Investment and Arbitrage Opportunities
Distress in the U.S. subprime market has spread to the corporate credit markets and is straining Collateralized Debt Obligation vehicles ("CDOs") and Collateralized Loan Obligation vehicles ("CLOs") that have heavily invested in general corporate debt. The current market not only raises issues for investors, both public and private, but also raises issues for audit committees and boards of directors of public companies that hold investments in CDOs and CLOs. Increasing defaults and potential downgrades of the financial guarantors that provided insurance for notes issued by CDOs and CLOs will likely give rise to opportunities for focused investors. Such opportunities can appeal to active investors seeking to replace the collateral manager and manage the underlying portfolio of loans ("Active Investors"), or to opportunistic investors simply taking advantage of pricing dislocations ("Trading Investors"). Finally, the current environment may cause existing investors in CDOs and CLOs to seek advice regarding their rights and remedies to the extent they believe the collateral manager has acted improperly in managing the portfolio or to the extent there may have been misrepresentations or omissions in the offering documents ("Existing Investors").
Issues for Active Investors
Active Investors should be mindful of the following issues in considering investments in CDOs and CLOs:
- What contractual and other rights are available to remove or replace the collateral manager? These will differ between and/or among the various tranches of debt issued by the CDO or CLO.
- What other rights and remedies are available to holders of each tranche of debt under the CDO/CLO documents?
- How can investors who seek to replace the collateral manager ensure that they step into the rights of the collateral manager without assuming the manager?s liabilities?
- What are the optimal tranches of notes in which to invest in order to achieve particular goals and objectives?
- What is the best method of purchasing an entire tranche or blocking position in notes?
- How can public/private information issues be managed during the execution of an activist strategy?
- How can investors accurately assess the value (and potential cost of terminating) any credit default swap or interest rate swap embedded in the CDO or CLO structure?
Issues for Trading Investors
Similarly, Trading Investors should carefully consider the following issues:
- Which tranche of notes provides the optimal value to achieve desired rates of return?
- What are the legal issues that may affect the relative priority of various tranches of debt?
- What are the impediments to recovery inherent in one or more tranches of notes?
- What issues arise in connection with one-off or bulk purchases of notes from either individuals or groups of noteholders?
Issues for Existing Investors
Existing Investors must evaluate their rights, remedies and options in determining whether to continue to hold the notes by considering the following issues:
- What rights do existing holders have to ensure that the collateral manager is a prudent stalwart of capital and is maximizing value?
- What potential claims exist against the collateral manager, underwriter and/or offering agent in a CDO/CLO?
- Who has legal standing to bring those claims or direct that such claims be asserted?
- Are there any conflicts of interest between the financial guarantor, the various tranches of securities and the collateral manager?
Issues Facing Audit Committees and Boards of Directors
Public Companies, Audit Committees, and Boards of Directors should be aware of the following issues:
- What issues are regulators and prosecutors exploring in this area and how should a public company, Board or Audit Committee prepare for and/or respond to governmental inquiries?
- What are the various disclosure obligations of public companies holding investments in CDOs and/or CLOs?
- What type of information should a Board and/or Audit Committee expect and demand regarding exposure to the credit markets?
- What duties are triggered or issues raised with respect to a public company's holdings of CDOs and/orCLOs?