Tuesday, June 10, 2014

RESCU and the MBS Litigation Circle Game

Introduction

This blog has taken particular interest in investment situations where a company's value is significantly affected by litigation claims asserted by that company.  

Since the financial crash in 2008-2009, this blog has reviewed claims by monoline insurers, such as MBIA, Assured Guaranty and AMBAC, involving breach of representation and warranty (R/W) made against mortgage originators and securitization issuers, such as Countrywide and its parent Bank of America (BAC), that issued mortgage-backed securities (MBS) that were insured by the monolines.

These R/W actions had to survive various defenses, such as the purported requirement for monolines to show loss causation, the purported requirement to offer evidence of R/W breach on an individual loan basis, rather than on a pool basis using statistical sampling, and claims that monolines either were aware of the R/W breaches, or failed to exercise proper due diligence with respect to the R/Ws, or otherwise placed unjustified reliance upon the R/Ws made by the securitization issuers.  

In short, these R/W cases were hard to win. They required plaintiffs to marshall significant resources to make hotly-contested and uncertain legal arguments over a significant period of time. Notwithstanding vigilant defendant pushback, monolines have managed to do quite well on the R/W scorecard, given the sole bench trial and various settlements reached to date.  Several monoline cases, including most notably AMBC v BAC, remain ongoing.

The investment opportunity of these special situations was that, especially in the case of monolines such as MBIA and AMBAC, the incremental value to the company from a successful litigation outcome was quite large when compared to the monolines' enterprise value.

Now, suppose you are presented with an investment opportunity in which i) the outcome of R/W actions will not only significantly affect a company's enterprise value, but constitutes the only determinant of value for the company, since the company's entire enterprise value is represented by the litigation, and ii) the legal merits of this company's R/W cases may be far stronger than the legal merits of the various monoline cases to date.

That investment opportunity might be appealing to consider.  That investment opportunity is ResCap Liquidating Trust (RESCU).  

This blog post will discuss the legal issues surrounding RESCU's investment opportunity, but will also highlight the investment uncertainty created by the lack of disclosure available relating to material information that affects the litigation (and therefore the entire investment) outcome.

RESCU's R/W Posture

Your first thought may be that as a prolific issuer of MBS, ResCap was a repeat defendant, not a plaintiff, in R/W cases, and you would be entirely correct until recently.  Indeed, ResCap confirmed its bankruptcy reorganization plan in December 2013 after it was inundated with R/W claims to such an extent that unsecured claims against ResCap in the aggregate amount of over $12 billion were allowed by the bankruptcy court. These $12 billion of allowed claims were converted into liquidating trust units of RESCU, which are essentially equity interests in RESCU, although more about that later.  

The assets deposited into RESCU and to be distributed over time to unitholders consisted of tangible assets that RESCU is liquidating, with a reasonably ascertainable value, and R/W claims that RESCU may assert against correspondent banks which supplied ResCap with mortgages to securitize, whose uncertain value gives rise to the investment opportunity.

So, ResCap has been transformed from a repeat MBS R/W defendant into a phoenix named RESCU, arising from bankruptcy as a R/W plaintiff. As opposed to Countrywide, which originated substantially all of the mortgage loans that it securitized, ResCap purchased all of the mortgage loans that it securitized from an army of correspondent banks, both large (eg. PNC and Suntrust) and small (eg. Broadview Mortgage Corp. and Lyons Mortgage Services).  Just as ResCap made loan-level and transaction-level R/Ws to purchasers and insurers of MBS issued by trusts that ResCap sponsored, ResCap received loan-level R/Ws from the correspondent banks about the mortgage loans that they sold to ResCap to securitize.  

So, unlike various vertically-integrated MBS issuers like Countrywide, which had only their own origination and underwriting departments to blame for R/W breaches (and fraud, such as the Countrywide "hussl" program that is currently the subject of a BAC/Justice Department settlement negotiation that may penalize BAC in excess of $12 billion), ResCap could turn around and bring in its own name, for the benefit of ResCap's unsecured creditors cum RESCU unit holders, R/W cases against the correspondent banks that conducted all of ResCap's outsourced MBS origination and underwriting responsibilities that fed the ResCap securitization pipeline.  

What goes around comes around.

In the five months since ResCap's bankruptcy plan has been confirmed, RESCU has undertaken a massive litigation program seeking to recover on R/W breaches by correspondent banks. Substantially all of the cases are brought under Minnesota law in federal district court in Minneapolis, with Minnesota law specified in the controlling law provision of the principal ResCap mortgage origination document.  

This principal document is the rather extraordinary ResCap Client Guide.

The ResCap Client Guide is a very ResCap-favorable document that contains R/Ws and remedy provisions so pumped up on steroids that any conceivable attempt by correspondent banks to defend against RESCU's R/W actions faces great difficulty.  ResCap was prepared apparently for the possibility of "garbage in, garbage out," and prepared its documentation accordingly. 

Among other provisions, the ResCap Client Guide provides 
  • an exhaustive list of R/Ws made by the correspondent banks with respect to mortgage loans they originated; 
  • that the correspondent banks made such R/Ws irrespective of their knowledge as to whether the mortgage loan was is breach;
  • ResCap has the sole authority to determine whether a R/W has been breached and constitutes an event of default, and ResCap need not show loss causation; 
  • the correspondent banks waive any right to judicial review of ResCap's declaration of an event of default; 
  • ResCap may pursue any remedy available at law and equity, including a putback of the defective loan to the correspondent bank for repurchase, provided that no remedy selected shall bar ResCap from pursuing additional remedies; 
  • no delay in exercising any remedy, such as the right to putback loans for repurchase, shall act as a bar to the exercise of that remedy; 
  • there are no conditions precedent to the exercise of ResCap's remedies, such as showing that ResCap exercised due diligence; and 
  • most significantly, as discussed below, ResCap shall have an additional right to be indemnified by the correspondent banks for any and all of ResCap's losses, including attorneys fees, arising out of "any claim, demand, defense or assertion against or involving [ResCap] based on or resulting from such breach or a breach of any representation, warranty or obligation made by [ResCap] in reliance upon any warranty, obligation or representation made by the [correspondent bank] contained in the [documents under which the correspondent bank sold mortgage loans to ResCap]”.
It is no exaggeration to say that the ResCap Client Guide is a plaintiff R/W lawyer's dream come true.

The enforceability of the ResCap Client Guide's favorable R/W provisions has been validated by the 8th Circuit Court of Appeals in Residential Funding v Terrace Mortgage.  In Terrace Mortgage, ResCap declared a handful of mortgage loans originated by Terrace to be defective, declared an event of default and demanded that Terrace repurchase the loans under the ResCap Client Guide. Terrace defended by objecting to the terms of the Client Guide, noting that its terms were so onerous that ResCap could on a whim order Terrace to repurchase all of its originated loans, and Terrace would have no recourse to contest this demand.

The federal appeals court affirmed the district court and held that contracting parties can agree to forgo judicial review of contractually-authorized determinations, such as ResCap's determination in its sole discretion that an event of default had occurred, and the court refrained from coming to the aid of a defendant when the terms it agreed to were unambiguous. Terrace was a sophisticated business entity, and there was some evidence to the effect that ResCap was paying top dollar for the loans Terrace had for sale, so it wasn't exactly a one-way street.  

Terrace Mortgage also confirmed that ResCap was subject to an implied duty of good faith in proceeding, which the court found that ResCap had complied with in the facts of the case. The possible ramifications of this implied duty of acting in good faith will be discussed later in this blogpost.

RESCU's Statute of Limitation Posture


It is now 2014, the financial crisis came to its crescendo in 2008-2009 with respect to securitized mortgage loans that were originated in the several year period before that, and the 6 year Minnesota statute of limitations for R/W breach starts to run from the respective dates the correspondent banks sold mortgage loans to ResCap. Isn't RESCU's potential recovery substantially limited by this 6 year statute of limitations period?

Two very important points must be considered in this regard that promote ResCap's ability to maximize its recovery.

First, the federal bankruptcy code provides a trustee in bankruptcy with a two year extension of any applicable state statutes of limitations, in an effort to promote creditor recovery, and provides a debtor in possession, such as RESCU, with generally the same powers as a trustee.  So RESCU's 6 year limitations period to bring R/W actions is really an 8 year period owing to its status as a debtor in possession seeking recovery for its creditors.

Second, ResCap's Client Guide provides for a separate contractual right to be indemnified for losses arising from claims made against ResCap based upon R/W breaches made by the correspondent banks. Remember, all loan-level R/W breaches by ResCap to MBS purchasers and monolines may be asserted by ResCap to be based upon R/W breaches made to it by correspondent banks.

The statute of limitations for contractual indemnification claims also is 6 years under Minnesota law, but the very important question arises as to whether this limitations period commences when the original correspondent bank sale of the mortgage loan occurred, or does it commence when ResCap's damage claim with respect to that R/W breach is fixed and determinable (i.e. at the end of 2013, when ResCap's bankruptcy plan was confirmed)?

Either case is a possibility, and the answer turns upon a simple question of legal framing.

If ResCap's right to indemnification is understood as one of several remedies, one would think the statute of limitations should run from the time of the original R/W breach.   For example, under New York law, a breach of a MBS putback provision was not viewed (at least by the appellate court division that heard the case) as a separate contractual breach giving rise to a new limitation periods, but rather as a failed remedy exercise that leaves the plaintiff with whatever limitation period was remaining for the underlying R/W breach that occasioned the putback demand. (I thought otherwise).

If on the other hand ResCap's right to indemnification is viewed as an ongoing independent contractual covenant that is first triggered when the damage or loss arises, and stands as a cause of action apart from the underlying R/W breach, then the indemnification period should be deemed to have started to run at the time of ResCap's plan confirmation at the end of 2013.

The difference in terms of ResCap's ultimate potential recovery is hard to quantify, in the absence of detailed knowledge about when the various correspondent banks sold loans to ResCap, but it is safe to assume that if the indemnification limitations period is determined to have began only recently, there will likely be no time bar to ResCap from recovering all of its losses, given the strength of the R/W claims ResCap can allege under the ResCap Client Guide (as interpreted by Terrace Mortgage).  As one would expect, defendant correspondent banks have asserted that ResCap's right to indemnification is barred with respect to loans that were sold more than 6 years prior to commencement of suit.

In Gateway, an early federal district court case considering such a dismissal motion against a ResCap indemnification action, the federal magistrate recommended to the district court that it rule in favor of ResCap on both the 2 year bankruptcy extension for R/W claims, as well as the commencement of the indemnification 6 year period at the time the ResCap bankruptcy plan was confirmed.  This is an important ruling and, if followed in subsequent federal court decisions hearing RESCU's cases and interpreting Minnesota law, this ruling provides the pathway for RESCU to recover the full amount of its damages that are recoverable from solvent correspondent banks.

I say, "if followed in subsequent federal court decisions hearing RESCU's cases", because Gateway cited, as authority for the proposition that the limitations period starts to commence for a contractual indemnification right at the time the damage has been fixed, Hernick v Verhasselt, which relied upon Oanes v Allstate, which was a Minnesota Supreme Court decision that held that the limitations period with respect to a right to indemnification for tort damages accrued at the time the adjudication against the tortfeasor was concluded, not the earlier date when the injury occurred.  

It is not clear that a holding with respect to the commencement of the limitations period for indemnification for tort damages should be applied to indemnification for contract damages, and a recent motion to dismiss filed against ResCap by National Bank of Kansas City seeks to establish this distinction.  So, notwithstanding the favorable holding of Gateway, one might attend the disposition of National Bank of Kansas City before coming to the conclusion that ResCap has definitively established the favorable limitations period for indemnification.


Preliminary Financial Analysis 

RESCU has approximately 100 million units outstanding and currently units trade at about $17.50, yielding an enterprise valuation for RESCU of approximately $1.75 billion.  RESCU's tangible assets have a book value as of March 31, 2014 of approximately $7 per unit, implying that the market currently values ResCap's litigation claims at approximately $1 billion, or $10 per unit.

While ResCap's unsecured creditors claimed losses arising from R/W breaches in excess of $40 billion, those were losses incurred by ResCap's creditors, not by ResCap.  In order to ascertain what are the maximum amount of ResCap's losses from R/W breaches, I believe that it is appropriate to use as a proxy the $12 billion of allowed claims that were confirmed in ResCap's bankruptcy reorganization.

On the assumption that the ResCap Client Guide permits ResCap to successfully assert all of the possible R/W breaches ResCap can identify against correspondent banks, and the indemnification period is deemed to commence in December 2013 upon plan confirmation, the upper limit of ResCap's potential recoveries over time should be $12 billion, or over $120 per unit.

Now, there is very good reason to expect ResCap's ultimate recovery over time will be substantially less.

First, many of the correspondent banks ResCap dealt with are not still in existence or are judgment proof.  I am unaware of what portion of ResCap's potential recovery may be uncollectible for this reason, but one might be able to review all of ResCap's litigation against correspondent banks and perform a solvency analysis to arrive at a best guess. When you have done this, let me know where you come out.

Second, ResCap does not appear to be using the strength of the Client Guide to its absolute limit, and this is where the implied duty of good faith discussed earlier comes into play.  In the complaints that ResCap has filed to date, it has identified loan principal balances that it believes have given rise to losses specific to each correspondent bank, as opposed to simply citing (as if upon whim) a maximum recovery sought from each defendant equal to all of the mortgage loans that correspondent bank originated. In other words, ResCap is playing fair, but this also requires ResCap to be able to document for each defendant the appropriate principal balance of defective loans and, in connection with ResCap's indemnification claims, the losses arising therefrom.

So some recovery less than $12 billion, due to collectibility concerns and the requirement that ResCap identify defective loans originated by the various correspondent bank defendants, will likely be recoverable by ResCap over time.  What that time period will be is hard to estimate; this is a massive litigation project and each case brought against a creditworthy defendant can be expected to be met with a vigorous defense.

Informational Drought


RESCU's units are publicly traded, and one would normally expect that publicly traded equity securities would be subject to the reporting requirements under the Securities Exchange Act of 1934, giving rise to, among other things, quarterly and annual financial reports filed with the SEC, and management discussion and analysis and other textual disclosure.  However, it appears that RESCU has not registered the units under the Exchange Act, and information available about RESCU's ongoing strategy to maximize recoveries and liquidations to unitholders is nowhere to be found.

Now, the original distribution of RESCU units was free from registration under the Securities Act of 1933 due to an exemption for distributions arising out of a bankruptcy proceeding, but it would appear that RESCU is proceeding also under the basis that units are exempt from registration under the Securities Exchange Act of 1934, most likely because there are not enough record holders of units.  Even when the record holder requirement doesn't apply, it is not uncommon for a reorganization liquidating trust to seek only a partial exemption from certain Exchange Act reporting requirements, since the trust is not engaging in business and many of the required disclosures aren't relevant or would be too costly.  See e.g. the no action request made on behalf of Motors Liquidation, the liquidating trust for the GM unsecured creditors.

Even without requirement for SEC reporting, RESCU should consider itself to be under a duty to its equity holders, as a matter of proper trust governance, to fully inform unitholders about material information affecting the value of the units, and there is no more material information than information relating to its litigation program.  

RESCU has satisfied this duty to date with simply a list of filed actions.  So any investment in RESCU must be made with the understanding that you won't receive much informational guidance from RESCU itself.  Of course, RESCU might well point out that anything of value that it might otherwise wish to disclose about its litigation program is privileged attorney-client information.  So, perhaps hoping for more issuer disclosure is unrealistic.

A Word of Caution

In this blogpost, I have referred to RESCU as an investment opportunity.  Indeed, RESCU is the prototypical litigation-influenced investment opportunity.  This raises the question as to whether a purchase of RESCU units is really an investment after all, or rather a speculation, whether or not prudent.

This may be a distinction without a difference, as many believe that the vagaries of investment in business enterprises are no less uncertain than investment in litigation-influenced opportunities.

It is my view that while the rule of law offers investors reasonable expectations as to litigation outcomes, uncertainty as to litigation outcome is so endemic that one must consider purchases of securities that are litigation-influenced as to value, such as RESCU units, to be a speculative, as opposed to investment, activity. It may be a prudent speculation, based upon the considerations that I have tried to examine in this post, but it is a speculation nonetheless. 

The question arises whether an investment in a litigation program, such as RESCU, is qualitatively different than an investment in an operating business.  I don't believe one has sufficiently understood the characteristics of litigation risk if one doesn't consider this question, as it is certainly posed by RESCU.


NB:  this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice.  Investing is a tough game, and everyone must do and "own" their own work, because you will certainly own your investments.

Wednesday, April 9, 2014

The Detroit GO Settlement, and My Halls of Fame and Shame

The monoline insurers MBIA, Assured Guaranty and Ambac ("monolines") scored a major victory when they settled with the City of Detroit with respect to the Chapter 9 treatment of the insured Detroit unlimited tax general obligation bonds (GOs).

The term sheet for the settlement provides, among other things, the following:
  • the entire $388 million claim in respect of the GOs will be allowed in the Chapter 9, and the existing ad valorem taxes securing the GOs will be treated as "special revenues" for purposes of the Chapter 9, thereby rendering the GOs as secured for purposes of the Detroit plan of confirmation.
  • 74% of the GOs will be reinstated for the benefit of the holders (Reinstated GOs), and 24% of the GOs (Stub GOs) will be reinstated and assigned to a fund for the benefit of the poorest Detroit pensioners.
  • ad valorem taxes securing the GOs will continue to be levied in an amount sufficient to pay off all of the GOs, but such tax revenues will be applied first to pay the Reinstated GOs, and any excess will be applied thereafter to pay the Stub GOs.
  • upon plan confirmation, the Reinstated GOs will be exchanged for GOs issued by the Michigan Financing Authority, which will be secured by both the existing Detroit ad valorem taxes as well as a 4th lien on state aid provided by the State of Michigan. There are further bond protections provided.
This is a significant victory for the monolines since the Detroit Emergency Manager (EM) had proposed an allowable claim of just 15%, or $58 million, in the proposed plan of adjustment.  This settlement constitutes an incremental $229 million win for the monolines.

Readers of this blog will not find this settlement win for the monolines to be surprising.  I have previously stated in this blog and in an online debate on the Public Sector Inc. website that I thought the monolines would win this fight with the EM.  It was clear to me that the GOs were secured by ad valorem taxes which were created and levied in connection with the authorization of the GOs, such that these taxes would be treated as "special revenues" and the GOs treated as secured obligations in Chapter 9.

Why the 26% discount if it was so clear that the monolines would prevail?  There are several possible theories.  One is that the monolines perceived some risk that given the weakening of property values in Detroit, the ad valorem taxes would not be sufficient to pay the GOs in full, even if the GO claim was allowed in full. This would explain why the monolines obtained in the settlement further security for the Reinstated GOs in the form of the state aid lien.  

Additionally, remember that the GOs were double barrel bonds, secured by (i) a full faith and credit pledge, as well as (ii) a pledge of specially levied ad valorem taxes in connection with the authorization of the bonds.  The monolines might have been concerned that while Judge Rhodes would find for the monolines on the ad valorem pledge, and therefore provide the monolines an allowable claim in full, Judge Rhodes might have found against the monolines on the full faith and credit pledge, thereby creating an undesirable precedent for monolines to deal with down the road.

Moreover, let's remember, that no matter how certain a litigant may believe it will prevail, one must discount one's chances by at least 10%, given the nasty vagaries of judicial whim.  If one starts with a 90% certainty that the monolines would prevail, settling for a 74% recovery is a meager settlement discount, especially in the face of a 15% offer.

Hall of Fame

My hall of fame award goes to the monolines.  They have proven to all municpal issuers and bondholders the practical value of bond insurance.

Consider this:  suppose you were a bondholder without the benefit of insurance, and the EM just told you that he was going to shaft you by offering $.15 on the dollar, even under circumstances where you rightly believe that on the merits you are entitled to par.  Would you have have been able to contest successfully the EM's proposal in an adversary Chapter 9 proceeding?  Would you have preferred to form a committee of bondholders and commenced litigation against the EM? You would have faced a collective action problem that likely would have prevented you from mounting an effective challenge.

If there was ever a perfect illustration of the value of bond insurance, this is it.  The monolines are keeping the bondholders whole and are obtaining a recovery that is $229 million better than what the EM offered.  Bond insurers provide financing benefits to issuers in the form of reduced interest rates, but they also provide benefits to holders after issuance by assuming the risks and costs of asserting creditors remedies.

Hall of Shame

My hall of shame award goes to the EM.  This is just another example of how the EM has screwed the pooch in the Detroit Chapter 9 proceeding.
  • The EM failed to understand municipal bankruptcy law and recognize the lien underlying the GOs in respect of the pledged ad valorem taxes, and therefore failed to make the monolines a fair offer in the proposed plan of adjustment.  The EM had a good faith obligation to classify Detroit's claims in Chapter 9 properly, and the EM both failed in this regard, and then wasted Detroit resources in trying to defend its failure.  
  • The EM failed to understand municipal bankruptcy law and recognize the absence of any lien securing the swap obligations, which has led the EM to make overly generous offers to the swap banks on two occasions, with the result that each settlement has been rejected by Judge Rhodes.  A third swap settlement between the EM and the swap banks has been teed up for a possible strike three later this week. 
  • The EM stated that it was central to its plan of adjustment that Detroit lease its water and sewer facilities to the surrounding counties, and apply any lease payments in excess of payments on the bonds secured by these facilities towards Detroit's rehabilitation.  The EM has not been able to even begin to implement this proposal, because the EM has not been able to provide the counties sufficient financial information for the counties to even understand the EM proposal, much less negotiate it.
  • The EM failed to find a way to maximize proceeds from the Detroit Institute of Art fine art collection while still maintaining the cultural viability of the DIA.  Here is a meaningful DIA solution offered up by a monoline insurer.  The EM ignored the huge collateral value of the DIA art and has made Detroit pensioners suffer losses because of this EM failure. 
Of course, the EM is good at making public appearances and giving press interviews, and is now busy trying to save face.  Notice this specious explanation from the EM spokesman regarding the GO settlement with the monolines given to a columnist in today's Detroit News:

"Orr spokesman Bill Nowling said bondholders are getting a better deal now because the city previously didn't include revenue from voter-approved property taxes in its iniital offer to investors of Detroit's debt."

This makes it seem like the EM has suddenly become magnanimous in reaching settlement, as opposed to the reality of the situation, which was that the EM was abjectly wrong in excluding such tax revenues as security in the first place in making the GO offer!

One simply hopes that this buffoonery on the part of the EM doesn't dissipate Detroit resources for too much longer.

Disclosure:  Long MBI; AGO.
NB:  this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice.  Investing is a tough game, and everyone must do and "own" their own work, because you will certainly own your investments.

Monday, February 24, 2014

Detroit Chapter 9 Redux: Finding the Lien Securing the Insured GOs

In my last blogpost, I discussed the merits with respect to the secured status of Detroit's insured General Obligation bonds (GOs) in terms of whether there had been a pledge as security for purposes of the Bankruptcy Code of the ad valorem taxes that have been levied to provide for the repayment of the GOs.  

In my view, the City of Detroit's emphasis that you won't find the word, "lien", in the granting language of the resolutions was unavailing, given the specific circumstances relating to the issuance of the GOs.

It is apparent, however, that Judge Rhodes won't have to strain himself unduly to find the lien in favor of the GOs that the City of Detroit has argued is absent.

Section 101(37) of the Bankruptcy Code defines "lien" to include "an interest in property to secure repayment of a debt."  I discussed in my last post that the legislative resolutions that authorized the levy and collection of the ad valorem taxes in connection with the issuance of the GOs mandate that Detroit deposit these tax proceeds into a segregated debt repayment account, and use such funds solely to repay the GOs.  Michigan law imposes personal liability upon any city official that doesn't apply such funds in this manner. The legislative resolutions also mandate that the City collect such taxes until the GOs have been retired.

Do the GO bondholders and the monolines insuring the GOs have a property interest in the ad valorem tax collections that are mandated to be deposited into the bond repayment account?  In other words, are such funds secured by a lien in favor of the insured GO bondholders and monolines, for purposes of Section 101(37) of the Bankruptcy Code?

As with all matters construing whether there is a property or security interest in favor of a Detroit Chapter 9 creditor under bankruptcy law, Judge Rhodes must look to Michigan law.  The monolines in their opposition brief refer to a Michigan Supreme Court case, Sawicki v. City of Harper Woods, that makes it clear that, under Michigan law, when taxes are levied and collected for the express purpose of being deposited into a segregated account and used for the sole purpose of paying specified debt, 

"[s]uch money, when collected from the several property owners becomes a trust fund, to be used only for the purpose specified, and when the bonds and interest and other legal expenses chargeable against such fund have been satisfied, the balance belongs to the landowners".

Sawicki makes it abundantly clear that, for purposes of Michigan law, the GO bondholders and the monolines are the beneficiaries of an equitable trust and, therefore, have a beneficial and equitable interest in and to the ad valorem taxes that must be levied, collected and deposited into the bond repayment account.

The GO bondholders' and monolines' ownership of this entire equitable and beneficial interest in and to the tax proceeds makes it clear that the GO bondholders and monolines are secured by a "lien" for purposes of the bankruptcy code.

So, to the City of Detroit's refrain, "where's the lien?", one can simply reply, Sawicki!

Disclosure:  Long MBI; AGO.
NB:  this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice.  Investing is a tough game, and everyone must do and "own" their own work, because you will certainly own your investments.

Friday, February 21, 2014

In Detroit Chapter 9, When is a Pledge Just a Promise, Not Security?

The City of Detroit and the monolines have finished their arguments before Judge Rhodes with respect to whether or not the insured Detroit GOs are secured obligations.  What turns on this question?  Seems like about 80% of the insured GOs aggregate principal amount (over $300 million), when you see that the Detroit plan of adjustment seeks to treat secured debt as fully-protected (100% recovery), whereas if the insured Detroit GOs are deemed unsecured, the plan's opening gambit is for only a 20% recovery.

The monolines' argument, boiled down for the sake of brevity (I do write this on a Friday afternoon, after all), seems to be that the resolutions that authorized the issuance of the insured GOs pledged a special levy of ad valorem taxes as a stream of revenue dedicated towards the repayment of the insured GOs.  This dedication took the form of a legislative requirement that the proceeds of the special ad valorem taxes be deposited into a special account, and be used solely for the repayment of the GOs.

Moreover, the legislative resolutions pledge these special taxes, which may only be deposited into this bond repayment account, toward repayment of the bonds.

The City of Detroit argues by asking, "Where's the Lien?"  This form of rhetoric worked for Wendy's, but not candidate Mondale, a few decades ago; will it work for the City of Detroit?  In other words, the City of Detroit is arguing that of the two common language definitions of "pledge," a) a promise, and b) an act of providing something as security for repayment, the proper understanding of the pledge underlying the creation of the insured GOs is only that of a "promise"(and mere promises may be impaired in bankruptcy).

Of course, the monolines argue for "security" as the proper understanding of the pledge, for purposes of constructing the meaning of the legislative resolutions relating to the insured GOs.

Everything turns on this because, if the monolines are right, then the pledge as security of the special taxes will mean these taxes constitute "special revenues" and the insured GOs should be deemed secured, under Sections 902E and 928 of Chapter 9.

Where will Judge Rhodes look for guidance to construe the meaning of "pledge," as it relates to these insured GOs?  He has no choice but to look to Michigan state law.  He has made clear that Michigan state law governs the application of questions like this, as well as whether Detroit's pension obligations were solely unsecured, or secured, obligations.

When Judge Rhodes turns to Michigan law to answer this question, he will be directed by the monolines to a state Michigan court of appeals decision, Kinder Morgan v. City of Jackson (744 N.W 2d 184, 2007), wherein the court states "'obligations pledging the unlimited taxing power of the local governmental unit' are necessarily obligations by which a municipality pledges its unlimited taxing power as security for the repayment of the debt." (emphasis added).

So, my guess is that Judge Rhodes will come to a decision about the secured status of the insured Detroit GOs based upon whether he signifies the word "lien" with shamanistic power, and focuses on the absence of the word in the legislative resolutions, as the City of Detroit would have him do, or is persuaded by the monolines' argument that in Michigan, a pledge is more than a mere promise and signifies security for repayment...especially in the context where, as here, the tax revenues are required by legislative mandate to be deposited only to a restricted account for application solely to repay the insured GOs.

I am still thinking that the monolines have the better of this one.

Disclosure:  Long MBI; AGO.
NB:  this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice.  Investing is a tough game, and everyone must do and "own" their own work, because you will certainly own your investments.

Monday, January 13, 2014

Public Sector Inc. Debate on Secured Status of Municipal GOs

debate the "Secured" side of the question, What's the Status of General Obligation Bonds in Municipal Bankruptcy? on Public Sector Inc.'s website.  Public Sector Inc. is a project of the Manhattan Institute's Center for State and Local Leadership

Tuesday, December 17, 2013

Detroit Emergency Manager Does a Laydown on Security for Unlimited Tax General Obligation Bonds

In my last post, I argued that the Detroit unlimited tax general obligation bonds (UTGOs) that MBIA and Assured Guaranty (AGO) insured were secured obligations, based upon the terms and provisions of their issuance under Michigan state law.  This question was recently at issue in connection with the Detroit Emergency Manager's (EM's) request for court approval of a debtor-in-possession (DIP) loan.  

Super-priority claims status for the DIP loan would be granted in all Detroit revenues not pledged to secure repayment of other obligations.  Of course, MBIA and AGO have filed a joint complaint arguing that their insured UTGOs are secured by certain ad valorem tax revenues created at the time the UTGOs were authorized and issued, so this raises the question for the court as to whether these tax revenues would be available to repay the DIP.

The wisdom and efficacy of the DIP has been discussed in an excellent article in the Financial Times by an author who goes by the twitter nome de plume of bondgirl (@munilass).  Focusing instead on the legal question as to whether certain tax revenues secure repayment of the insured UTGOs and are thus not available to repay the DIP, it can only be stated that the EM's argument against such secured status for the UTGOs in connection with approval of the DIP was extraordinarily weak. 

EM's argument was contained in two throw-away paragraphs at the end of his reply to objections to the DIP (EM Reply).

Paragraph 91 of the EM Reply states that MBIA and AGO have presented no evidence that there is a statutory lien upon the tax revenues that they assert secure repayment of their insured UTGOs.  Of course, this is correct.  It is also completely beside the point.

There are essentially two ways that UTGOs can be secured: (i) state law may provide that there is a statutory lien that automatically is granted upon certain revenues upon bond issuance (see Spiotto, Primer on Municipal Debt Adjustment--Statutory Liens Protect Bondholders), or (ii) the terms and provisions of the UTGO provide for the financing of a specified improvement, and are secured by a pledge of taxes that were levied specifically in connection with the issuance of the UTGOs.

MBIA and AGO argue that their insured UTGOs are secured by means of (ii) above.  The EM argued that they were not secured because (i) above was not satisfied.  This response by the EM doesn't meet the red face test.  (One might think that the EM would fire his counsel, Jones Day, after seeing such a weak legal argument made in his case...except that, one recalls, the EM was a partner of Jones Day, and one might assume will again be a partner of Jones Day once the Detroit bankruptcy plan is confirmed.)

The second response of the EM was contained in paragraph 92 of the EM Reply.  Essentially, the EM argues that Judge Rhodes doesn't have to decide now, in connection with his approval of the DIP, whether the insured UTGOs are secured; if the court eventually finds that they are secured, the DIP super-priority claim will not apply to the tax revenues that support the insured UTGOs.

Taken together, these two paragraphs, which constitute the entirety of the EM's response made up to now to the monolines' argument of secured status of the insured UTGOs, are known in the trade as a complete laydown.  You offer one response which is not germane to the question, and you follow with a second response that says if we lose, then we will lose, but you don't have to tell us right now that we have lost.

Accordingly, if the DIP is to be approved on the basis of the EM laydown (hearings are being conducted today and tomorrow), it will carve out (for now) from the DIP loan super-priority claim the tax revenues securing the insured UTGOs.  The proposed order reads:


"There is litigation pending before the Court between certain bond insurers of certain of the limited and unlimited tax obligation bonds, on the one hand, and the City, on the other, in respect of ad valorem property tax revenue (the “Property Tax Revenue”).  To the extent this Court finds and determines (and pending such finding or determination), or approves any settlement or confirms any plan of adjustment that provides that any Property Tax Revenue of the City is subject to a property interest (such as a lien or pledge) of any holders of limited or unlimited tax general obligation bonds issued by the City or that such Property Tax Revenue is not generally available for use by the City other than for payment of such limited or unlimited general obligation bonds and is not available for distribution to general unsecured creditors as part of a plan of adjustment in this case, then the Superpriority Claim granted hereunder shall not, in such circumstance, be paid from the Property Tax Revenue unless and until any allowed claims arising from such limited or unlimited general obligation bonds have been satisfied in full."


So, you have now seen the EM's best shot in support of his initial determination that the insured UTGOs are unsecured, and it is nothing more than a laydown. 


Disclosure:  Long MBI; AGO.


NB:  this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice.  Investing is a tough game, and everyone must do and "own" their own work, because you will certainly own your investments.