wish to consider when investing in CLOs, with a particular focus on investment in the most subordinated tranche of CLO securities, commonly referred to as the CLO “equity.”  The author of this article is Greg B. Cioffi, co-head of Seward & Kissel LLP’s Asset Securitization and CLO Practice Group.  See also “CLO 2.0: How Can Hedge Fund Managers Navigate the Practical and Legal Challenges of Establishing and Managing Collateralized Loan Obligations? (Part Two of Two),” The Hedge Fund Law Report, Vol. 6, No. 26 (Jun. 27, 2013).

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  • From Vol. 6 No.26 (Jun. 27, 2013)

    CLO 2.0: How Can Hedge Fund Managers Navigate the Practical and Legal Challenges of Establishing and Managing Collateralized Loan Obligations? (Part Two of Two)

    CLO deal volumes in 2012 and the first quarter of 2013 clearly indicate that investor appetite for CLO investments has returned.  At the same time, establishing and managing CLOs can present attractive revenue-generating opportunities for fund managers.  Nonetheless, these opportunities are accompanied by new challenges for managers, which are outlined in this two-part series of articles.  This second article in the series presents a brief overview of various legal developments that have altered or may alter the CLO management landscape, including (1) risk retention rules, the Volcker Rule and various Commodity Futures Trading Commission requirements under the Dodd-Frank Act, (2) enhanced registration requirements under the Investment Advisers Act of 1940, (3) the implementation of the Foreign Account Tax Compliance Act provisions of the Internal Revenue Code (Code), and (4) Sections 409A and 457A of the Code.  The first installment of the series touched upon several of the practical challenges CLO managers can expect to encounter in establishing a CLO in the current market environment.  Specifically, the first article addressed a number of common documentation requests by anchor investors in the most senior and subordinated (or equity) classes of the CLO capital structure and explored certain inherent difficulties in obtaining warehouse financing in connection with the ramp up of the CLO portfolio prior to the initial issuance of CLO notes.  See “CLO 2.0: How Can Hedge Fund Managers Navigate the Practical and Legal Challenges of Establishing and Managing Collateralized Loan Obligations (Part One of Two),” The Hedge Fund Law Report, Vol. 6, No. 25 (Jun. 20, 2013).  The authors of this series are Greg B. Cioffi and Jeff Berman, both partners in Seward & Kissel’s Structured Finance and Asset Securitization Group, and David Sagalyn, an associate in the group.  See also “Key Legal and Business Considerations for Hedge Fund Managers When Purchasing Collateralized Loan Obligation Management Contracts,” The Hedge Fund Law Report, Vol. 3, No. 13 (Apr. 2, 2010).

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  • From Vol. 6 No.25 (Jun. 20, 2013)

    CLO 2.0: How Can Hedge Fund Managers Navigate the Practical and Legal Challenges of Establishing and Managing Collateralized Loan Obligations? (Part One of Two)

    While its much-maligned counterparts, collateralized debt obligations (CDOs) and structured investment vehicles, have languished, the cash-flow collateralized loan obligation (CLO) has emerged from the financial crisis relatively unscathed.  The issuance of post-crisis CLO paper has experienced a sustained resurgence, surpassing $53 billion in 2012 and catapulting past $27 billion in the first quarter of 2013 alone.  For many fund managers, managing a CLO may present a very attractive opportunity.  Unlike the standard hedge fund platform, a CLO can generate lucrative and stable management fees with minimal redemption risk during the non-call period while remaining largely insulated from market value declines.  Although the characteristics of the post-crisis “CLO 2.0” hardly represent a sea-change from the pre-crisis version, there have been a number of important structural developments.  The CLO 2.0 era has also ushered in changes to the underlying transaction documentation aimed at addressing various lessons learned from the failings of CDOs and other structured products during the market meltdown.  Despite the recent fanfare, there remain several practical and legal obstacles that a CLO manager can expect to encounter in the current market environment.  This article is the first in a two-part series discussing the practical challenges of establishing a CLO in the current market environment, and how CLO managers can address the challenges.  Specifically, this article addresses a number of common documentation requests by anchor investors in the most senior and subordinated (or equity) classes of the CLO capital structure and explores certain inherent difficulties in obtaining warehouse financing in connection with the ramp up of the CLO portfolio prior to the initial issuance of CLO notes.  The second installment in this series will present a brief overview of various legal developments that have or may alter the CLO management landscape, including (1) risk retention rules, the Volcker Rule and various Commodity Futures Trading Commission requirements under the Dodd-Frank Act, (2) enhanced registration requirements under the Investment Advisers Act of 1940, (3) the implementation of the Foreign Account Tax Compliance Act provisions of the Internal Revenue Code, and (4) Sections 409A and 457A of the Internal Revenue Code.  The authors of this series are Greg B. Cioffi and Jeff Berman, both partners in Seward & Kissel’s Structured Finance and Asset Securitization Group, and David Sagalyn, an associate in the group.  See also “Key Legal and Business Considerations for Hedge Fund Managers When Purchasing Collateralized Loan Obligation Management Contracts,” The Hedge Fund Law Report, Vol. 3, No. 13 (Apr. 2, 2010).

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  • From Vol. 3 No.13 (Apr. 2, 2010)

    Key Legal and Business Considerations for Hedge Fund Managers When Purchasing Collateralized Loan Obligation Management Contracts

    CLOs, a species of collateralized debt obligation, are special purpose entities that issue senior rated debt securities and junior unrated equity-like securities which provide different levels of exposure to a pool of loans owned, directly or indirectly, by the entity.  The principal and interest payments on the securities issued by the CLO generally come from the principal and interest payments made by the borrowers of the loans held by the CLO and, in some cases, from purchases and sales of the underlying loans.  The idea behind issuing multiple classes – or “tranches” in CLO parlance – of CLO securities is to reallocate the risk of underpayment or nonpayment on the underlying loans, and thereby diminish the risk assumed by the senior noteholders.  In other words, if a pension fund wanted exposure to a loan used to fund a leveraged buyout in 2006, it might purchase the loan directly, but it would cease receiving principal or interest payments as soon as the borrower stopped making such payments.  However, if the pension fund purchased senior notes issued by a CLO that held that same leveraged loan along with other leverage loans, a default by the borrower on that leveraged loan might not cause the pension fund to cease receiving principal and interest payments on the senior CLO note.  This is because other leveraged loans in the CLO would, in theory, continue paying principal and interest, thus enabling the CLO to continue making principal and interest payments to its senior notes holders.  Also, any underpayment or nonpayment on any of the underlying loans would first be absorbed by holders of the junior or “equity” notes.  What this theory – and the associated AAA ratings of many of the senior notes issued by CLOs – did not take into account prior to 2008 was the possibility that all of the leveraged loans in a CLO could simultaneously stop paying principal and interest.  In other words, the high ratings of senior CLO notes and the associated perception of safety was based on the idea that a diversified portfolio of otherwise risky loans to companies in different industries and geographies was considerably safer and less volatile than the individual loans in the portfolio – especially when the initial losses on that diversified portfolio were contractually allocated to other people.  But credit markets seized up globally starting in 2008, CLO equity tranches were wiped out and CLO senior notes were revealed as significantly riskier than their coupons suggested.  In short, CLOs got a bad name during the credit crisis, and from September 2007 until March 30, 2010 (three days ago), no new CLOs were issued.  However, many CLOs remain in existence and various hedge fund managers currently manage CLOs, have managed CLOs or have the personnel and infrastructure in place to manage CLOs today or with minor adjustments.  For example, the skill sets and infrastructure required to manage distressed debt or credit hedge funds are similar to those required to manage CLOs.  Accordingly, for certain hedge fund managers, purchases of the contracts to manage those existing CLOs may offer a number of attractive features including: (1) an ongoing, reasonably predictable revenue stream; (2) “sticky” investor assets at a time when assets remain difficult to raise and retain; (3) a potential foot in the door with major institutional investors; (4) an asset (the management contract) that may be illiquid, and thus may be obtained at a discount to fair value; (5) forced sellers of management contracts; and (6) an “infrastructure arbitrage” (in the sense that certain larger hedge fund managers may enjoy economies of scale that enable them to manage a CLO at lower cost than smaller managers).  For analysis of another situation in which an albatross for one hedge fund manager may be an opportunity for another, see “Will Reported Purchases by D.E. Shaw Hedge Funds of Assets in Other Hedge Funds’ Side Pockets Set a Precedent, or Highlight the Fiduciary Duty, Valuation and Other Challenges in Such Transactions?,” The Hedge Fund Law Report, Vol. 3, No. 11 (Mar. 18, 2010).  To assist hedge fund managers in evaluating, entering and negotiating the CLO management market, the remainder of this article discusses: the mechanics of CLOs, including features relating to investments, fees, payment priority, ratings and withdrawals; recent precedent transactions involving sales of CLO management contracts; rationales for selling CLO management contracts; rationales for buying CLO management contracts; and key legal considerations in connection with purchases or sales of CLO management contracts, including consent requirements and how to avoid the assumption of liabilities of the prior manager.

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