The unprecedented market upheaval due to the Covid-19 health and safety crisis has triggered significant issues, and in some cases investment opportunities, for asset managers, institutional borrowers, and institutional investors.
The market swings have caused collateral calls, cancellation of transactions, and liquidity shortfalls as market participants grapple with cash needs. A variety of legal disputes typically arise from this type of disruption.
Below are key factors to consider.
Valuing Assets Based on Fire-Sales, Unorthodox Standards May Breach Agreement Terms
One lesson learned from the 2008 credit crisis is the need to pay attention to the valuation determination process when a counterparty exercises rights to collateral, demands additional assets, or attempts to close out positions.
Valuations typically must be obtained from either market benchmark, or mutually agreed-upon, sources. If financial institutions are using inappropriate sources—or determining valuation in the midst of economic disruption—values may be distorted in favor of the acting party and violate the “commercially reasonable” requirements in the parties’ agreements.
For example, where a counterparty has determined an asset’s value at a point in time where the value is at its lowest (such as in a recession or moment of significant market volatility), and shows no attempt to reassess that valuation when the asset recovers shortly thereafter, they may be in breach of either their contractual obligations or duty of good faith (which is implied in every contract under New York law).
Similarly, a counterparty’s proceeding with the sale of the asset during a period of market disruption may be further evidence that they are not acting in a commercially reasonable manner. Under these circumstances, the injured party could consider bringing a suit to prevent the sale of the asset, and further seek damages associated with the improper conduct.
Conflicts of Interest Could Impede Compliance with the Contract
It is important to consider whether parties wearing multiple hats have complied with contractual or other applicable standards.
For example, where a party has overall administrative responsibility for the assets in a structure or a transaction and is also an investor in that structure or transaction, a careful review of that parties’ actions and motivations may be warranted to determine if it has valued assets in accordance with the transaction documents and applicable law.
Similarly, if you are an entity that has multiple roles in a transaction, there may be steps you can take to reduce the litigation risk associated with certain transactions.
Often times, there are provisions in structured product documentation that allow a party to seek approval from certificate holders before moving forward with such a transaction. In our experience, however, that provision is rarely used. By taking advantage of such a provision before the action is taken and having the proposed course of conduct approved by a majority of the holders, a party can minimize an outlier’s ability later complain about the transaction at issue.
Conversely, by not taking advantage of that provision, a party risks that a disgruntled holder may later complain that the proposed course of conduct was improper and in violation of that party’s obligations.
The above is just one example that shows how conducting a litigation analysis of the relevant transaction provisions before taking a contemplated course of action may yield ways to minimize the risk of litigation down the line. At the very least, such an analysis would better position a party should litigation ensue.
Key Provisions, Rights and Remedies Should Inform the Strategy
Finally, it is important to review the rights and remedies in the transactional documents. For example, one may find that the rights that financial institutions are attempting to assert in order to liquidate or seize collateral may not, in fact, exist.
Similarly, where an agreement purports to limit remedies to a particular type of right, there may be ways to remediate the wrongful conduct by identifying breaches of related, but distinct, duties. For example, where a contract has a “sole remedy” provision that limits to only one type of remedy in case of a breach, courts have found that such provisions do not always apply and in particular do not apply where the breaching party was grossly negligent.
Indeed, in such circumstances, punitive damages may be available, although then the conduct would need to be, among other things, egregious in nature and part of a pattern of misconduct directed at the general public.
While it may be too soon to determine the exact scale and shape of market volatility in the wake of the Covid-19 pandemic, it’s clear that those who have not properly learned the lessons of 2008 will be insufficiently equipped to handle what is to come.
Valuation disputes may be just one face of an impending wave of litigation this year, but they will be an important area to look at nonetheless. Rather than take a “wait and see” approach, parties facing valuation disputes should move early, deliberatively and creatively.
In addition, it is especially important in these situations to be well-served to evaluate the propriety of the valuation process, consider conflicts of interest, and understand the key contractual terms, as these steps may enable parties to improve their positions in commercial negotiations or, if necessary, in court or arbitration.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Steven Perlstein is an experienced trial lawyer at Kobre & Kim, who practices in the area of complex civil litigation, focusing on litigation related to complex commercial transactions (such as collateralized debt obligation and mortgage-backed securities transactions), business break up disputes and securities-related litigation. He also conducts litigation related to data security, particularly with regard to civil remedies available to prevent the widespread dissemination of proprietary information.
Danielle L. Rose regularly serves as lead counsel at Kobre & Kim in high-stakes commercial disputes, often involving major financial institutions and/or institutional investors. She has extensive experience in litigating matters related to complex financial products such as residential mortgage-backed securities and similar structured products, as well as related to corporate governance, including in advising boards of directors with respect to shareholder demands.
Zachary D. Rosenbaum is a highly accomplished litigator at Kobre & Kim whose practice focuses on global financial markets. He represents bondholders, shareholders, foreign and domestic asset managers, private equity funds, and other institutional investors in high-stakes civil disputes annd has tried to verdict jury and non-jury cases in the U.S. and abroad, and has litigated against virtually every major Wall Street bank.
D. Farrington Yates is a bankruptcy lawyer at Kobre & Kim who focuses on litigation related to complex, cross-border insolvencies and restructurings. He advises clients on the investigation, monetization and pursuit of high-value claims against principals and stakeholders in distress situations.