Often criticized but neither illegal nor prohibited by standard transfer documentation, the practice of short-selling loans is now subject to new Distressed Buy-In Sell-Out Rules that make it extremely difficult for sellers to timely cover their trades. Here we take a closer look at short-selling after distressed BISO, and consider the implications for breaking trades both under and outside of the new Rules.
The practice of selling loans short in the domestic secondary market has always operated in the shadows. Often criticized1 but violating neither applicable law2 nor the express provisions of standard loan assignment documentation3 loan-shorting strategies have taken advantage of the fact that the duration of the period between the trade date and the closing date of a secondary loan transfer is often indeterminate.4 Buyers, mindful that premature termination of their purchases might place them in breach of the transfer documentation, have hesitated5 to break trades even after enduring long delays.6 Sellers, by making relatively modest accommodations to assure their buyers that they would be no worse off than if sellers had actually owned the shorted loans on the trade date of their sales, have often been able to provide timely cover.
Before the LSTA7 implemented its new Distressed Buy-In Sell-Out (“BISO”) Rules on September 9, 2011, standard domestic secondary loan market documentation imposed three basic obligations upon short-sellers. First, short-sellers were required to pass along to their buyers all proceeds of the loans (such as permanent principal reductions) ordinarily distributable to sellers after the trade dates of their sales, whether or not actually received by sellers.8 Second, short-sellers were required to indemnify their buyers for failing to pass along to buyers the representations, warranties, covenants and indemnities typically made by holders of the loans for the period from the trade date of the short-sale to the trade date of the cover trade.9 Finally, short-sellers were required to cover their sales timely. It is by redefining what constitutes “timely cover” that the new Distressed BISO Rules seek to curtail short-selling.
Under the new Distressed BISO Rules, buyers can break short sales more than 50 business days old if sellers have not covered after an additional 20 business days’ written notice.
Until the LSTA implemented Par/Near Par10 and Distressed BISO Rules, the primary weapon in its war against closing delays was “Delayed Compensation”. By effectively freezing the economics of the parties’ trade as of the later of the closing date and the parties’ “Commencement Date”–T+7 for par/near-par trades11, and T+20 for distressed trades12 – so that neither side would profit from further delay, Delayed Compensation seeks to defuse rather than combat closing date delays. The BISO Rules represent a sea-change in the LSTA’s approach to this issue. Compliance with the document delivery requirements of trade confirmations, so often observed by market participants in the breach, is now critical to the exercise of this new remedy.
In essence, the Distressed BISO Rules authorize a buyer13 that has performed all of its “delivery obligations” (generally, executing the confirmation and closing documents, and confirming in writing its willingness to close), and whose seller that has not performed its delivery obligations14, once 50 days15 have elapsed from the Trade Date, to notify Seller that Buyer intends to terminate the trade after an additional 20 business days (the “Cure Period”) if it has not closed by then16, subject to Buyer’s agreement to the terms of a cover trade with a third party within the following ten business days.17 The price at which the cover trade is entered into is determined by the buyer, subject to mandatory arbitration before a panel of LSTA board members if the seller disputes its reasonableness.18
A short-seller that commits to cover its sale of a loan more than five business days after the sale was orally agreed must be ready actually to close the sale within 70 business days of agreeing to it in order to block buyer from covering it.
While the Distressed BISO Rules do make available a so-called “Upstream Shield” against termination to sellers who can provide buyers with reasonably satisfactory evidence that sellers have pending upstream buys pending19, it is likely to be of little use to the typical short-seller. Unlike under current market practice, where short-sellers sometimes enter into cover trades weeks or even months after short sales, the Distressed BISO Rules expressly prohibit parties from utilizing as an Upstream Shield a cover trade verbally agreed to more than five business days after the short sale.20
What this means for the short-seller as a practical matter is that, if it hasn’t verbally agreed to a cover trade within a calendar week after the short-sale, (1) it must actually agree to and be ready actually to close a cover trade not later than the end of the BISO cure period, and (2) unlike the short sale itself21, the cover trade must actually close in time for Seller to be deemed to be in compliance, and its failure to obtain agent, borrower or other third party consents to its cover trade, even if requested in good faith22, is not an excuse for non-compliance with the five-business-day Upstream Shield rule. So the short-seller that misses the five-business-day window, then agrees to a cover trade, and uses its best efforts diligently to close it in time but fails to do so, may find itself in a position where both its short has been terminated and it is now legally bound to a purchase of the loans.23
Although “BISO’ed” short-sellers may lose the right to cover, if buyers cover the terminated short sale, sellers are still entitled to any resulting profits, and still obligated for any resulting losses.
The potential silver lining in the Distressed BISO cloud for short-sellers of domestic loans is that a loss of control over when the short will be covered is not tantamount to a loss of the potential benefits accruing from having shorted the loans in the first place. The Distressed BISO Rules, like the Delayed Compensation rules already in effect, are a “no-fault” remedy in the sense that Seller’s “fault” in delaying the closing of the sale by failing to cover it does not work a forfeiture on any gains Seller would have realized from the short as of the date Buyer’s cover of the short is complete. To the extent the short was in the money, subject to a few caveats, Buyer has an absolute obligation to remit to Seller the difference between the lower price at which Buyer covered and the purchase price on the short sale.24
Where the price of the loans rises instead of falling after the date of the short sale, short-sellers are obligated to buyers for the difference between the original sale price and the price at which buyers entered into a cover trade with a third-party seller. The Distressed BISO Rules also expressly obligate short-sellers who have been successfully BISO’ed by their buyers to reimburse their buyers for up to $5000 in attorneys‘ fees expended by buyers in attempting to close the short sale before it was terminated.25
Notwithstanding the implementation of the Distressed BISO Rules, buyer termination of short-sales after unreasonable delay without covering them is likely still permissible, but possibly only after more than 70 business days has elapsed from the Trade Date.
Provisions of both the Par/Near-Par and the Distressed BISO Rules that have received little notice, but may portend even more serious consequences for the short-seller of domestic loans, are, respectively, Section 16(8) and Section 16(c)(7), which render the BISO Rules optional for the party seeking recourse for its counterparty’s failure to perform its Delivery Obligations, and preserve for the parties any additional remedies that may be available to them under applicable law. Chief among these remedies, and seemingly not extinguished by the enactment of the two sets of BISO Rules, is Buyer’s right to declare a “total” or “material” breach of the contract under New York law, and argue that such breach excuses Buyer from performing any of its obligations under the parties’ agreement of sale, most notably, the obligation to remit any proceeds from a cover trade.
There is little doubt that failing to deliver the loans agreed to be sold is a material breach of a contract the primary and arguably sole object of which was to transfer ownership of the loans in exchange for payment of the purchase price. The more difficult question, and the one that has swirled around unilateral terminations since long before the BISO Rules were enacted26, is whether failing to close a trade more quickly can be deemed to be a material or total breach of a contract which does not stipulate that time is of the essence as regards the parties’ performance.
Absent an explicit agreement by the parties to the contrary, the buyer has to wait, but it does not have to wait forever. New York law is clear that a party may be excused from its obligations under a contract when a party so delays its performance that this can be construed as a repudiation of its obligations under the contract, even if the party never explicitly says it will not perform.27
Somewhat perversely, the enactment of the Distressed BISO Rules may have made buyer termination for total breach outside of the Rules both easier and harder: harder on trades that Buyer attempts to terminate before the 50+20 day-periods under the Rules have run their course, but perhaps easier after this length of time has expired. The reason is that courts may over time come to see the Cure Period as the embodiment of a market standard for generally how long a closing delay is an unreasonable delay. The message for prospective short-sellers is that a successful bet on a short-sale not timely covered is not necessarily a safe separate avenue to realizing the economics of the trade, and that where its closing delays are material, Seller may be best advised to consider rushing the cover trade to closing before the BISO Trigger Date, or at least the end of the Cure Period, even at the potential risk of binding itself to a cover trade that closes too late for Buyer to be obligated to accept it.
- 1 See, e.g., Pierre Paulden and Caroline Salas, Goldman Targeted by Investor Complaints of Naked Short-Selling, Bloomberg (November 17, 2008), http://www.bloomberg.com/apps/news?sid=as3PwfEfBlhk&pid=newsarchive. ↩
- 2 Although the Securities and Exchange Commission temporarily banned the shorting of securities of certain domestic financial firms during the 2008 financial crisis (Short Sales in Securities of Financial Firms, Exchange Act Release No. 58592, 2008 WL 4287187 (September 18, 2008)), and in recent months several European countries have prohibited the shorting of the securities of their lending institutions (Louise Story and Stephen Castle, Four European Nations to Curtail Short-Selling, New York Times (August 11, 2011), http://www.nytimes.com/2011/08/12/business/global/europe-considers-ban-on-short-selling.html), no express legal prohibitions against shorting loans are currently in effect in the U.S. ↩
- 3 See, e.g., The Handbook of Loan Syndication and Trading 412 (Allison Taylor and Alicia Sansone eds., 2007)(“[t]echnically, a loan market participant can short a loan simply by selling a loan that it does not own, but the net effect is similar to that of shorting a bond without a borrow, and the practice is generally frowned upon . . .). ↩
- 4 See UBS v. Highland Capital, No. 52098, slip op. at 2 (N.Y. Sup. Ct. Dec. 2010)(observing that since the parties’ LSTA trade confirmation defined the settlement date as “as soon as practicable” and did not “include a fixed time for performance, performance must be made within a reasonable time.”). ↩
- 5 But see Goldman Sachs Lending Partners, LLC v. High River Ltd. P’ship, Index No. 603118/2009 (N.Y. Sup. Ct. N.Y. Co.)(seller of Delphi loans, caught in apparent “short squeeze” on eve of Delphi plan distribution deadlines, sued by Buyer who unilaterally terminated trades due to Seller’s alleged failure to timely cover); Credit Suisse First Boston v. Utrecht, No. 246, slip op. 1 (N.Y. App. Div. 1st Dep’t 2011)(finding that there was an open factual issue as to whether defendant, in unilaterally breaking the parties’ trade without any advance notice, was acting in good faith); Fulcrum Credit Partners v. Strategic Capital Resources, No. A-10-CA-137LY (W.D. Tex. Apr. 27, 2010) (Seller determined by jury to have breached contract to assign bankruptcy claims without justifiable excuse). ↩
- 6 Ted Basta, The 2010 LSTA Secondary Settlement Study, LSTA Loan Market Chronicle 2011 (observing that the current average settlement time for distressed trades is 67 business days after the trade date, and that nearly 30% of distressed trades take more than four months to settle). ↩
- 7 The Loan Syndications and Trading Association. The LSTA is the leading trade association for, and promulgates substantially all trading documentation currently in use in, the domestic secondary loan market. ↩
- 8 See LSTA Standard Terms and Conditions for Purchase and Sale Agreements for Distressed Trades (“PSA STC”), §8.2. ↩
- 9 See PSA STC, §4.1(r)(ii), §1.2, “Transferred Rights”, clause (d). ↩
- 10 The LSTA implemented Par/Near-Par BISO Rules in 2009. ↩
- 11 See LSTA Standard Terms and Conditions for Par/Near-Par Confirmations (“Par STC”), §6. ↩
- 12 See LSTA Standard Terms and Conditions for Distressed Confirmations (“Distressed STC”), §6. ↩
- 13 Substantially the same requirement apply to buyers that have delayed closing past the operative deadline, but the above discussion is limited to seller delays due to this newsletter’s focus on short-selling. ↩
- 14 Seller delivery obligations generally also include delivery of upstream PSAs. See Distressed STC, §16(b)(10). ↩
- 15 This initial period may be increased to 60 or even 70 days under certain circumstances, depending upon the sequence and timing of delivery of the relevant documents. See Distressed STC, §16(b)(3). ↩
- 16 See Distressed STC, §16(a)(1), though a BISO Notice recipient, if a short-seller, can overcome such a BISO Notice if it has timely performed its upstream BISO obligations with its seller on the cover trade. See Distressed STC, §16(c)(9). ↩
- 17 For par/near-par trades of domestic loans, the existing BISO provisions under the LSTA Standard Terms and Conditions for Par/Near-Par Confirmations establishes shorter periods of 15 days to be able send out a BISO Notice threatening termination of a sale (or purchase), and five business days to cure any seller failure to perform its delivery obligations. ↩
- 18 Arbitration is before an ad-hoc, three member panel appointed from the LSTA’s Board of Directors. Section V of the LSTA Rules Governing Arbitration between Loan Traders with regard to Cover Price for Trades that Do Not Settle by BISO Trigger Date. See Distressed STC, §16(a)(5). ↩
- 19 Sellers are also obligated to likewise demand during the Cure Period that their immediate upstream counterparties similarly perform their delivery obligations. See Distressed STC, §16(c)(9). ↩
- 20 This 5-day limit on cover trades usable to establish an Upstream Shield is consistent with the treatment under the BISO provisions of the LSTA Standard Terms and Conditions for Par/Near-Par Confirmation Letters already in effect. See Par STC, §16. ↩
- 21 A separate exception from application of the Distressed BISO Rules exists for trades upon which all “delivery obligations” have been performed, but necessary agent, borrower or other third-party consents have been requested but not received. ↩
- 22 See Distressed STC, §16(c)(5). ↩
- 23 Oral agreements to purchase or sell loans are enforceable under NY Gen. Oblig. Law. §5-701(b)(2)(i). “Type I” agreements under New York law, as to which price, quantity, credit and all other material terms are agreed, are fully enforceable even if parties never execute formal documentation (see Bear Stearns Inv. Products, Inc. v. Hitachi Auto. Products (USA), Inc., 401 B.R. 598 (S.D.N.Y. 2009)). Since LSTA confirmations legally bind parties that have made oral agreements to standard confirmation terms and conditions for all future trades, (see Par STC and Distressed STC, §§21 and 26, respectively), and since the Standard Terms and Conditions for Distressed Confirmations bind parties to execute substantially the form of Purchase and Sale Agreements (“PSAs”) for their trades, there’s a reasonably good chance that, absent unresolved material, trade-specific issues raised on the trade date but never resolved, a legally binding agreement to a short sale of bank loans could be determined to exist even if it had only been orally agreed, and Seller then attempted to abandon the cover trade prior to closing. ↩
- 24 See Distressed STC, §17. ↩
- 25 See Distressed STC, §17(b)(i). ↩
- 26 See FN4 and FN5, supra. ↩
- 27 See, e.g., Peng v. Willets Point Asphalt Corp., 910 NYS.2d 407, 4 (N.Y. Sup. Ct. 2010) (observing that “the obligor may say or do nothing that suggests his unwillingness or inability to perform, but the circumstances may nonetheless indicate that performance is not likely,” thereby entitling the obligee to discharge its duty to perform under the contract); Credit Suisse First Boston v. Utrecht at FN5, supra. ↩
