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]”.
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.
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.