Capital Markets

Professor Paulus Speaks on Sovereign Debt Restructuring

By John Muse-Fisher, J.D. Candidate 2014 | Posted on

On April 17, legal practitioners, bankers, scholars, and students met at the Federal Reserve Bank of San Francisco to discuss recent developments in sovereign debt restructuring.  Sovereign debt restructurings date to at least 300 B.C. and are a practical fact of life in today’s global economy.  Recent developments in the realm of sovereign debt restructurings include Greece’s recent restructuring, the Second Circuit’s potentially destabilizing decision in NML Capital v. Argentina, and the seemingly perpetual Eurozone debt crisis.

Professor Christoph Paulus, Director of the Institute for Interdisciplinary Restructuring (Berlin) and graduate of Berkeley School of Law (LLM ’84), presented his framework for creating a Eurozone sovereign debt restructuring mechanism (SDRM).  The IMF proposed an international SDRM in the early 2000s, but the plan lost out to market driven approaches.  Market driven approaches to sovereign debt restructuring include the use of Collective Action Clauses (CACs) in debt contracts, which allow a qualified majority of bondholders to change the terms of the contracts to effectuate a restructuring. 

Professor Paulus’s proposed Europe-centered SDRM envisions a “resolvency” proceeding for sovereigns – a more optimistic and palatable vision of restructuring than an “insolvency” proceeding.  The proposal includes three key requirements: (1) the inclusion of a resolvency clause in bond contracts that would trigger resolvency proceedings under certain circumstances; (2) the creation of a resolvency court overseen by a president who would in turn select 30–40 elder statespersons to serve as judges in potential resolvency proceedings, and; (3) the development of the resolvency court rules of procedure.  The envisioned resolvency process is roughly comparable to insolvency proceedings under most country’s corporate laws and would be intended to promote orderly negotiations between sovereigns and bondholders.

Following Professor Paulus’s presentation, Professor Barry Eichengreen facilitated a lively discussion detailing the limitations and virtues of an institutional approach as compared to market driven approaches, including CACs.  Professor Eichengreen described the moral hazard argument against the creation of an SDRM – that such an institution could make it too easy for sovereigns to write down their debt.  Nonetheless, Professor Eichengreen pointed out that the moral hazard argument now cuts the other way out of concerns that sovereigns borrow too much, and the market for sovereign debt requires greater discipline.  The group also considered Contingent Convertibles (CoCos), an additional market driven approach, as a means to facilitate smooth sovereign debt restructurings.  CoCos would convert sovereign debt to equity on the occurrence of certain measurable conditions, such as sustaining a particular GDP.

The ideas and issues raised at the Federal Reserve Bank provided a useful framework for understanding the potential of a Europe-centered SDRM to facilitate sovereign debt restructurings in the future.  Limitations and questions remain. There are hurdles to applying resolvency clauses in non-European jurisdictions. Certification is required for ensuring the legitimacy of the elder statespersons who would serve as judges. Methodological questions remain about calculating accurately the effect of an SDRM on liquidity in the bond market, and an account of the insufficiency of market-based solutions (especially CACs) to shore up the argument that an SDRM is in fact needed. Indeed, these ideas are still being developed and stakeholders are not in consensus about the best way forward.

Upheaval in the Sovereign Debt Market: The Argentinean Story (Part 2)

By Parag Patel, J.D. Candidate, 2013 | Posted on

[Editor’s Note:  This article is a continuation of yesterday’s post.]

Ripple Effects in Restructuring Sovereign Debt:

Although the ruling in NML Capital v. Argentina only binds the Second Circuit, the sovereign debt market will feel the ripples of the district court and Second Circuit’s rulings, especially because of New York’s prominence as a financial center and because many sovereign debt contracts are governed by New York law.  The exact effects of the courts’ decisions are hard to discern until the dust settles.  For instance, following the courts’ decisions, bond issuers have included a warning of the uncertainty surrounding the meaning and interpretation of the pari passu clause in bond offering brochures.  Paraguay, one of many sovereigns to include warnings in its offering information, has notified investors of the following:

“In ongoing litigation in federal courts in New York captioned NML Capital, LTD. v. Republic of Argentina, the U.S. Court of Appeals for the Second Circuit has ruled that ranking clause in bonds issued by Argentina prevents Argentina from making payments in respect of the bonds unless it makes pro rata payments in respect of defaulted debt that ranks pari passu with the performing bonds.  The judgment has been appealed.

“We cannot predict when or in what form a final appellate decisions will be granted. Depending on the scope of the final decision, a final decision what requires ratable payments could potentially hinder or impede future sovereign debt restructuring and distress debt management unless sovereign issuers obtain the requisite creditor consents under their debt pursuant to a collective action clause such as the collective action clause contained in the Bonds, if applicable, or otherwise. . .  [We] cannot predict whether or in what manner the courts will resolve the dispute or how any such judgment will be applied or implemented.”

Historically, the restructuring of bonds involves negotiations between the external creditors and the sovereign. Deals struck during negotiations are not always able to placate all participants–resulting in holdout creditors.  Additionally, some creditors sell their bonds at a discount in the secondary market to vulture funds, purchasers of distressed securities who seek full payment of the bonds.  Holdout bondholders, including vulture funds, have the option to seek legal recourse and compel full payment.  Conventionally, sovereigns may not formally subordinate payments due to holdout bondholders when issuing newly restructured bonds but may instead delay payments on the nonrestructured bonds while intending to or actually paying on restructured bonds.  Under the Second Circuit’s broad interpretation of the pari passu clause, a sovereign’s informal subordination of bond payments to holdout bondholders may result in a contractual default under the pari passu clause.

The courts’ rulings have injected a new level of risk into the sovereign debt markets.  The pro rata payment requirements ordered by the district court and recently affirmed by the Second Circuit make it more difficult for sovereigns to restructure external debt contracts with pari passu clauses that parallel the language of the pari passu clause in the FAA.  Fundamentally, the courts’ rulings have provided external creditors with additional means of recourse against sovereigns, especially those able to satisfy payment obligations but who refuse to do so.  Because of the absence of an international bankruptcy regime, holdout bondholders have limited recourse against a defaulting sovereign.  The primary incentive for a sovereign to pay holdout bondholders is to maintain the sovereign’s access to international capital markets and, to a lesser degree, to avoid “harassment” from holdout bondholders.  The courts’ broad interpretation of the pari passu clause, however, has provided holdout bondholders with additional leverage to argue for full payment on distressed securities.

The increased protection for creditors comes at a cost to those bondholders willing to restructure bond payments.  The holdout bondholders will free ride on the bondholders who accept the haircut on the original bonds.  The Argentinian restructure dealt with the freeriding problem through a law prohibiting higher payments to holdout bondholders.  The courts’ rulings, however, hold that such a law violates the FAA’s pari passu clause.

If courts carry over the Second Circuit’s interpretation of the pari passu clause to corporate bonds, the consequences may be more pronounced.  A broad interpretation of pari passu clause under corporate bonds may result in a perverse incentive for creditors.  Such an interpretation incentivizes creditors to refuse to allow an insolvent business to make ordinary business payments in order to gain bargaining power against other creditors.  This may result in a premature dissolution of the business.  Consequently, creditors may not be able to support debtor’s business if just one creditor objects.

The possible blowback because of a broad interpretation to the pari passu clause has not convinced all sovereigns to drop the “payor” language in pari passu clauses in its bond contracts.  Professor Mitu Gulati, a Duke Law professor, has compiled a list of sovereign bond offerings that show no significant changes from the boilerplate pari passu clause used in Argentina’s FAA.  The list of countries includes Ivory Coast, Serbia, Mongolia, Costa Rica and Ukraine.  Some have speculated that sovereigns may feel safe because the clause only becomes important if the economy implodes–a small, tail-end risk for some, because the sovereign does not want to be associated with novelty by changing the pari passu clause and because the collective action clauses in the sovereign’s bond contracts are sufficiently strong.  Others argue that collective action clauses will not prevent the holdout issue seen in NML Capital v. Argentina.  English law governs the bond contracts of Ukraine and Serbia.  English courts have not adopted the views of the U.S. courts and it remains to be seen how this ruling will affect them.

Conclusion:

It is unclear how the ruling in NML Capital v. Argentina will affect the sovereign debt market.  Recent sovereign debt offerings have noted the risk and uncertainty surrounding the Second Circuit’s rulings, though many sovereign bond contracts preserve the boilerplate pari passu language used in Argentina’s bond contract.  What is clear is that there is a real risk that Argentina will default on bonds issued under the FAA as a result of this decision.

Upheaval in the Sovereign Debt Market: The Argentinean Story (Part 1)

By Parag Patel, J.D. Candidate, 2013 | Posted on

On October 26, sovereign debt markets felt the shock of the Second Circuit’s ruling in the ongoing case of NML Capital v. Argentina.  The court rejected a narrow interpretation of the pari passu clause advanced by Argentina.  Under the narrow interpretation, a sovereign violates the pari passu clause if it formally or legally subordinates debt; instead, the court adopted a broader interpretation of the clause, holding that the clause prevents making payments to creditors of restructured notes and holding out creditors.  In addition to interpreting the pari passu clause broadly, the court also upheld a novel injunction issued by the district court requiring ratable payments for holdout bondholders of the 2005 and 2010 Argentinian debt swaps.  

This article will first describe the events leading up to the Second Circuit’s ruling in NML Capital v. Argentina.  The next section will focus on the legal conclusions of the Southern District of New York (“S.D.N.Y”) and the Second Circuit.  Finally, this article will provide high-level analysis of the fallout of the Second Circuit’s ruling.

The 2005 and 2010 Haircut:

The Argentinian bond saga begins in 1994, when Argentina began originating debt securities under the Fiscal Agency Agreement (the agreement will hereafter be referred to as “FAA” and debt instruments created by the FAA as the “Bonds”).  The Bonds had a coupon rate ranging from 9.75 percent to 15.5 percent and maturity ranging from April 2005 to September 2031.  The FAA contained a pari passu clause, standard in international sovereign bond agreements.  Simply stated, a pari passu clause places all bondholders on equal footing–that is, protects bond payment obligations from subordination.

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Week in Review: Dell Buyout and Mortgage Crisis Litigation

By Christopher Hammond, J.D. Candidate 2015 | Posted on

More is better – or so it’s said.  That’s bad news for Dell stockholders, as the Blackstone Group has dropped its bid for the company.  Blackstone had not formally announced an offer to compete with the $13.65 per share Michael Dell hopes will take the company private.  Through the due diligence process, Blackstone became unsatisfied with the world’s third-largest PC maker’s rapidly-atrophying marketshare—notably including a 14% decline in PC volume during 2013 Q1.  With Blackstone out, the activist investor Carl Icahn is the only likely competitor.  Mr. Icahn has preliminarily discussed a $15-per-share offer, but has not yet put it on the table.  For more, see NYTimes and Business Insider.

AIG v. BAC is headed to New York state court.  American International Group’s $10 billion lawsuit against Bank of America, filed in August 2011, alleges “fraudulent misrepresentations” regarding $28 billion in residential MBSs (mortgage-backed securities) which resulted in heavy losses for the insurer.  The merits of the case have been stalled as each side has jockeyed for jurisdictional advantage.  The Second Circuit Court of Appeal ruled this morning that the lower court had improperly denied AIG’s motion the case to state court.  For more, see Reuters.

SEC Staff Provides New Guidance Regarding the Rule 15a-6 Registration Exemption for Foreign Broker-Dealers

By Latham & Watkins LLP - Dana G. Fleischman, Stephen P. Wink and Kaitlin M. Betancourt | Posted on

[Editor’s Note:  This post is a Latham & Watkins Client Advisory.  The Network has further coverage in another post.]

On March 21, 2013, the Staff of the Division of Trading and Markets of the US Securities and Exchange Commission published guidance in the form of Frequently Asked Questions on Rule 15a-6 under the Securities Exchange Act of 1934.

The FAQs resulted from the efforts of a Task Force assembled by the Trading and Markets Subcommittee of the American Bar Association to discuss and seek clarification from the Staff with respect to certain recurring issues regarding Rule 15a-6.  This clarification was requested in the form of published FAQs to provide greater transparency to the industry and to resolve certain inconsistencies created by, among other things, Staff turnover and general confusion by the industry and other regulators as to the proper application of the Rule’s rather complex provisions to a marketplace that has become markedly more global and technologically advanced in the nearly 25 years since the Rule’s adoption.

In the FAQs, the Staff affirms the general applicability of certain previously issued interpretive guidance and addresses certain aspects of the operation of Rule 15a-6, primarily with respect to issues concerning solicitation, the dissemination of research reports, recordkeeping requirements and chaperoning arrangements between foreign broker-dealers and SEC-registered broker-dealers. Although necessarily limited in scope, the FAQs provide much welcome guidance at a time when cross-border transactions have become an integral part of the securities markets.

Background

Rule 15a-6 permits foreign broker-dealers to conduct certain limited activities in the United States and with US persons without having to register as a broker or dealer under the Exchange Act. Under Rule 15a-6, foreign broker-dealers may (i) effect “unsolicited” transactions with any person; (ii) solicit and effect securities transactions with SEC-registered broker-dealers, US banks acting in compliance with certain exceptions from the definitions of “broker” and “dealer”, certain supranational organizations, foreign persons temporarily present in the United States, US citizens resident abroad and foreign branches and agencies of US persons; and (iii) subject to a number of conditions, provide research to and effect resulting securities transactions with certain types of large institutional investors.  Rule 15a-6 also provides that a foreign broker-dealer may engage in a broader scope of activities, including soliciting and entering into transactions with specified categories of institutional investors, with the assistance or intermediation of an SEC registered broker-dealer (the establishment of such an arrangement is typically referred to as a “chaperoning arrangement” and the SEC-registered broker-dealer is often referred to as the “chaperoning broker-dealer”).

To read the rest of this Client Advisory, please click here and search the Advisory number “1495.”

From the Bench: Second Circuit denies class certification in lawsuit against J.P. Morgan

By Bonnie Watson, J.D. Candidate 2015 | Posted on

In Levitt v. J.P. Morgan Sec., Inc., 10-4596-CV, 2013 WL 1007678 (2d Cir. Mar. 15, 2013), the Second Circuit reversed a district court’s grant of class certification to a group of plaintiffs who alleged that Bear Sterns (subsequently bought by J.P. Morgan) had violated its duty to disclose when it did not notify investors of a fraudulent scheme by Sterling Foster, a now-defunct brokerage firm.

The case concerned allegations of fraud arising from a September 1996 IPO of ML Direct, a television marketing firm.  Sterling Foster orchestrated the IPO as the introducing broker, with Bear Sterns (subsequently acquired by J.P. Morgan) acting as the clearing broker.  In general, the clearing broker in a transaction owes no duty of disclosure to the customers of the introducing broker.  However, the plaintiffs sought to overcome this hurdle by establishing that Bear Sterns actively participated in the fraudulent scheme.

The district court agreed with the plaintiffs that Bear Sterns’s participation was extensive enough to trigger a duty to disclose.  However, the Second Circuit held that the plaintiffs had failed to allege “sufficiently direct involvement” by Bear Sterns.

The Second Circuit noted that providing “normal clearing services” do not give rise to a duty to disclose, even when the broker providing those services is aware of the introducing broker’s fraudulent intentions.  Rather, to trigger a disclosure duty, the clearing broker would have to actively depart from its normal passive clearing functions and affirmatively exert “direct control” over the introducing broker and the fraudulent trades.  The court found that Bear Sterns, by merely “allowing” such trades to proceed, had not assumed such a level of control.

The plaintiffs’ counsel characterized the ruling as “a sad day for investor protection,” stating that the court had “has for the first time held that a clearing firm has no duty to disclose that it is knowingly participating in market manipulation by its introducing broker.”

The court, however, carefully declined to address the legal implications of “market manipulation itself” on the duty to disclose, confining itself to its factual conclusion that Bear Sterns did not directly engage in such manipulation.  Underscoring the narrowness of the Second Circuit’s ruling, the New York district court refused to apply Levitt to a case where a defendant had made misleading statements, holding that the making of misleading statements constituted direct involvement.  The same district court has also recently observed that the question of market manipulation remains open.

SEC Reminds Private Funds of Broker-Dealer Registration Requirements

By Arnold & Porter LLP - Robert E. Holton, Lily J. Lu, D. Grant Vingoe, and Lauren R. Bittman | Posted on

[Editor’s Note:  The following is an Arnold & Porter LLP Client Advisory, written by Robert E. Holton, Lily J. Lu, D. Grant Vingoe, and Lauren R. Bittman.]

SEC official reminds private funds, including contacts private equity funds, that certain fund-raising and marketing activities and fees for “investment banking activities” require broker-dealer registration.

On April 5, 2013, David Blass, Chief Counsel of the Division of Trading and Markets of the Securities and Exchange Commission (SEC), spoke before the Trading and Markets Subcommittee of the American Bar Association on broker-dealer registration issues that arise in the private funds context. In his remarks, Mr. Blass warned that acting as an unregistered broker-dealer is a violation of the Securities Exchange Act of 1934, as amended (the Exchange Act), and can have serious consequences, including sanctions by the SEC and rescission rights, even when no other wrong-doing is found. Mr. Blass also noted that the SEC staff has increased its attention to the issue of broker-dealer registration, and he reminded the audience that compliance by private fund advisers with the requirements of the Investment Advisers Act of 1940, as amended, is not enough. In light of the significant consequences of acting as an unregistered broker-dealer and the SEC staff’s increased attention to this issue and the private fund space in general, private fund advisers should review their fund-raising and marketing activities, policies and procedures and contracts and arrangements with portfolio companies and solicitors to ensure compliance.

Click here to read the entire Arnold & Porter Advisory.

Are All MOEs Created Equal?

By Kirkland & Ellis LLP | Posted on

[Editor’s Note:  The following post is a Kirkland & Ellis M&A Update, authored by Daniel E.Wolf, Sarkis Jebejian, Joshua M. Zachariah, and David B. Feirstein.]

With valuations stabilizing and the M&A market heating up, a rebirth of stock-for-stock deals, after a long period of dominance for all-cash transactions, may bein the offing.

If this happens, we expect to see renewed use of the term “merger of equals” (MOE) to describe some of these all-equity combinations.  As a starting point, it may be helpful to define what an MOE is and, equally important, what it isn’t.  The term itself lacks legal significance or definition, with no requirements to qualify as an MOE and no specific rules and doctrines applicable as a result of the label.  Rather, the designation is mostly about market perception (and attempts to shape that perception), with the intent of presenting the deal as a combination of two relatively equal enterprises rather than a takeover of one by the other.  That said, MOEs generally share certain common characteristics.  First, a significant percentage of the equity of the surviving company will be received by each party’s shareholders.  Second, a low or no premium to the pre-announcement priceis paid to shareholders of the parties. Finally, there is some meaningful sharing or participation by both parties in “social” aspects of the surviving company.

While each of the aspects of an MOE deal will fall along a continuum of “equality” for the shareholders of each party, there are a handful of key issues that require special attention in an MOE transaction.  

Click here to read the entire Kirkland & Ellis LLP publication, discussing Social Issues, Change of Control, Shareholder Vote/Fiduciary Issues, Consideration, and Agreements.

Social Entrepreneurship Panel: A Recap

By Libby Hadzima, J.D./M.B.A. Candidate 2015 | Posted on

On April 3, 2013, the Berkeley Center for Law, Business and the Economy (BCLBE) hosted a Social Entrepreneurship: Legal, Financial and Public Policy Dimensions panel moderated by Professor Eric Talley.  Panelists included legal experts R. Todd Johnson (Partner, Jones Days), Jonathan Storper (Partner, Hanson Bridgett), Kyle Westaway (Founder of Westaway Law) and Jordan Breslow (General Counsel at New Island Capital) as well as Vince Siciliano (CEO and President of the New Resources Bank).

Talley began by asking for a definition of social entrepreneurship.  Johnson offered “any organization that makes money and does social good” and Siciliano added “maximizing distribution [for a given product] while being profitable” as social enterprises attempt to maximize social impact for a given product or service.  Breslow, who works for an impact investment advisor, talked about how one of the downsides of a nonprofit, as compared to a social enterprise, is that “in giving money away [investors] lose control.”

Measuring profits is straightforward but measuring social impact is not always so easy.  However, as Johnson notes, “we need to get past the head-scratching period of asking ‘how do we measure impact’ that comes from looking at social entrepreneurship as a sector. It’s not a sector. It’s a way of doing business.”  Social impact can be applied to any business sector — health care, education, technology, etc. For some sectors, the impact equation is simple. For example, d.light solar sells solar light and power products so it is “relatively easy to calculate how much kerosene and therefore CO2 is avoided by its products.”  It is harder for other sectors, such as services, or where impact is based upon human transformation or long-term goals. “Sometimes the outcome should be obvious, but is simply hard (or expensive to capture) such as greening of supply chains.”  Westaway agreed noting that he “applauds the idea of standardization but it is hard to do.”

Talley asked the panelist to assess whether these types of enterprises are more risky than others, that perhaps, do not consider their social impact. Siciliano suggested that some social enterprises may be considered risky by traditional investors because they are not well understood.  “As a commercial bank, one of the New Resource Bank’s competitive advantages” he explained “is its sector expertise.” He offers that it is not about the risk of the underlying business model as much as that traditional commercial banks assess high risk to these enterprises because of their limited exposure to some of the new sectors these enterprises are operating in. “We don’t view these companies as risky because we better understand their markets and stage of growth.” Specific industry examples include organic products, alternative energy, energy efficiency retrofits, green real estate, and nonprofits.

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Using the Web to Match Private Companies and Potential Investors: SEC No Action Letters Open a Door, but Questions Remain

By Goodwin Proctor LLP | Posted on

[Editor’s Note:  The following post is a Goodwin Proctor Alert, which relays regulatory and legislative developments.]

In a no action letter dated March 26, 2013 (the “FC Letter”), the staff of the U.S. Securities and Exchange Commission (the “SEC”) indicated that they would not recommend action against the operators of the FundersClub website (“FundersClub”) for failing to register as a broker/dealer under the U.S. Securities Exchange Act of 1934 (the “Exchange Act). Two days later, a similar letter (the “AL Letter”) was issued to the operators of the AngelList website (“AngelList”)

The Letters may remove one of the most significant obstacles to the development of a broad-scale, online business in which accredited investors are able to select and invest in private companies. However, the Letters are based upon a number of representations made by FundersClub and AngelList that may be difficult to defend or apply in practice. They also leave unaddressed a number of related legal issues. Thus, the Letters may represent only the beginning of a process in which entrepreneurs, investment managers, private companies, the Staff, the SEC and others explore and develop the rules and practices under which such a business may be operated.

This Client Alert briefly describes certain key issues and conclusions associated with the Letters and highlights some of the issues and risks that remain.

Click here to read the entire article.

[The Alert concludes that t]he Letters may be a key milestone in the development of a broad-based marketplace in which Web-based efficiencies are applied to matching (i) private companies seeking capital with (ii) accredited investors willing to provide it. Nevertheless, important open issues remain. In particular, the representations made by FundersClub and AngelList in obtaining the Letters may prove difficult to defend or apply in practice. Moreover, key questions (e.g., regarding general solicitation and the procedures by which investors may be verified as “accredited”) await further guidance from the SEC. Finally, other parties such as state regulators and various self-regulatory organizations have not yet weighed-in and may have a material impact.