U.K. CDO firms are scurrying to make sure their documents are legally watertight in the wake of the signal by HSH Nordbank last month that it is taking Barclays Bank to court in London over some collateralized debt obligations deals that went sour. However, many have concluded they don't have any fiduciary duty in these deals and the manager in some CDOs doesn't even have to run the portfolio for the benefit of its investors. Simon Firth, partner at Linklaters, and Alex Burton, partner at Richard Butler, representing Barclays and HSH Nordbank respectively, declined comment.
HSH is taking Barclays Bank to the High Court over the manner in which two CDOs was sold to its predecessor LB Kiel, subsequently managed and the accuracy of pricing information LB Kiel received.
In synthetic CDOs, in which the swap counterparty has the right to substitute assets, banks likely don't have a duty to noteholders, according to lawyers. However, most investors assumed the whole point of a managed CDO was to have a manager, whether external or an in-house principal finance-type player, looking out for the investor and steering the vehicle away from troubled credits. Part of the reason for this belief is the manager is usually also an investor in the deal. In this case Barclays is thought to have kept exposure to the first loss tranche when it sold the deal to HSH.
CDOs are structured as notes so none of the investor safeguards in fund management legislation apply. Also many of the deals similar to Corvus and Nerva--the transactions Barclays sold to HSH Nordbank--use derivatives documentation to ensure there is no fiduciary duty.
Some CDO documentation actually lays this out, stating the manager is not required to manage the deal for the noteholders' interest. But most do not address the question, leaving the door open for a normal trading relationship, which implies no duty of care, according to one lawyer.
In the Barclays/HSH case, the likelihood is the only restrictions on the manager would be those imposed by Fitch Ratings, which rated the deal. These, however, were concerned with the diversity between industries and geography as well as maturity and would therefore not rule out so called ratings arbitrage in which a manager substituted credits for those trading at a wide spread due to a perceived imminent downgrade. Fitch did not comment by press time.
One lawyer thinks if HSH can prove Barclays took assets from its own balance sheet, placed them in the CDOs and they tanked soon after it will have a better chance of winning the case. This is because it will be hard for Barclays to prove it put them in at the right price and did not have any insider knowledge of what would happen to the assets. Officials said Barclays used its substitution rights to put Argentinean bonds, airplane pass throughs, Conseco Finance Securitizations and Marconi bonds into the portfolio. Lawyers said Barclays is thought to have retained short positions in some of the CDOs it put into Corvus and this will likely be used to try and prove it expected those tranches to perform poorly.
As for the manner in which the instrument was sold, lawyers said HSH would have a hard case proving wrongdoing because the law between sophisticated counterparties is largely based on buyer-beware.
This could mean any assurances or opinions structured credit salesman offer their clients that the manager will run the deal in their best interest are useless if the client signs a term sheet, which clearly states it supersedes any previous conversations or agreements. On the other hand, if a bank does explain the nature of the effect of the transaction or tender advice it owes a duty to give the explanation or tender the advice fully, including considering the merits of the transaction from the customer's perspective, according to lawyers.
The outcome, however, will likely depend on how literally the judge interprets the law, according to lawyers, although most of the betting money is placed firmly behind Barclays. If HSH does win it could send the whole market into disarray because the sellside would have to radically change the way it conducts business. In practice, with the exception of copy cat cases from other disgruntled investors, banks would likely continue as normal on the basis that these cases don't come up often and can normally be settled for a small write-back in P&L.
