Funds Talk: July 2018
Legal commentary on the news and events that matter most to alternative asset managers and funds.
Topics covered in this issue include:
- Opportunities in Permanent Capital Vehicles Fund managers considering opportunities in permanent capital vehicles have a variety of alternatives to choose from. The following chart highlights some of the key differences among these alternatives so that fund managers can determine which ones best suit their strategies and objectives.
- Comptroller of the Currency Announces That Leveraged Lending Guidance Is Not Expected to Be Changed Comments are the second time the comptroller of the currency has surprised an audience with unexpected remarks on the guidance.
- SEC Amends Definition of ‘Smaller Reporting Company’ Expanding the Number of Companies Eligible for Reduced Disclosure On June 28, 2018, the Securities and Exchange Commission voted to amend the definition of “smaller reporting company” (SRCs) to expand the number of companies eligible to take advantage of the reduced disclosure requirements applicable to SRCs.
- SEC Acts on Liquidity Disclosure Rules and Proposes Easing Regulation of ETF Launches At an open meeting on June 28, 2018, the SEC adopted liquidity disclosure amendments and proposed new rules to ease the approval process for new exchange-traded funds.
- Opportunistic CDS Strategies Available to CDS Protection Sellers, Part I: An Introduction
Over the past few years, the CDS market has seen an increase in activism and the evolution of creative refinancing and restructuring strategies intended to achieve particular outcomes in the CDS market. With the proliferation of unconventional credit events, opportunistic CDS strategies may have appeared available only to protection buyers.
McClatchy and Sears were two recent situations in which a proposed refinancing significantly affected the CDS market for the reference entity because of the reduction in the risk that the CDS contract on those entities would be triggered. Although these cases may or may not have been driven by CDS considerations, they illustrate how CDS strategies may be effectively implemented to benefit CDS protection sellers.
- New York’s High Court Holds That Three-Year Statute of Limitations Applies to Martin Act Claims, Trimming the State’s Securities Law
New York Court of Appeals ruling gives financial industry professionals greater clarity on Martin Act’s statute of limitations relating to the Act’s registration and disclosure requirements with respect to the sale of security interests in condominium and cooperative apartments, and the broad definition of “fraudulent practices.”
Opportunities in Permanent Capital Vehicles
Fund managers considering opportunities in permanent capital vehicles have a variety of alternatives to choose from. The following chart highlights some of the key differences among these alternatives, so that fund managers can determine which ones best suit their strategies and objectives.
Comptroller of the Currency Announces That Leveraged Lending Guidance Is Not Expected to Be Changed
On May 24, 2018, Joseph Otting, the comptroller of the currency, announced that he does not expect that the Office of the Comptroller of the Currency (OCC) will be making revisions to the 2013 Interagency Guidance on Leveraged Lending (Leveraged Lending Guidance).
“What we would look for is if they are doing it in a safe and sound manner,” Otting, the principal regulator of all national banks, said during a telephonic press conference. “We want to make sure they have the capital and the talent to evaluate that kind of activity and that the risk profile has been approved.”
This is the second time in recent months that Otting has made extemporaneous and unexpected remarks regarding the policy of federal banking regulators with respect to leveraged lending. On Feb. 27, 2018, speaking at an industry conference in Las Vegas, Otting announced that the OCC would no longer be enforcing the Leveraged Lending Guidance. “As long as banks have the capital, I am supportive of banks doing leveraged lending. When the guidance came out — it was like people were afraid to jump over the line without feeling the wrath of Khan from the regulators. But you have the right to do what you want as long as it does not impair safety and soundness. It is not our position to challenge that,” he said. Otting further indicated that the OCC would no longer challenge lending activities solely because the lending violated the guidance.
In October 2017, the Government Accountability Office ruled that the Leveraged Lending Guidance had been illegally adopted and should have been subject to congressional review under the Congressional Review Act. Additionally, on Dec. 5, 2017, then-Federal Reserve Bank Chairwoman Janet Yellen, in a letter to Rep. Blaine Luetkemeyer, stated that the Federal Reserve Board is “considering soliciting public comment on the guidance in the near term with a view to improving the clarity of the guidance and reducing any unnecessary burden.”
To date, the federal banking regulators have not issued any revised leveraged lending guidance or sought public comment on the existing guidance.
SEC Amends Definition of ‘Smaller Reporting Company’ Expanding the Number of Companies Eligible for Reduced Disclosure
On June 28, 2018, the Securities and Exchange Commission voted to amend the definition of “smaller reporting company” (SRC) to expand the number of companies eligible to take advantage of the reduced disclosure requirements applicable to SRCs, including certain financial data required under Items 301 and 302 of Regulation S-K, market risk disclosure, compensation discussion and analysis, and compensation committee report.
Under the amendment, a company that is not an investment company, an asset-backed issuer or a majority-owned subsidiary of a parent company that is not an SRC and is either (1) a company with a public float of less than $250 million as of the last business day of its most recently completed second fiscal quarter or (2) a company with a public float of less than $700 million and with less than $100 million of annual revenue during the most recently completed fiscal year for which audited financial statements are available or a nonpublic company, will qualify as an SRC. Prior to the amendment, only companies with a public float of less than $75 million or nonpublic companies with less than $50 million of annual revenue could qualify as an SRC.
If an SRC loses its SRC status, it can re-qualify as an SRC if it has a public float of less than $200 million or if it has less than $80 million of annual revenue and a public float of less than $560 million.
These amendments do not change the threshold in the definitions of “accelerated filer” and “large accelerated filer.” As a result, an SRC that is also an accelerated filer or large accelerated filer is still required to comply with the timing requirements applicable to the annual and quarterly reports required by such filers. The Securities and Exchange Commission has begun to formulate recommendations to amend these definitions that would reduce the number of companies that qualify as accelerated filers.
The Securities and Exchange Commission estimates that 966 additional companies will be eligible for SRC status in the first year under the amended definition.
The amendments will become effective 60 days after publication in the Federal Register.
SEC Acts on Liquidity Disclosure Rules and Proposes Easing Regulation of ETF Launches
At an open meeting on June 28, 2018, the SEC adopted liquidity disclosure amendments and proposed new rules to ease the approval process for new exchange-traded funds (ETFs).
With regard to the liquidity rules, which were initially adopted by the Commission in October 2016, the Commission approved amendments to Form N-PORT changing certain pending disclosure requirements. The first amendment eliminates the requirement that funds publicly provide the aggregate liquidity classification profile of their portfolios on Form N-PORT. Instead, the amendment requires funds to include “brief, narrative” disclosure in their annual or semiannual shareholder reports regarding the operation and effectiveness of their liquidity risk management programs. The second amendment allows funds the flexibility to split their N-PORT classification of portfolio holdings into more than one category under certain limited circumstances. Under the amendments, funds must also disclose on N-PORT cash/cash equivalent holdings not otherwise reported on the Form. For more information, please visit https://www.sec.gov/news/press-release/2018-119.
The Commission also proposed new rule 6c-11, which would permit ETFs that meet certain conditions to come to market without needing to apply for exemptive relief. The conditions of the proposed rule are generally the same as the conditions currently required to obtain exemptive relief. The proposed conditions also include the following requirements: (i) daily posting of portfolio holdings on an ETF’s website; (ii) usage of custom baskets (i.e., baskets that do not reflect a pro-rata representation of a fund’s portfolio) conditioned on the adoption of certain written rules and procedures; and (iii) increased website disclosure regarding historical information on premiums/discounts and bid-ask spreads. If adopted, the proposed rule would revoke exemptive relief previously granted to ETFs that would now be able to operate under the rule. The rule would not cover ETFs organized as unit investment trusts, ETFs structured as a share class of a multiclass fund, or leveraged or inverse ETFs. The proposed rule is open to comment for 60 days from publication of the rule in the Federal Register. For more information, please visit: https://www.sec.gov/news/press-release/2018-118.
Opportunistic CDS Strategies Available to CDS Protection Sellers Part I: An Introduction
Over the past few years, the CDS market has seen an increase in activism and the evolution of creative refinancing and restructuring strategies intended to achieve particular outcomes in the CDS market. The authors have written extensively on the development of one such strategy — unconventional credit events — in the Codere, iHeart and, more recently, Hovnanian cases.
Amid the ongoing Hovnanian saga, and against the background of the prior unconventional credit event cases of iHeart and Codere, opportunistic CDS strategies may have appeared available only to protection buyers. This picture of vulnerable CDS protection sellers as sitting ducks for aggressive protection buyer-driven strategies that undercut the value proposition of CDS protection misses the reality. In fact, the CDS market has created a parallel source of financing for reference entities, where both CDS protection buyers and sellers can engage with reference entities, and offer economic incentives in exchange for cooperation that enhances their CDS positions. The restructuring option most readily available to CDS protection sellers is a migration of debt across a reference entity’s affiliated group of companies, resulting in the creation of a succession event or a so-called orphan CDS.
This article addresses the basic principles of a succession event and orphan CDS strategies. The companion article in this issue looks at two recent cases where those strategies may have played a role.
CDS Protection Seller Strategies
The succession event strategy involves transferring debt incurred by a reference entity to one or more (successor) reference entities, with a view to changing the entity referenced in all or a portion of the CDS contract.
In order to generate value for a CDS protection seller, all or some portion of the debt of the reference entity is assumed by one or more successor reference entities with a different credit profile. Under current rules, if the outstanding debt of a reference entity were assumed by an affiliate, a succession event would occur if at least 25% of the outstanding obligations at the existing reference entity are part of the succession. The CDS contract would then split, such that an equal portion of the notional amount will reference each entity (i.e., the initial reference entity and the affiliate) (See the infographic for a summary of post-succession event scenarios). For the strategy to be effective, the successor(s) would have to be more creditworthy, on a net basis, than the pre-succession reference entity. This would have the effect of narrowing the CDS spread in the aggregate for the CDS contract referencing the successor entities.
As a hypothetical example, consider a succession event where long-dated unsecured debt trading significantly below par is transferred to an affiliate of the reference entity, leaving only secured debt trading around par at the reference entity. Assuming all the succession event requirements were satisfied, and both the initial reference entity and its affiliate are deemed successor reference entities, 50% of the notional amount of CDS protection would now reference an entity with only secured debt trading around par. Compared to the pre-succession situation where 100% of the CDS protection referenced an entity with long-dated unsecured debt trading well below par, the spread on 50% of the CDS protection post-succession should significantly narrow. If the spread on the CDS referencing the entity holding the unsecured debt does not drastically widen, the succession event would result in a substantial net gain for the CDS protection seller.
Another strategy for enhancing the position of CDS protection sellers is the creation of an orphan CDS. In this scenario, there is no succession event, but the debt of the reference entity is nonetheless eliminated. For example, an affiliate of the reference entity could issue debt whose proceeds would be provided to the reference entity. The reference entity would then use the proceeds to repay or otherwise retire its existing indebtedness.
In such a scenario, the CDS protection seller would be left with a CDS contract referencing an entity that cannot default (if there were no debt that remained outstanding) or that is highly unlikely to default (if the amount of debt remaining at the reference entity were de minimis). As long as no additional debt is incurred by the reference entity, the CDS would remain an orphan. The protection seller would confidently collect its CDS premium from the protection buyers for the duration of the contract, with little or no risk of making a settlement payment. With the CDS spread substantially narrowing, the protection seller might also unwind its CDS position at a profit.
These strategies, of course, require the cooperation of the reference entity. Particularly where a CDS protection seller has sold protection on a reference entity that has come under financial distress, a protection seller may be strongly motivated to offer a reference entity economic incentives to cooperate in the creation of a favorable succession event or an orphan CDS. It may also be worthwhile for the protection seller to acquire a position in the debt of the reference entity, thereby affording it some input or influence over the restructuring process, where consent of the debtholders is required.
Cheapest to Deliver Obligations
One of the key components of the buy-side strategy in Hovnanian was the issuance of a low-coupon, long-dated note, potentially creating a cheapest to deliver debt security that would likely trade significantly below par. The result would be a CDS auction clearing well below par, and a corresponding gain for CDS protection buyers.
CDS protection sellers can implement the same strategy in reverse, with stratagems directed toward increasing the price of the cheapest to deliver obligations. By providing appropriate financial incentives, a CDS seller may be able to induce the reference entity to retire its cheapest to deliver debt. Even an issuer repurchase program, which did not wholly eliminate the cheapest to deliver debt, could boost the price of the debt and create substantial gains for a protection seller.
CDS protection buyers are not the only ones with options to impact the market for CDS contracts on distressed reference entities. CDS protection sellers may also employ strategies that take advantage of the existing procedures and contractual quirks in the CDS market to engineer gains. In the companion article, we examine two recently proposed refinancing situations — McClatchy and Sears — which may not necessarily be driven by CDS considerations, but in which the effects of protection sellers’ opportunistic CDS sell-side protection strategies may be observed.
Opportunistic CDS Strategies Available to CDS Protection Sellers Part II: McClatchy and Sears
In the first article of this two-part series on sell-side opportunistic engineering in the CDS market, we surveyed a number of strategies that could be used by sellers of CDS protection to create sell-side gains. In this second part, we analyze two recent situations where a proposed refinancing dramatically affected the CDS market for the reference entity because of the reduction in the sell-side risk. Although these cases may or may not have been driven by CDS considerations, they illustrate how sell-side CDS strategies may be effectively implemented.
The McClatchy Refinancing
McClatchy Co. is a publisher of newspapers and online content and owns a number of widely distributed publications across the United States. Through Q1 2018, the company had approximately $800 million in debt outstanding and $1.5 billion in assets, a little under half of which was goodwill. McClatchy has been suffering losses for some time, and a sizable CDS market has developed on its name, reaching almost $500 million of net notional outstanding in March 2018.
McClatchy’s outstanding debt obligations consist of $344 million of 9% secured notes due 2022, $89 million of 7.150% unsecured debentures due 2027 and $276 million of 6.875% unsecured debentures due 2029. The 2027 and 2029 Debentures appear to be held almost entirely by Chatham Asset Management. This circumstance seems to have been factored in by the CDS market, with the result that McClatchy’s CDS contracts have been priced more in line with the 2022 Notes. Chatham also appears to be a seller of CDS protection on McClatchy.
On April 26, 2018, McClatchy announced a refinancing sponsored by Chatham in which Chatham would provide McClatchy with $418.5 million in new secured term loans, on the condition that the new financing was incurred at a new entity (New FinanceCo), and the proceeds of the new term loans would be used to repurchase the 2027 and 2029 Debentures held by Chatham. It was also announced that, as a condition to the term loan refinancing, the 2022 Notes would also be refinanced with the issuance by New FinanceCo of new first lien debt.
McClatchy Co Pre-Refinancing
McClatchy Co Post-Refinancing
Succession Events and Orphan CDS
There would be no succession event under the proposed McClatchy restructuring, because New FinanceCo would not be assuming debt issued by McClatchy or exchanging its debt for debt issued by McClatchy. Rather, the existing debt at McClatchy Co would be repaid with the proceeds of the New FinanceCo debt. From a practical standpoint, the result is the same either way; the refinancing leaves the McClatchy parent company on a consolidating basis with substantially less debt. But from a CDS perspective, the difference is substantial: (i) the risk of McClatchy defaulting on its own debt would be materially reduced, seemingly resulting in the creation of an orphan CDS; and (ii) the CDS contracts on McClatchy could become difficult to settle due to the relatively small amount of debt remaining at the reference entity.
As the market learned of the proposed refinancing, the CDS spread narrowed dramatically. Almost 70% of the value of protection evaporated in a matter of hours,1 indicating that the market internalized the possibility of an orphan CDS.
Subordination and Deliverable Obligations
The specter of an actual orphan CDS has since dissipated, because, as disclosed in subsequent public filings, McClatchy intends to guarantee the debt issued by New FinanceCo. Under the proposed refinancing, as currently disclosed, McClatchy would guarantee both the New FinanceCo term loans and its new first lien debt, with the former being guaranteed on a subordinated basis. Assuming the remaining debentures at McClatchy Co. are ultimately retired, the subordinated guarantee may very well not be considered a deliverable obligation for purposes of the settlement of the McClatchy Co. CDS contract. However, the guarantee on a senior basis of the New FinanceCo first lien debt should be taken into account for settlement purposes, precluding the creation of an orphan CDS.
Despite the subsequent clarification of the structure of the McClatchy refinancing, the spread for the CDS contracts on McClatchy has not returned to its prior levels. This may be a function of the market’s pricing in the subordination of the guarantee of the term loans, which may be fully disregarded for purposes of settling the CDS contracts, and the only remaining deliverable obligation for CDS settlement purposes being the guaranteed new first lien debt. In any event, as a result of the refinancing, Chatham will have a more valuable book of CDS positions. It will also enjoy flexibility to sell out of the new term loans that it is extending to McClatchy without negatively impacting the value of its CDS contracts. For McClatchy, the upside is the ability to slightly de-lever and push out maturities of key obligations by three years without significantly increasing its costs of funding.
It is unclear whether the McClatchy refinancing was designed to impact the CDS market, or whether the impact is an unintended collateral effect. Nonetheless, the interplay of the economics of the refinancing and its effect on the CDS market cannot be overlooked. With or without the orphan CDS, McClatchy appears to be receiving better-than-market refinancing terms in a transaction that seemingly results in a creditor realizing a significant windfall on CDS protection it has sold.
Sears has been in well-documented financial difficulty for some time. For the past several years, the CDS market has traded on the basis that a default on Sears’ debt was almost inevitable.
On April 23, 2018, Sears announced a refinancing proposal from ESL Investments Inc. ESL has been involved with Sears for a number of years both as a significant and even controlling shareholder — it has two seats on the board, one of which is the Sears CEO — and as a creditor.
The proposed refinancing includes (i) a purchase of certain Sears real estate by ESL, and an assumption by ESL of approximately $1.2 billion of the debt secured by that real estate, with Sears continuing to operate its stores under a sale-leaseback arrangement with ESL; (ii) an exchange by ESL of $600 million second lien debt for equity in Sears; and (iii) a purchase by ESL of the Kenmore brand and related business units for $500 million. The proposal requires that the proceeds of the refinancing be used by Sears to tender for certain long-dated unsecured bonds issued by its subsidiary, Sears Roebuck Acceptance Corp., the reference entity for CDS purposes, at a discount to par, reflective of current trading prices.
Bond Rally and CDS Spread
Following the announcement, the unsecured bonds traded up to around 70 cents on the dollar, approximately double the trading price for the bonds prior to the announcement. With the jump in bond prices came the narrowing of CDS spreads. From a CDS perspective, a default appears less likely in the short term, and the cheapest to deliver obligation now trades at a far smaller discount to par.
Whether the ESL proposal will materially change the credit outlook for the retailer struggling with cash flow issues remains to be seen. But in the short term, the proposal has resulted in a significant price swing that favors CDS protection sellers. If the tender offer is consummated and the unsecured bonds are retired, the market for Sears CDS should remain, at least for some time, in its now seller-friendly state.
As with McClatchy, the impact on the CDS market may not be a motivating factor in the Sears refinancing. However, the Sears situation illustrates how a sponsor that is long the reference entity via CDS protection may be incentivized to make certain arrangements with a reference entity that favor its CDS positions. CDS protection buyers should therefore be wary of reference entities in which investors both have substantial degrees of control or influence and have also sold significant CDS protection.
State of the Market
The McClatchy and Sears cases provide road maps for opportunistic strategies available to CDS protection sellers as a counterweight to the strategies available to CDS protection buyers. By moving the price of the cheapest to deliver obligation and driving the probability of default, both CDS protection buyers and sellers can generate substantial gains on their CDS investments, using a portion of the economic benefits to incentivize the cooperation of the reference entities. One can envision a situation in which the CDS protection buyers and sellers compete with CDS strategies on a reference entity, with the prevailing party being the one that can generate economics justifying the better financing package for the issuer.
As discussed in prior articles Hovnanian, questions have been raised regarding the viability of the CDS product if these opportunistic strategies were to proliferate. Both ISDA and the CFTC have stated that they are looking into such strategies and how they comport with existing rules and regulations.
It remains unclear whether the market has an appetite for changes or, indeed, whether the regulators can get ahead of sophisticated market participants and their creative strategies without undermining the utility of the product they are trying to protect. Also, the market has now likely come to the realization that CDS is not an arena reserved for parties hedging commercial relationships or taking passive investment exposure. It is clearly also frequented by investors actively using CDS as well as other investment products such as equity and debt securities to achieve specific outcomes with respect to their holdings in a particular reference entity. In that worldview, both regulators and participants may have to contend for the foreseeable future with the presence of peer activism in the CDS market.
1 5yr CDS Spread: 4/26/2018: 903, 4/30/2018: 360, 5/30/2018: 385.
New York’s High Court Holds That Three-Year Statute of Limitations Applies to Martin Act Claims, Trimming the State’s Securities Law
In People v. Credit Suisse Securities (USA) LLC, New York’s highest court considered the applicable statute of limitations for Martin Act claims, holding in a June 12 opinion that such claims are governed by a three-year statute of limitations, rather than the six-year statute of limitations urged by the New York attorney general. This is the first time that the New York Court of Appeals has weighed in on the statute of limitations that applies to claims brought under the Martin Act, a 1921 state law that authorizes the attorney general to pursue civil and criminal cases for fraudulent practices in connection with the sale of securities. The statute has been used to regulate a wide variety of conduct, from Wall Street financings to the sale of condominiums and cooperative apartments in public offerings. The Martin Act is one of the most powerful tools in the attorney general’s regulatory arsenal because, unlike similar causes of action, it does not require scienter, or intent to defraud.
Appellants, Credit Suisse Securities (USA) LLC and affiliated entities, argued that a three-year statute of limitations should apply to Martin Act claims under CPLR 214(2), which imposes a three-year limitation period for a claim based on a New York statute. The attorney general argued that a six-year limitation period should apply to Martin Act claims, pointing out that the limitations period for an “action based upon fraud” is six years under CPLR 213(8).
As the Court of Appeals explained, the applicability of CPLR 214(2) turns on whether a claim is truly created by statute, as opposed to one brought pursuant to a statute that merely codifies an existing common law claim. Only claims that would not exist but for the statute are subject to CPLR 214(2)’s three-year limitations period. The question for the Court of Appeals, therefore, was whether the Martin Act creates liabilities that did not exist at common law. The Court of Appeals answered that question in the affirmative. Writing a majority opinion for four judges, with two judges on the Court not participating, Chief Judge DiFiore emphasized the ways in which the Martin Act has a broader sweep than common law fraud, noting the Act’s registration and disclosure requirements relating to the sale of security interests in condominium and cooperative apartments, as well as its broad definition of prohibited “fraudulent practices” that dispenses with certain common law requirements such as justifiable reliance and intent to defraud.
The Court’s opinion was not a total loss for the attorney general, however. The Court held that, when the attorney general prosecutes cases of “persistent fraud or illegality” under Executive Law 63(12), lower courts must “look through” Executive Law 63(12) and apply the statute of limitations applicable to the underlying liability. When the attorney general brings a case of “persistent fraud or illegality” under Executive Law 63(12) that also satisfies the elements of common law fraud, then the statute of limitations is six years pursuant to CPLR 213(8).
In a concurring opinion, Judge Feinman wrote separately to provide guidance to the lower courts in determining which sorts of claims brought under Executive Law 63(12) were actionable at common law and therefore enjoy a six-year limitations period. Judge Rivera dissented, echoing the attorney general’s view that restricting the statute of limitations for Martin Act claims to three years is inconsistent with the legislative intent of providing a muscular antifraud provision with which to regulate the state’s securities markets.
Given the broad reach of the Martin Act, the three-year limitation period will provide greater certainty and respite to financial firms, securities industry professionals and real estate developers, among others, who may become subject to investigation by the New York attorney general.