As an investment vehicle, asset backed commercial paper ("ABCP") grew dramatically from $10 billion in 1997 to $115 billion in 2007. Some $32 billion of that amount (Canadian non-bank ABCP) is in the process of being restructured under the Companies' Creditors Arrangement Act. This is due to mismatching between the cash flows from the underlying assets (i.e., receivables) and the funds needed to make payments on maturity of the notes held by investors, and a liquidity crisis that traces its roots to the sub-prime melt-down in the United States that involved securities that are themselves an example of asset backed commercial paper.
Sponsors, namely corporations that made a business of making asset backed commercial paper available to investors, established Special Purpose Vehicles in the form of trusts that, in the context of ABCP, are known as "conduits." These conduits issued debt to investors in series, typically on a 365-day commercial paper basis. The different series were designed to reflect different levels of risk. The debt was rated by approved credit rating agencies. It should be noted that both the duration and the rating are requirements for these investment vehicles to be exempted under applicable securities laws in Canada.
The debt issued by the conduits, in turn, was used to purchase or secure assets from asset providers, that, for the most part, consisted of financial institutions. The types of assets pooled included more traditional financial assets such as residential and commercial mortgages, corporate loans, and credit card receivables. In the case of the Canadian non-bank ABCP, traditional financial assets accounted for approximately 19% of the underlying assets. The remaining 81% consisted of derivative contracts (sometimes called synthetic assets), mainly in the form of credit default swaps. Of these synthetic assets, the majority (approximately 54%) were leveraged super senior swaps.
There was a significant mismatch between the asset backed commercial paper held by the investors, which was short-term, and the underlying assets, that consisted of medium- and long-term financial assets. The whole structure was predicated on investors "rolling over" their asset backed commercial paper. This assumption evaporated in the week of August 13, 2007 when, despite the previous actions of a number of central banks arising from the sub-prime mortgage problems in the United States, there was a sudden liquidity crisis and conduits faced a run by investors who no longer wished to roll over their asset backed commercial paper. This effectively caused the market to freeze, since no one was prepared to hold medium- or long-term financial assets due to the risk of default. Thus, the need to restructure the conduits under the Companies' Creditors Arrangement Act.
Possible Outcomes of the Proposed Restructuring
If the proposed restructuring of the Canadian non-bank ABCP proceeds as the applicants have requested, a multitude of lawsuits will be replaced with a supposedly orderly and long-term solution in which the investors will be required to wait for a period of years before return of their investment, and in which a number of other players have agreed to provide funds and support, also for a prolonged period of time.
If the restructuring arrangement is not successful, and for other asset backed commercial paper structures that are not able to restructure in a similar fashion, the allegations made by some of the participants in the Canadian non-bank ABCP, as well as the experience of the United States in the sub-prime crisis, are suggestive of the type of claims that could be expected.
Simply put, investors who suffer loss can be expected to sue. Class actions involving investors can be expected and investor class actions are already prominent in the United States sub-prime litigation scene. Their targets will likely include broker dealers for inappropriate and negligent advice (i.e., suitability), breach of fiduciary duties, misrepresentation, and worse, if the broker dealers were affiliated with the architects of the scheme. Conduits that issued the ABCP may be targeted for inadequate disclosure and for other breaches of the securities legislation if the exemptions on which they relied were improper. Again, to the extent that conduits are affiliated with other actors, they may be involved, and the allegations may rise up the ladder of impropriety. The allegations include acting in conflict of interest, bad faith, and potentially even fraud.
Based on the American experience, directors and officers are also directly in the line of fire. In 2007, 97% of the sub-prime related litigation named them as defendants and, to date this year, 72% of the cases also targeted directors and officers.
Dangers and Pitfalls
Directors and officers and their corporate counsel should be aware of some of the dangers and pitfalls that might arise in the event that they become targets. In this abridged article, only some of these will be identified as they relate to directors and officers insurance policies ("D&O policies").
D&O policies are not standard form policies and the wording varies widely:
- Does the policy provide for presumptive indemnification and thereby presume that the corporation is providing indemnification on a broader basis than may actually be the case? If so, there is a gap between the exposure and the policy cover.
- If fraud is alleged, does the exclusion operate immediately or only after there has been a final adjudication that fraud has occurred? The difference may mean being provided with a defence or not.
- Are there coverages in favour of the company or entity (for example, for "Securities Claims" ) that would reduce or even exhaust the limits available for coverage for directors and officers?
- Are there majority shareholder actions that could arise and that might result in claims being excluded from coverage in the policy?
- Are the claim notice provisions either too short in terms of timing or too onerous in terms of the level of detail required? If the claim notice provisions are too short or too restrictive, a potential claim may not be able to be reported in time. When and on what basis must or can an insured report a claim or a circumstance that could give rise to a claim?
A Few Final Words
The sub-prime crisis in the United States and the related ABCPevents in Canada will no doubt take much time, effort, money,and angst to ultimately resolve. Corporate counsel will need to beactively engaged to assist their corporations in identifying potentialexposure and undertaking effective risk management.