Directors’ Cut – Lessons from the Credit Crisis

GM: Starting with a general question, what do we think the biggest issue was during the credit crisis from the perspective of the directors of the issuer?

Andrew Dean (“AD”)

While the market dislocation that followed the crisis clearly presented a multitude of stress related scenarios, such as problems with unenforceable swap documentation, I think issues related to expenses and reserves were paramount from our perspective.  At a basic level, if the deal can’t cover its administration expenses or pay service providers, you are effectively handcuffed as a director. As you run into complex issues around events of defaults you need to take advice, and quickly.  The speed at which economic positions changed created something of a domino effect, because noteholders were suddenly facing multi-million dollar losses, often with calls to then remove the manager, leading you into a dispute scenario, where you start getting into voting rights. There was a need to tread extremely carefully when deals were under stress.

From a director’s perspective, being able to take advice from competent counsel in that scenario was critical, and vehicles that had expense caps that were too low or no waterfalls at all presented enormous challenges for us.

GM: What was the most difficult issue for directors to resolve?

Chris Watler (“CW”)

I don’t recall many straight forward problems that were easy to resolve so that’s quite a difficult question.  Our philosophy in any challenging scenario was always, and still is, to follow the documents and, where they were ambiguous, take legal advice and be impartial.

For me though, the most enduring problems revolved around liquidations and terminations.  I think people would be surprised to know that just from our own book we have over 200 “zombie deals” (over a quarter of the total deals in 2008) that are still around from that time and are stuck in limbo.

There have been many underlying factors at play here, ranging from apathetic noteholders suffering economic loss to deals with no clean up call options to deals stuck with illiquid assets and no means to get rid of them.  Whilst we were able to address some of the issues with illiquid assets through our FLP illiquid assets solution, other more systemic issues have still not been resolved.

There were also a number of static deals that ran into problems where someone had to make the hard decisions.  In these scenarios as a director you need to have integrity and do your best to resolve the problems, albeit that you don’t have the power in the documentation to do so.  Fund legal maturity for these zombie deals can’t come quickly enough.

AD: Ambiguous, inconsistent or uncomprehensive documentation from the pre-credit crisis era, often templated and not taking into account special circumstances, caused a slew of issues for transactions.  As Chris just mentioned with zombie deals, documents were structured with no real end result possible.  The point here is that you need an exit plan and now when we are reviewing documents, it’s something we review closely. If noteholders know they have zero chance of getting any economic value, we find that if you have to reach out to them, they are difficult to find and are understandably apathetic in helping issuers resolve structural problems.

Other areas that caused us problems included negative consent mechanisms, which were often unclear, and affiliate / principal trades where documents did not set out mechanics clearly.

GM: It’s interesting to look again at the challenges we faced from a fiduciary standpoint, but turning to investment managers, Carrie, what do you think the most difficult issue was for them?

Carrie Bunton (“CB”)

Collateral managers of these types of deals all faced similar challenges from the dislocation in the credit market, but I think for smaller managers in particular, the biggest problem was their inability to remove themselves from problem deals or ultimately sell their businesses when they were non-performing.  Deal documentation made it difficult for them to be replaced and you felt some of them effectively became trapped.  In some cases there were creative solutions around delegation and sub-delegation at the manager or transaction level.  Things would definitely have been improved on some deals if documentation had more clearly addressed this issue.

CW: Tell-tale signs for managers undergoing stress included significant levels of staff turnover, downsizing and fees being squeezed.  That’s where we started to see the writing on the wall and it’s a real pressure for a manager who has not got the staff to then deal with the complex issues that were coming up.  When the manager cannot consolidate quickly or cannot get hold of noteholders to facilitate a sale of their business, or where the documentation was unclear, it was a big problem for them, especially when their own financial interests were at stake in deals.

GM: The credit crisis was such a difficult environment for managers of all sizes and relationships easily became strained when tough decisions had to be taken.  Peter, what was the most contentious issue you faced as a director?

Peter Lundin (“PL”)

Again, there were many.  However, flipping the discussion around from managers who wanted to get off deals, the forced removal of managers raised a number of important issues for fiduciaries.  I recall a few highly contentious situations where we were receiving conflicting instructions from different stakeholders, but with no one advising us, it placed the issuers and us as directors in a very difficult position. In some cases a super majority is required for removal of the manager but I can, for example, recall an instance where 66 and two thirds percent was needed and we got 66 and one third.  There was little margin for error.

Abandonment of notes, which in turn affected performance ratios with significant implications for the deal, was another perennially contentious issue, often resulting in stand offs between investors, managers, issuers and trustees.  At the time this was somewhat of a novel concept, but I think the good news is that it should be fully addressed in 2.0 deals.  The industry has moved towards a workable solution where provisions specifically addressing the abandonment of notes have been commercially agreed.  Significantly, the provisions now usually address the procedure required, including the requirement for the Trustee to cancel the abandoned notes and to reduce the amount of notes outstanding for the purpose of the Trustee reports, or otherwise make it clear that the notes cannot be abandoned.  That certainty of position in the documents is always welcomed.