In a recent decision, Quadrant Structured Products v. Vertin, the Court of Chancery of Delaware resolved a dispute involving several topics of interest to distressed investment professionals (and the restructuring attorneys who advise them), including fiduciary duties, fraudulent transfer, and indenture protections. This entry will focus on the background of the case and the arguments that the indenture both expressly and impliedly prevented actions taken by equity to realize its investment strategy.
The case involved Athilon Capital Corp., a company formed in 2004 to sell credit protection including for uncollateralized credit default swaps. The company’s business depended on a triple-A credit rating. To obtain that rating, it committed to adhere to certain operating guidelines that had been approved by leading credit rating agencies. As set forth in the decision, among other things, the guidelines specified terms and conditions on which the company could write swaps and generally restricted it to investing in the highest credit-quality securities (e.g., treasury bonds). As also described in the decision, the guidelines included a feature that, upon the occurrence of certain conditions (“suspension events”) persisting for an amount of time, would put in place a ban on writing new swaps and require the company to run-off its remaining swaps as they matured.
The company’s business was originally funded with a $100 equity infusion and then $600 million in unsecured debt (including both senior and junior notes, both of which were subordinate to the company’s swap obligations). With its capital and its credit, the company was able to write swaps in a substantial amount (at its height, $45 billion in notional value). And then came the 2008 financial crisis. The swap market was decimated and, according to the decision, “all of [the company’s] swaps suffered mark-to-market losses.” The financial crisis also resulted in the revocation of its triple-A credit rating and Moody reporting that several suspension events had occurred. According to the decision, by “the end of 2009, Athilon was insolvent and had no operating business.”
According to the decision, in 2009, Merced, who we will refer to as the “equity investor,” began investigating Athilon as an investment opportunity. The equity investor “concluded that Athilon’s Notes looked attractive at the distressed prices prevailing in the market,” noted the court, and purchased notes in late 2009. The equity investor also analyzed the company’s equity, the court noted. While the equity investor “recognized that unless [a certain swap] was successfully commuted, Athilon’s equity was worth ‘probably zero,’” it “also thought that with a successful commutation the equity could be worth $60 million.” The court noted that the equity investor had “correctly perceived that Athilon’s Charter, the Operating Guidelines, and the indentures governing the Notes did not require Athilon to dissolve and liquidate after its swap book ran off,” and “believed that Athilon would be able to reposition its portfolio from cash equivalents to higher yielding investments.” Once repositioned, “because of the Notes’ distant maturity dates, virtually non-existent covenants, and low coupon, Athilon could support the interest payments with significantly less than $600 million in capital,” the court noted. “Using the excess capital, Merced could achieve a return on its investment by ‘equitizing’ the Notes and paying a large dividend.” In early 2010, the equity investor “successfully negotiated to buy all of Athilon’s capital,” the court noted.
The decision also states that Quadrant, who we will refer to as the “debt investor,” began purchasing notes in early 2011. The debt investor’s investment thesis was that “the Notes were undervalued.” As stated by the court, the debt investor “invested in the Notes believing that [the equity investor] would dissolve Athilon and liquidate its assets.” The court noted that, “[a]lthough in liquidation Athilon’s assets might not be sufficient to satisfy all of its creditors, it could pay off the senior notes in full and provide a meaningful recovery on the more junior notes.” As stated by the court, creditors “who had purchased the notes at discounted prices would reap healthy returns.” Although the debt investor “knew its strategy was risky,” the court stated that it “did not think [the equity investor] would be able to extract a return from Athilon without dissolving the Company, and . . . believed it had a reasonable legal argument that Athilon was required to liquidate.” It “decided to take the risk and invest in the Notes.”
Both investors clearly had different goals, but only the equity investor had control (as the court noted, it had reconstituted the board of directors after it acquired the company’s equity). The company began taking steps to reposition its portfolio. This first required an amendment to the operating guidelines (which restricted investments), which was only possible if the credit agencies found that the modifications would not harm the company’s credit rating. The credit agencies approved the changes to the Operating Guidelines.
As the company moved forward, the debt investor contacted the company and the equity investor with numerous complaints and the intent of nudging it towards liquidation, the opinion notes.
- Repositioned Portfolio. The debt investor complained about the company’s decision not to liquidate after its run-off, and to instead invested in “XXX” securities (which were riskier than the cash-equivalent and treasury-type securities previously required under the operating guidelines), the court noted. The debt investor complained that by engaging in this strategy the equity investor was in a “heads-I-win, tails-you-lose” circumstance because if this “riskier strategy” paid off, the equity and junior notes would benefit, but if it did not, the senior notes would bear the loss, the court explained.
- Cash Payments. The debt investor also complained that the company was continuing to pay interest on its junior notes, all of which were owned by the equity investor, the court noted. The company had the right to defer payments on the notes for up to five years. The debt investor contended that, because the junior notes would not recover in a near-term liquidation, the company was, in-effect, transferring value from the more senior notes to the equity investor, the court noted.
- Management Services Contract. In addition, the debt investor also contended that the company was paying excessive fees to an affiliate of the equity investor through a management services contract, the court noted. The debt investor argued that it could provide the same services for much cheaper, as it was in the business of doing so. However, in the court’s words, the debt investor “quickly discovered that it was being naïve.” All credit default companies were sponsored by a parent, and all had entered similar service agreements with affiliates of their parent, the opinion stated. As was typical for the industry, these agreements were “not negotiated at arms’ length and did not reflect a market rate,” and “effectively provided a way for the parent company to obtain a return on its investment,” the court noted.
As stated in the opinion, the company’s board and the equity investor were not convinced by the debt investor’s arguments, did not accede to its demands, and did not alter the company’s business strategy.
The company’s new investments were performing, and the equity investor began taking steps to improve the company’s balance sheet, the court noted. Among other things, the equity investor reduced the company’s debt and increased its equity value by tendering a portion of its notes in December, 2014, the court noted. As a result of this and other developments, the opinion states, the company had positive equity of $173 million on its subsequent audited financial statements. The company purchased the equity investor’s remaining notes ($194.6 million in principal amount) in January, 2015, the court noted. The company did not purchase any of the debt investor’s senior notes.
The Lawsuit and Decision
When the debt investor’s complaints went unanswered, it brought its qualms to court. Its initial suit was commenced in October, 2011, and expanded with a supplemental complaint in March, 2015 (filed after the debt investor learned of the January note repurchase). Among other things, the debt investor claimed that the equity investor had breached its fiduciary duties, that its note repurchases violated fraudulent transfer laws, and that note repurchases breached the terms of the senior notes’ indenture (both express and implied).
The lawsuit progressed through what the court characterized as a “complex procedural history,” which culminated in the decision addressed here, which was issued on October 20, 2015. The court rejected the debt investor’s arguments. While there were a variety of legal issues in dispute, this post will only focus on the court’s resolution of arguments relating to the indenture.
The debt investor had claimed that the company’s selective purchase of senior notes violated the indenture’s redemption procedures. That argument was squarely rejected by the court. As it explained, the redemption provision was not intended to restrict the actions of the company in any way. Rather, it gave the company a right to redeem notes where it otherwise would not be able to redeem them without holder consent. Other transactions, for example the purchase of outstanding securities from a willing holder, had nothing to do with the redemption provision.
In reaching this conclusion, the court consulted the canonical American Bar Association model indentures and commentaries. For those who are unfamiliar, these commentaries are a product of multi-generational efforts to clarify corporate indentures through standardized provisions and explanations for their rationale. They are a useful interpretive tool, not only for their guidance on the standard provisions, but also for drawing inferences of intent where deviations occur. The court also drew on the commentaries to dismiss several creative arguments of the debt purchaser that acquired notes had automatically became “redemptions.” This is a sound lesson that creative interpretation is more likely to prevail when it operates within the constraints of accepted conventions, and less so when unhinged.
Implied Covenant of Good Faith
The debt investor had also claimed that company violated the implied covenant of good faith and fair dealing, arguing that the covenant requires a company without any remaining business return its capital to all of its stakeholders, and not just its insiders. While there is an apparent fairness of making sure everyone gets their share of a company at the end of the day, the court quickly put this argument in its place.
When it comes to indentures, certainty is the prevailing policy. Interpretations that open up otherwise established understandings create turmoil in the markets, while clear rulings allow parties to adjust and plan their affairs accordingly. While the court recognized that the indenture did include the implied covenant of good faith and fair dealing, it held that the covenant could not override the express provisions of the agreement. The indenture clearly provided when the senior notes would be paid, when they could be redeemed, and what restrictions they placed on the company, and adding implied restrictions would be contradict such provisions. As the court noted, the debt investor was, through the good faith and fair dealing claim, “seeking to obtain a right that it did not bargain for explicitly.”
Notably, the court also surveyed indentures of peer companies. Unlike the senior notes indenture here, the other examples provided for mandatory redemption upon the conclusion of a run-off. Clearly the infractions the debt investor complained of (i.e., not liquidating) were not beyond the purview of drafters, they just weren’t included. The court left open the possibility for the implied covenant to have an impact under the right circumstances, but that was not the case here.
At the end of the day, the debt investor failed to force a liquidation through the court. There were a number of red flags, however, that it could have picked up on and that may have led it to avoid this investment in the first place. The covenant-lite loan documents that it invested in did not protect it, and did nothing to ensure that its investment thesis would pan out. Indeed, even the court’s cursory examination of comparable indentures showed that many key protections that would have changed the game entirely were absent. Moreover, the operating guidelines were not absolute and could be changed to accommodate different business decisions and strategies.
Hindsight is 20/20, and it is impossible to tell what drove the debt investor’s decision. We don’t know how it thought about a contingency case or whether it made an informed decision of the risk that the company would not liquidate. But the result stands as a reminder: Investment teams that are considering putting capital behind an investment thesis should not only understand how the thesis works, but how it doesn’t. While no substitute for a crystal ball, the right counsel can help understand whether the strongholds and weak points in the legal landscape validate a path to value, and identify potential ways that road blocks, pitfalls, and booby traps could be stumbled upon – or used.