The Collateralized Loan Obligation (“CLO”) market appears to be heading for turmoil. Prior to the COVID-19 pandemic, concerns about the performance of CLOs were already on the rise. The pandemic has applied increased pressure on these securities, resulting in even greater scrutiny of the previously identified underlying weaknesses.
The negative economic effect of the pandemic has already caused ratings downgrades,1 and may lead to an increase of loan defaults. It is likely that this negative performance of CLO transactions due to potential and actual loan defaults will spur disputes, and litigation, among transaction participants and stakeholders.
BACKGROUND
CLOs are generally issued by a Special Purpose Vehicle, or SPV, and are collateralized by a diversified pool of senior secured loans to leveraged corporations with below-investment-grade credit ratings (each such loan, a “Leveraged Loan” or “Loan,” and together, “Leveraged Loans” or “Loans”). The types of Leveraged Loans in the typical CLO have historically been made by banks to be held on their balance sheets. CLOs are tranched, or sliced into credit tiers, from triple-A, the senior-most tranche, down to single-B tranches. Often, there are also one or more unrated equity classes. The CLO debt is repaid from the principal and interest payments made on the pool of Leveraged Loans underlying the CLO.
Prior to 2013,2 originators of Leveraged Loans customarily required that the terms of any such Loan contained financial covenants. Those covenants required various measurements of the borrower’s financial strength, such as leverage, interest coverage and capital expenditures. A violation of those covenants would be an event of default under the related loan agreement, and often resulted in a restructuring of the loan or the borrower’s capital structure. In a typical CLO, the violation of such a covenant would give the CLO manager the opportunity to take early steps to mitigate any potential losses to the CLO associated with that Loan.
RECENT DEVELOPMENTS IN THE LEVERAGED LOAN AND CLO MARKETS
Since the end of the last financial crisis, the Leveraged Loan and CLO markets have grown significantly. According to the Financial Stability Board (“FSB”), “[t]he securitisation of leveraged loans through CLO issuance, which had come to a halt almost entirely between 2009 and 2010, exceeded pre-crisis levels in 2014 and has remained strong since then.”3 The Congressional Research Center (“CRS”) reported that since year-end 2008, when the aggregate outstanding balance of Leveraged Loans was $592 billion, the total amount of Leveraged Loans has grown to approximately $1.2 trillion through 2020.4 Around the same time period, the outstanding balance of CLOs has more than doubled – reaching $845 billion at the end of the third quarter of 2020.5 While most Leveraged Loans are originated by banks, the role of non-bank financial institutions in the Leveraged Loan and CLO markets has increased.”6 This substantial increase in loan origination volume and transaction size has led to the development of a deep secondary market for Leveraged Loans.
Many industry observers have noted the developing negative credit trends in this market in recent years.7 Leveraged Loan originators have been lending to riskier borrowers with fewer or less restrictive covenants.8 Such loans are called “covenant-lite” or “cov-lite” loans. In addition, as noted by the FSB, “Alongside looser covenants, there is evidence that headline debt-to-EBITDA may be understated.”9 The reason for this is that lenders are increasingly using a practice called “add-backs” when determining the debt-to-EBITDA used to underwrite the loan. That is, such lenders are recognizing expected savings in the cash flows of potential borrower companies before such savings have actually been realized, understating the debt-to-EBITDA ratio.10 Even with add-backs, the CRS reported: “Leveraged loans’ debt-to-EBITDA ratio has risen substantially since 2019, even before the pandemic, largely because of a significant decline in firms’ earnings.” The weighted average debt-to-EBITDA of approximately 5X in 2018 grew to approximately 6.5X by the end of first-quarter 2020.11
These negative trends have made CLOs more vulnerable to economic shocks and have increased the potential for higher defaults and losses than have been experienced historically. According to one rating agency, “Deteriorating debt structures at companies with first-lien cov-lite loans bode poorly for recoveries.”12
CORONA VIRUS IMPACT ON CLOS
The sudden COVID-19 pandemic economic shock caused further stress on the Leveraged Loan market. As noted in a Federal Reserve publication, “Against the backdrop of the COVID-19 crisis, leveraged loans have deteriorated and concerns about collateralized loan obligations (CLOs), the main buyers of loans on the secondary market, have increased.”13 The Leveraged Loan default rate increased from 1.39% in December 2019 to approximately 3.89% in December 2020, and is expected to go as high as 4.76% by the end of 2021.14 The default rate for Leveraged Loans hasn’t been at this level since 2010.15 The CRS reported: “The ratio of credit rating downgrades to upgrades for U.S. leveraged loans has also reached a record high, suggesting credit quality deterioration.”16 The data reflects that the ratio of credit rating downgrades to upgrades for Leveraged Loans reached a record high of around 23:1 as of April 2020, up from a ratio of less than 3:1 for the previous 10 years.17
The CLO market experienced sudden increased stress in the spring of 2020 as rating agency actions reflected concerns regarding performance of the underlying Loans. In March and April of 2020, three major rating agencies (Moody’s, S&P and Fitch) placed about 2,400 CLOs on review for a possible downgrade.18 As of August 2020, nearly 1,500 CLOs were placed on review by Moody’s, and about 22% were downgraded (with 51% still to be reviewed). During the same time period, S&P placed about 630 CLOs on review, with about 38% downgraded (and about 50% still to be reviewed), and Fitch placed 290 CLOs on review, with about 12% downgraded.19 Additional downgrades are expected to occur as an increasing number of Leveraged Loan borrowers experience financial difficulties and their credit ratings are reduced.
POTENTIAL PARTIES TO DISPUTES
Loan defaults may result in some CLO tranches actually experiencing Losses. CLO transactions are typically structured to require modifications of cash flows if the trust experiences shortfalls due to delinquencies and/or defaults. The redistribution of the cash flow within a transaction may create the potential for disputes involving any of the transaction parties, including CLO investors, managers, arrangers and trustees. The following is a brief list of parties and types of disputes that may occur if the ratings and performance of CLOs continues to decline:
Disputes among CLO investors – Priority of payment disputes may arise among investors in different tranches of a CLO. Additionally, disputes may arise when the CLO manager or holders of senior tranches make decisions regarding the transaction that are viewed as adverse to the interests of other tranches – typically the more junior or subordinate tranches.
- Disputes involving the CLO arranger may arise from alleged disclosure problems with respect to the related offering documents.
- Disputes involving the CLO manager may arise from an alleged departure from the prescribed CLO investment criteria, failure to act within the terms of the management agreement, or manipulation of certain tests, including the overcollateralization test.
- Disputes involving the CLO trustee may be based upon the alleged failure of the trustee to act in the best interest of the CLO investors.
- Disputes involving allegations that the CLO manager’s valuation of certain Leveraged Loans underlying the transaction was flawed. This valuation by the CLO manager will be a key factor in whether cash flow will be diverted from one tranche to another.
CONCLUSION
As the economy moves through the current credit cycle, the effects of the pandemic continue to materialize. Many industries and businesses will have to alter, or have already altered, how they operate. It is unclear what the effect of economic stimulus or government action, if any, will have on the overall economy, or how effective the loss mitigation strategies of CLO managers will be. Many companies are already struggling; they may fail or may need to restructure their debt. This will cause further downgrades and will have a direct negative impact on the CLOs that hold this debt. The different interests, rights and obligations of the various parties to CLO transactions will likely give rise to disputes. It is essential that CLO transaction participants understand these issues, and take early action, in order to mitigate their respective potential litigation risks.
At Friedman LLP, our team is at the forefront of the structured finance market, and is the provider of choice for expert witness testimony and dispute resolution services in connection with securitized transactions, including CLOs. We balance analytical rigor, practical experience and market insight to assist our clients in developing and executing litigation strategies when the stakes are high. We are capital markets professionals rather than simply professional experts, which earned us a leading role in many successful, high-profile, complex commercial litigation matters arising out of the financial crisis. Contact us today with any questions you have about pending or potential disputes relating to CLOs, or other securitized products.
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Sources
1 Cezary Podkul, “Expected Surge of CLO Downgrades Slow to Arrive,” Wall Street Journal, August 28, 2020.
2 Maya Rodriguez Valladares, “Syndicated Leverage Loan Covenant Quality Is At a Record Weakness,” Forbes, April 27, 2020.
3 Financial Stability Board, Vulnerabilities associated with leveraged loans and collateralized loan obligations, December 19, 2019, page 1.
4 Rachelle Kakouris, “2021 Leveraged Loan Survey: Defaults edge higher; credit quality a concern”, S&P Global Market Intelligence, December 18, 2020.
5 “Research Quarterly: Fixed Income – Issuance and Trading, Fourth Quarter 2020”, SIFMA, January 2021.
6 Financial Stability Board, Vulnerabilities associated with leveraged loans and collateralized loan obligations, December 19, 2019, page 1.
7 Ibid, “Recently, several authorities and international financial institutions, including FSB members, have expressed concerns about the rapid growth in the leveraged loan market and the lower credit quality of corporate debt more generally.”; Maya Rodriguez Valladares, “Syndicated Leverage Loan Covenant Quality Is At a Record Weakness,” Forbes, April 27, 2020.
8 Maya Rodriguez Valladares, “Syndicated Leverage Loan Covenant Quality Is At a Record Weakness,” Forbes, April 27, 2020.
9 Financial Stability Board, Vulnerabilities associated with leveraged loans and collateralized loan obligations, December 19, 2019, page 9; EBITDA is a cash-flow measure abbreviation that means earnings before interest, taxes, depreciation and amortization expenses.
10 Ibid.
11 Congressional Research Center, Leveraged Loans and Collateralized Loan Obligations (CLOs): Recent 12 Developments and Policy Actions, June 11, 2020, Figure 7 description, page 5.
12 Moody’s Investors Service, “Moodys - Cov-lite 2.0 loans structurally resembling bonds make up market majority. Are set to recover lower upon default,” March 23, 2020.
13 Laurie DeMarco, Emily Liu, Tim Schmidt-Eisenlohr, Federal Reserve FEDS NOTES, “Who Owns U.S. CLO securities? An Update by Tranche,” June 25, 2020.
14 Rachelle Kakouris “2021 Leveraged Loan Survey: Defaults edge higher; credit quality a concern”, S&P Global Market Intelligence, December 18, 2020.
15 Ibid.
16 Congressional Research Center, Leveraged Loans and Collateralized Loan Obligations (CLOs): Recent Developments and Policy Actions, June 11, 2020, Figure 5, also Deborah Ogawa, Peter Connolly and Joseph Farfsing, CFA, “What Investors Want to Know: Coronavirus Impact on U.S. CLOs,” Fitch Ratings, May 8, 2020, 2.
17 Ibid.
18 Cezary Podkul, “Expected Surge of CLO Downgrades Slow to Arrive,” Wall Street Journal, August 28, 2020.
19 Ibid.
