Collateralised debt obligation (CDO) transactions have recently come under scrutiny as a result of the subprime mortgage crisis. This is because many, although not all, CDO transactions invest in residential mortgages. The U.S. Securities and Exchange Commission (SEC) confirmed in June 2007 that it had begun more than a dozen inquiries into CDO transactions, and there have also been reports of litigation between parties in relation to underperforming CDO transactions. An unreported effect of current market conditions will be increased pressure upon those who act as trustees to the CDO transactions.
CDOs can appear complex even to sophisticated investors. However, at the heart of the structure is a relatively simple relationship whereby an issuing vehicle (the issuer) holds assets and grants security over itself and such assets to a trustee (the trustee) that represents the interests of investors (the noteholders) in the structure.
CDOs pool assets and issue notes supported by the income from those assets. The pool of assets spreads the risk borne by the investors. Fundamentally, however, the structure cannot remove risk, because the CDO is reliant for its performance on the underlying assets. The notes are often layered, with each layer bearing a separate level of risk. Another area of complexity is the number of entities charged with the management of the deal. Each undertakes tasks such as portfolio management, cash payments and numerous other subsidiary roles.
The trustee of a CDO has the difficult task of dealing with the competing interests inherent in the layers of notes. Care must be taken to ensure each participant obtains its due reward. In circumstances where the assets perform well, the underlying contracts are usually sufficient to provide a road map for the deal. Difficult and unforeseen market conditions can, however, give rise to conflicts or situations not expressly dealt with in the contracts.
Competing Interests of Different Classes of Notes
A key feature of CDOs is the layering of the notes, with the highest layer receiving interest payments first, and each layer then being paid in turn. Investors in the different layers of the CDO can often have very different interests. Typically, the trustee will be required to take instructions from the highest class of noteholders and prioritise higher classes in the event of any conflict of interest. On occasion, however, the documents will provide that the trustee needs to look towards the subordinated noteholders. This is only fair because the subordinated noteholders suffer the first loss if any debt in the portfolio defaults.
Interpretation of the Contracts
The contracts inevitably come under scrutiny when the collateral is underperforming or an unforeseen event occurs. Where there is an uncertainty about the meaning of any contract terms, a senior noteholder may advocate an interpretation which favours its interests, whilst the junior noteholders may have an opposing view. In these circumstances, the trustee cannot favour the contractual interpretation put forward by the senior class even if there are provisions stating it must favour their interests. The trustee must determine which interpretation is legally correct. A court would find that there is only one right answer, and if the trustee chooses the “wrong” interpretation, it may be exposed to the claim that it has allowed a breach of contract to occur.
In circumstances where there is a disputed interpretation, the trustee can protect itself by applying to the courts for a declaration as to the meaning of the applicable provision. The trustee is well advised to ask the court to rule on the correct meaning, because otherwise the trustee can be exposed to a claim for breach of trust.
Claims by the Trustee
The daily management of any CDO is entrusted to numerous contracting parties who manage particular functions. Typically they contract with both the issuer and trustee.
Where a CDO underperforms, investors may seek to blame past decisions on contracting parties such as the portfolio manager. Investors do not have any contractual relationship with entities such as the portfolio manager and may therefore request the trustee to commence litigation to recover damages on behalf of the noteholders.
In these circumstances, the trustee will need to consider the merits of potential litigation. The trustee may face a difficult decision, with some noteholders demanding litigation and others worried that trust assets will be dissipated by litigation costs. The trustee can protect itself by applying to court for a declaration as to whether the litigation should be pursued.
Liability and Indemnification of Trustee
The trustee is not responsible for the performance of the CDO. Only upon enforcement of the security will the trustee take over the issuer’s role and take direct responsibility for the relationship with entities such as cash managers and portfolio managers who run the day-to-day activities of the CDO. A properly advised trustee will only assume such a role upon receipt of appropriate indemnities, to which it will often be entitled as a matter of law quite apart from any provision in the trust instrument.
Finally, it should be noted that the trustee’s liability is invariably limited to negligence and wilful default. This is a prudent level of protection given the number of moving parts in the structure and the possibility of a default occasioned by the failure of another party to perform.
Amendments to the Contracts
The contracts of CDO transactions are frequently amended during the life of the transaction. The diversified portfolio and the complex payment mechanism mean that careful administration is required to ensure each noteholder receives its entitlement. This appears to be a mechanical role, but the complexity and diversity of debt instruments have significantly increased over the past few years, and often an administrator is called upon to make complex judgments. It is, of course, the responsibility of the lawyers who put together the CDO to set clear guidelines for the administrators, but despite careful execution, the debt markets continue to change, and new products or unforeseen circumstances emerge that need to be dealt with in the structure.
CDOs typically allow amendments to occur where the rating agencies and the trustee give their consent. In exercising its discretion to amend the contract, the trustee has a fiduciary duty to the noteholders to consider their interests. The trustee is not entitled to simply rely upon the opinion of the administrator that the amendment should take place. The trustee must exercise its own judgment.
Current market conditions can create conflict between participants in CDOs, and it is likely that the role of the trustee will become more difficult as a result. Seeking the guidance of the court affords the trustee protection when it comes to interpreting contracts or embarking on a course of action. Recently, the administrator in respect of Cheyne Finance’s Structured Investment Vehicle (SIV) sought the court’s guidance on an insolvency test. SIVs are similar in some respects to CDOs, and there are parallels to be drawn here. The issue at stake with regard to the insolvency was crucial, and the court’s decision led to a halt in payments on the vehicle’s short-term debt. Trustees should take comfort in knowing that the option of receiving guidance from the court is open to them.