Lovells’ restructuring of Cheyne Capital’s $7bn structured investment vehicle set an example for other troubled SIVs. Writer Edward Russell-Walling.

Capital markets bankers may have been having a listless time until relatively recently, but some specialist lawyers have been very busy indeed. One blur of activity has involved the salvage of shipwrecked structured investment vehicles (SIVs), and here no one has been more visible than the team from London-based firm Lovells.

The final chapter in the brief and ultimately unhappy history of the SIV is still being written, as wiped-out Sigma Finance creditors try to take their case to the UK’s House of Lords. Of that, more later. Lovells’ part in the story becomes significant with the restructuring of Cheyne Finance, a $7bn SIV run by Cheyne Capital – a restructuring that became a template for other sunken SIVs.

Boom and bust

SIVs were children of the credit boom, and victims of its collapse. Although most have been wound up or reabsorbed by their sponsors, they were bankruptcy-remote, tax-­efficient vehicles set up by banks or fund managers to arbitrage between rates on long- and short-dated fixed-income paper. They would buy highly rated medium- and long-term assets – invariably structured products such as mortgage-backed securities and collateralised debt obligations. They would fund these with less costly short-term borrowing in the form of commercial paper and medium-term notes. Subordinated debt was provided by ‘capital’ noteholders, who would take first loss on the underlying investments.

While their high rating demanded a capital cushion, their assets had to be marked-to-market regularly, and most included a default trigger based on the ratio of net asset value to debt. If it fell below a certain level, that was an ‘enforcement event’ which triggered irreversible action by the SIV’s security trustee.

Crunch time

As the credit crunch began to bite in the summer of 2007, that is what happened to Cheyne. Asset-backed security values tumbled and the commercial paper market dried up. Receivers had to be called in from Deloitte & Touche to assess the situation. Lovells advised Bank of New York Mellon, the security trustee, and, subsequently, the receivers.

Cheyne was not the first SIV to find itself in trouble. Others had defaulted or been taken back onto their sponsor’s balance sheet, and Lovells had advised the security trustee in most of the instances where ­English law prevailed. “But Cheyne was the first to have receivers appointed,” notes Andrew Carey, head of Lovells’ London capital markets team.

At this point there were two concentrations of activity. One was to get some measure of what creditors wanted. Ultimately, the receivers would decide what was in creditors’ best interests, but they wanted to find out what the creditors might settle for. The other was to get to grips with the documentation and to determine what the contracts would and would not allow. “As with all structured finance vehicles, the language hadn’t been stress-tested before,” explains James Doyle, a partner in the capital markets group and a structured product specialist. “We needed clarity.”

Law unto themselves

When things go wrong, these contracts are their own legal universe – insolvency law does not offer solutions. When SIVs were set up, the legal documents took into account the possibility of failure. What they had not envisaged was systemic failure in the context of a disorderly market. At that point, according to Mr Carey, the situation became unworkable. “It didn’t lend itself to the creditors getting together and directing the receiver what to do,” he says. “There were so many different [bond] series and different creditors, with so many different interests, that it was impossible to restructure on a consensual basis.”

Some short-term holders wanted a quick sale. Others wanted a longer-term work-out. The receivers invited them to form two separate committees, a senior and a junior (capital noteholder) committee, with whom they could consult. Lovells spent considerable time digging into the documentation to see what ‘optionality’ was available, but the answer was not much. “You couldn’t cherry-pick,” says Mr Carey. “There was one waterfall, and you couldn’t interfere with it.”

“It wasn’t that you just had to get the consent of the majority of creditors,” says litigation partner Hugh Lyons. “Each series had blocking rights, so you had to get a majority on each series.”

Matters were not made easier by the fact that some creditors wished to remain anonymous. Some of the many carefully worded calls made by Lovells to sound out creditors were with parties identified only as “investor A” or “investor B”.

This was the first phase of the distress scenario, when the receivers continued to pay amounts to creditors as they became due. As asset valuations continued to worsen, phase two kicked in – the ‘insolvency event’. At that point, creditors ceased to stand in a pay-as-you-go queue and stood shoulder to shoulder, to be paid pari passu. The courts confirmed that the receiver had acted correctly. But at this point a solution had to be found.

The junior creditors were clearly out of the money so the wishes of the senior creditors became paramount. Some wanted to sell the assets and conclude matters. Others wanted to keep the assets in the vehicle so that everyone could get paid off in the end. Yet others favoured a restructuring of some kind, while maintaining exposure to the assets. But it was not possible for some to stay exposed unless they all opted to stay in. “There had to be a sale of assets in some shape or form,” Mr Carey reports.

Seeking solutions

Various financial institutions were asked to come up with solutions, and five investment banks made presentations. The senior creditors committee picked Goldman Sachs International’s proposal and the receivers went with that. The receivers sold a ‘vertical strip’ – a proportionate share of each security in the portfolio – by competitive auction, and the proceeds were given to those investors who wanted to cash out. The remaining vertical strip was bought by Goldman Sachs at a corresponding price, satisfying the receivers’ obligation to sell all the assets. Total proceeds were just less than $2.6bn.

Goldman then offered senior creditors two options. If they wished to take on the risks and rewards of future performance, they could take pass through notes issued by a new company (Newco), which acquired Goldman’s vertical strip. “In essence, this was a structured finance version of the debt-for-equity swap arrangement used in many corporate restructurings,” says Mr Doyle.

Those who wanted full repayment, regardless of how long it took, could take zero coupon notes issued by Goldman, using the distribution received in respect of their claims. They would deliver par value during a period relative to prevailing interest rates and the size of the distribution.

Model approach

The Cheyne solution was so effective that it was used again in the restructuring of Rhinebridge, a $1.1bn SIV set up by IKB Deutsche Industriebank. Lovells again advised the security trustee and the receivers (Bank of NY Mellon and Deloitte) and ­Goldman again stumped up the capital. This was a simpler exercise as there were relatively few creditors. “The Rhinebridge restructuring gave creditors the additional optionality of taking a vertical strip directly from the receiver,” says Robin Spencer, Lovell’s head of business restructuring and insolvency. “The fact that we knew who all 14 of the creditors were made it easier.”

Lovells has been advising the Ernst & Young receivers in Gordian Knot’s Sigma restructuring, as mentioned earlier. Sigma did not have market-value triggers but, unusually, its pay-as-you-go queue is honoured for 60 days after an enforcement event. The problem is that the assets would be exhausted long before the 60 days were up, so creditors due to be paid at the front of the queue scoop the pool, while those further back get nothing. The latter still hope to make their case before the UK’s Law Lords.

Once Sigma has been resolved, the SIV will be virtually extinct. There should not be any shortage of work for the Lovells team, however. “Other forms of structured finance are starting to suffer – CFOs [collateralised fund obligations], for example,” says Mr Spencer. “Then there are some Lehman-established vehicles, and lots of vehicles with money stuck inside Lehman Brothers.”

 

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Standing on steps (top to bottom, left to right): James Doyle, Natasha Williams, David Hudd, Philip Harle, Paul Apathy, Hugh Lyons, Caroline Rasaiah, Andrew Carey. Standing on ledge (left to right): Zip Jila, John Tillman, Robin Spencer, Emma Ozols

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