A successful rescinded trade of an asset- or mortgage-backed security could signal a wave of putbacks, Rick Fried, New York-based partner at Stroock & Stroock & Lavan, told TS senior reporter Daniel O’Leary in this week’s “Tranche Talk” podcast. But the heavy burden of proof on investors to show underwriters and issuers acted inappropriately when configuring the deals means most attempts are likely to fail, he said.
Fried outlined legal pitfalls and obstacles that investors, issuers and underwriters face when attempting to rescind trades or “putback” poor performing collateral. The conversation ranged from legal defenses for underwriters to examples of past rescinded trades.
Below are highlights from the conversation. Listen to the complete podcast here.
What is the statute of limitation on rescinding structured finance transactions?
The Sarbanes Oxley Act [2002] has provisions that deal with the statute of limitations. The general rule for an investor to maintain a claim is that it would need to have occurred two years after the investor discovers the alleged misstatement. Or no more than five years after the alleged activity took place.
What burden of proof do buyers of securities need to overcome in order to successfully rescind a trade?
To put it into plain English, if I bought a CDO tranche in a Rule 144a transaction and I subsequently discover a material misstatement or omission, if I want to put that security back to the underwriter that sold it to me, not only do I have to prove a material misstatement or omission, but I have to prove the underwriter knew about that material misstatement at the time they sold the security to me. But there are a number of hurdles that have to be overcome depending upon when you’re bringing the action and under what provision you’re brining the action and if you are maintaining the action for a privately listed security or an unregistered one.
What defense do underwriters have against these allegations? Explain the due diligence defense?
Getting an accountant comfort letter is important, because to the extent you have a part of the offering document that has been “expertized” and the underwriter relies on that part of the document, if there is a problem they should be able to defend themselves successfully because they’ve done their diligence effectively. In terms of the “un-expertized” parts of the document, it’s a more subjective standard that the underwriter would have to show that after reasonable investigation, it had reasonable ground to believe that the offering document did not have any untrue statement of material fact or omission.
Do you know of successful incidences of this happening? What factored into the decision by underwriters to take back a trade?
Particularly in the asset-backed area, I’m unaware of a situation where there’s actually been adjudication or determination one way or the other. These are very difficult burdens to have to prove. And also it’s a costly exercise and undertaking for a plaintiff if they wanted to do this type of transaction. It’s not the type of thing you would typically be able to get a class action certification for, so it would be each individual plaintiff at a time. But anecdotally, I have heard of situations where, maybe as an accommodation, an underwriter would purchase back a security from a disgruntled investor where that investor may be a very good customer.
Does this set a negative precedent? Does it open the floodgates for more putback attempts?
Absolutely! Particularly, if on that very transaction one investor was able to successfully show and prove the various elements necessary to maintain a claim, then any other disgruntled investor who bought that security would be able to take advantage of that. And also in different situations, would be able to use some leverage to get the underwriters to effectively repurchase securities. Part of the reason you haven’t seen these types of actions, is that there are very significant barriers to successfully maintaining it. That’s why, what you’re seeing now is a focus on having the issuers repurchase individual loans. It’s not being done at the securities level.
We’ve seen RMBS putback claims. Is this likely for ABS structures with shorter-dated bonds?
I haven’t heard of wholesale problems in the origination of other collateral. What we’re seeing with RMBS is underwriting standards not being adhered to and problems with loan documentation not being delivered to the right place. “Robo-signers” seems to be another buzzword. I don’t see these problems in other asset classes.
What about pre-crash equity investors in CLOs or RMBS CDOs who were caught up in the shuffle? For example, some arranging banks failed to launch these vehicles but the investors are still out of the money. Will we see litigation on that end?
Anything is possible, anyone can maintain a lawsuit. But I think a lot of that will be governed by what the contracts said and what their responsibilities were. You could have had funds set up where the equity was taken in and the expectations that you go out and raise debt. But there was no obligation to do so. A risk of putting in the equity was that if the venture fails you lose your investment.
--Dan O'Leary