In brief
- since the financial crisis, there has been a significant increase in the market for collateralised loan obligations (“CLOs”), complex products commonly based on portfolios of leveraged loans.
- in the same way that the financial crisis gave rise to a surge in disputes related to complex financial products, an economic downturn in 2020 may trigger claims to recover losses incurred in connection with CLOs.
- the complex nature of CLOs means that there is potential for a wide range of disputes between parties with an interest in them.
CLOs
The focus on leveraged lending as a potential source of financial stability risks has intensified recently; in 2019 the Bank of England estimated that there is more than US$2.2 trillion in leveraged loans outstanding worldwide - comparable to US subprime before the financial crisis.
A large share of leveraged loans are sold to non-bank institutional investors and held through CLOs. CLOs are securitisations where highly leveraged business loans are bundled up and sold in tranches. Demand for CLOs, which are popular with Asian investors searching for yield, has fuelled growth in leveraged lending.
Regulatory and underwriting standards of securitisations like CLOs have improved since the financial crisis. But CLOs are complex products. It is uncertain how resilient they will be to economic stress, which could lead to unexpected losses for investors and therefore claims. An economic downturn in 2020, which many are predicting, may create the conditions for this.
We see a stress scenario for CLOs as potentially giving rise to a number of disputes.
The contractual structures which give CLOs their form may be tested (in many cases for the first time) before the Courts. These will generally encompass the priority of payments between holders, credit enhancement, triggers, inter-creditor rights and control rights. A notable feature of CLOs in this respect is the lack of standardisation when compared with other structured products, meaning that each CLO has the potential to throw up unique issues. CLO investors seeking to improve the position of their tranche relative to other investors, or challenge the actions of the collateral manager, may commence legal proceedings where there is scope for uncertainty in the contractual structure. Claims of this nature followed the financial crisis in respect of similar complex products.
Notable examples include:
- the Supreme Court decision in Belmont Park Investments Pty Ltd v BNY Corporate Trustee Services Ltd concerning the priority of payments in a complex note structure where the order of priority was reversed upon the occurrence of a solvency event;
- the Court of Appeal decision in Napier Park European Credit Opportunities Fund Ltd v Harbourmaster Pro-rata CLO 2 BV concerning the contractual interpretation of a CLO collateral manager’s contractual obligation to reinvest unscheduled repayments of underlying loans; and
- the Court of Appeal decision in Credit Suisse Asset Management LLC v Titan Europe 2006-1 Plc concerning the contractual interpretation of CMBS note terms relating to the calculation of “excess spread” paid to the note originator.
Potential defendants
Many CLOs are managed by a professional credit manager, who constructs the initial loan portfolio and then actively trades the portfolio throughout the CLO’s life. Poor performance in a CLO portfolio may therefore give rise to negligence claims against the manager. The manager will not usually have a direct contractual relationship with the CLO holders, meaning that establishing a tortious duty of care owed by the manager will be challenging for investors who suffer losses as a result of poor performance in the portfolio. Nevertheless, if investors can succeed in showing that the manager assumed a direct duty, then cases from the financial crisis illustrate the potential for negligence claims in respect of portfolio management. Chief among these is the Court of Appeal decision in UBS v KWL, in which the manager of a collateralised debt obligation was found to have been negligent in its selection of reference entities for a credit portfolio, despite the defaults in that portfolio taking place against the backdrop of the wider credit crunch.
Losses to CLO investors are likely to trigger mis-selling claims against the product arranger in much the same was as mis-selling claims relating to other complex products proliferated after the financial crisis. The likely basis for mis-selling claims will be the level of disclosure provided to investors about the nature of the portfolio assets underlying the CLO and how the portfolio is structured. Given the nature of CLO investors, the majority of whom are sophisticated institutional investors, and the general approach of the English Courts to enforcing contractual protections for the selling party, such as basis clauses, it is not clear how much success mis-selling claims will have.
What this means for you
- the growth of CLOs as an asset class in recent years gives rise to the risk of disputes if there is a downturn and CLO investors suffer losses.
- for managers and arrangers of CLOs, risks can be reduced through clear and unambiguous contractual documentation and close adherence to those arrangements in practice. Where structures give rise to uncertainty or practical arrangements depart from the contractual position (for example, so as to give rise to a direct relationship between manager and investor), risks will arise.
- for investors, risks will arise where investment decisions are made based on representations which are not expressly incorporated into the contractual documentation, particularly where the investor does not carry out its own due diligence on the CLO structure and its underlying assets.
