SOURCE: Lang Michener LLP
AUTHOR: Frank Palmay
As an investment vehicle, asset-backed commercial paper ("ABCP") grew
dramatically from $10 billion in 1997 to $115 billion in 2007. Some $32
billion of that amount (Canadian non-bank ABCP) is in the process of
being restructured under the Companies' Creditors Arrangement Act.
This is due to mismatching between the cash flows from the underlying
assets (i.e., receivables) and the funds needed to make payments on
maturity of the notes held by investors, and a liquidity crisis that
traces its roots to the sub-prime melt-down in the United States that
involved securities that are themselves an example of asset backed
Sponsors, namely corporations that made a business of making
asset-backed commercial paper available to investors, established
Special Purpose Vehicles in the form of trusts that, in the context of
ABCP, are known as "conduits." These conduits issued debt to investors
in series, typically on a 365-day commercial paper basis. The different
series were designed to reflect different levels of risk. The debt was
rated by approved credit rating agencies. It should be noted that both
the duration and the rating are requirements for these investment
vehicles to be exempted under applicable securities laws in Canada.
The debt issued by the conduits, in turn, was used to purchase or secure
assets from asset providers, that, for the most part, consisted of
financial institutions. The types of assets pooled included more
traditional financial assets such as residential and commercial
mortgages, corporate loans, and credit card receivables. In the case of
the Canadian non-bank ABCP, traditional financial assets accounted for
approximately 19% of the underlying assets. The remaining 81% consisted
of derivative contracts (sometimes called synthetic assets), mainly in
the form of credit default swaps. Of these synthetic assets, the
majority (approximately 54%) were leveraged super senior swaps.
There was a significant mismatch between the asset-backed commercial
paper held by the investors, which was short-term, and the underlying
assets, which consisted of medium- and long-term financial assets. The
whole structure was predicated on investors "rolling over" their
asset-backed commercial paper. This assumption evaporated in the week of
August 13, 2007 when, despite the previous actions of a number of
central banks arising from the sub-prime mortgage problems in the United
States, there was a sudden liquidity crisis and conduits faced a run by
investors who no longer wished to roll over their asset-backed
commercial paper. This effectively caused the market to freeze, since no
one was prepared to hold medium- or long-term financial assets due to
the risk of default. Thus, the need to restructure the conduits under
the Companies' Creditors Arrangement Act.
Possible Outcomes of the Proposed Restructuring
If the proposed restructuring of the Canadian non-bank ABCP proceeds as
the applicants have requested, a multitude of lawsuits will be replaced
with a supposedly orderly and long-term solution in which the investors
will be required to wait for a period of years before return of their
investment, and in which a number of other players have agreed to
provide funds and support, also for a prolonged period of time.
If the restructuring arrangement is not successful, and for other
asset-backed commercial paper structures that are not able to
restructure in a similar fashion, the allegations made by some of the
participants in the Canadian non-bank ABCP, as well as the experience of
the United States in the sub-prime crisis, are suggestive of the type of
claims that could be expected.
Simply put, investors who suffer loss can be expected to sue. Class
actions involving investors can be expected and investor class actions
are already prominent in the United States sub-prime litigation scene.
Their targets will likely include broker dealers for inappropriate and
negligent advice (i.e., suitability), breach of fiduciary duties,
misrepresentation, and worse, if the broker dealers were affiliated with
the architects of the scheme. Conduits that issued the ABCP may be
targeted for inadequate disclosure and for other breaches of the
securities legislation if the exemptions on which they relied were
improper. Again, to the extent that conduits are affiliated with other
actors, they may be involved, and the allegations may rise up the ladder
of impropriety. The allegations include acting in conflict of interest,
bad faith, and potentially even fraud.
Based on the American experience, directors and officers are also
directly in the line of fire. In 2007, 97% of the sub-prime-related
litigation named them as defendants and, to date this year, 72% of the
cases also targeted directors and officers.
Dangers and Pitfalls
Directors and officers and their corporate counsel should be aware of
some of the dangers and pitfalls that might arise in the event that they
become targets. In this abridged article, only some of these will be
identified as they relate to directors and officers insurance policies
D&O policies are not standard form policies and the wording varies
Does the policy provide for
presumptive indemnification and thereby presume that the corporation
is providing indemnification on a broader basis than may actually be
the case? If so, there is a gap between the exposure and the policy
If fraud is alleged, does the
exclusion operate immediately or only after there has been a final
adjudication that fraud has occurred? The difference may mean being
provided with a defence or not.
- Are there coverages in favour of
the company or entity (for example, for "Securities Claims" ) that
would reduce or even exhaust the limits available for coverage for
directors and officers?
- Are there majority shareholder
actions that could arise and that might result in claims being
excluded from coverage in the policy?
- Are the claim notice provisions
either too short in terms of timing or too onerous in terms of the
level of detail required? If the claim notice provisions are too
short or too restrictive, a potential claim may not be able to be
reported in time. When and on what basis must or can an insured
report a claim or a circumstance that could give rise to a claim?
A Few Final Words
The sub-prime crisis in the United States and the related ABCP events in
Canada will no doubt take much time, effort, money, and angst to
ultimately resolve. Corporate counsel will need to be actively engaged
to assist their corporations in identifying potential exposure and
undertaking effective risk management.
Copyright 2008 Lang Michener LLP. Frank Palmay is a partner and Chair
of the Corporate & Insurance Group in Toronto. Contact him directly at
416-307-4037 or email@example.com. This article appeared in
InBrief Fall 2008. The unabridged version of this article was co-written
by Frank Palmay, Jordan Solway, and Patrick Bourk. Mr. Solway is
Regional Vice President – Claims & Legal with Arch Insurance Canada. Mr.
Bourk is an associate within the Management Risk Practice of Integro
(Canada) Ltd., an insurance brokerage firm. The views, information and
content expressed herein are those of the authors and do not necessarily
represent the views of any of the organizations or firms represented.
The unabridged version of this article appeared in Ultimate Corporate
Counsel Guide, published by CCH Canadian Limited. A copy of the
full-length article may be obtained from any of the co-authors.