In September 2021, Rohit Chopra was confirmed as the third Director of the Consumer Financial Protection Bureau (CFPB). After receiving his bachelor’s degree from Harvard as well an MBA from Wharton, Director Chopra worked in management consulting with McKinsey & Company, previously served as a Federal Trade Commission (FTC) Commissioner, and was the CFPB’s first Student Loan Ombudsman. Senate Banking Committee Chair Sherrod Brown (D-OH) praised Director Chopra as a “bold and experienced” nominee who would return the agency to its “central mission.” Senator Elizabeth Warren (D-MA) offered similar comments, hailing Director Chopra as a “terrific” pick to lead the CFPB. Accordingly, Director Chopra is widely viewed as an assertive regulator who will seek to leverage the full authority of the CFPB, and he has assembled a leadership team that includes several CFPB alumni and veterans.
The early days of the Chopra CFPB have been especially active, with the agency issuing marketing monitoring orders to several Big Tech players about their payments businesses and inquiries directed to leaders in the rapidly growing “Buy Now Pay Later” space. The agency has also issued research reports on overdraft fees and a Request for Information on so-called “junk fees” charged by financial institutions. However, fair lending issues are widely perceived to be on the forefront of Director Chopra’s policy priorities.
In that vein, and consistent with his focus on Big Tech, data privacy, and algorithmic bias at the FTC, Director Chopra has made crystal clear that fair lending—and in particular, algorithmic discrimination—and other practices that adversely impact communities of color will be a top agency priority. For example, in remarks announcing the settlement of a traditional redlining case, Director Chopra focused largely on “digital redlining.” He specifically called out companies that gather “massive amounts of data and use it to make more and more decisions about our lives, including loan underwriting and advertising” and encouraged data scientists, engineers, and others with “detailed knowledge of the algorithms and technologies used by those companies and who know of potential discrimination or other misconduct” to report potential fair lending violations to the CFPB. These comments have led many to believe that Director Chopra may potentially pursue new or novel fair lending theories related to artificial intelligence, machine learning, and related underwriting with algorithms.
Similarly, the Biden Administration’s focus on racial equity and the racial wealth gap could lead Director Chopra to focus his efforts on a variety of fair lending concerns, including collections and services issues, foreclosures, evictions, and credit reporting, or issues specifically stemming from the pandemic, such as potential discrimination in the issuance of PPP loans. And many industry observers believe the CFPB will pursue somewhat controversial “disparate impact” theories to pursue fair lending violations.[1]
Indeed, Director Chopra has also made clear that the agency will focus on large companies and market players, seek to pursue a broad range of remedial measures—including individual liability where appropriate—to redress consumer harms, and partner closely with state authorities in enforcing consumer financial protection laws. The latter likely includes exploring ways to expand the CFPB’s authority to enforce federal consumer protection laws and access remedies such as the civil monetary penalty funds authorized under the Consumer Financial Protection Act.
Additionally, comments by the CFPB at an industry fair lending conference in November of 2021 restated its goals of using its authority to narrow the racial wealth gap and ensure markets are clear, transparent, and competitive. In addition to the areas noted above, the comments indicated an intent to specifically focus on:
Appraisal bias in home valuation;
Special purpose credit programs or “SPCPs”;
Small business lending and the implementation of Section 1071 of Dodd-Frank;
Limited English Proficiency consumers; and
Unfair and discriminatory practices, including illegal practices outside of the ECOA and the HMDA.
If his initial actions and related commentary from the CFPB are any indication, Director Chopra will pursue a bold new approach to CFPB rulemaking, supervision, and enforcement in the areas of fair lending and beyond.
At the ABA Business Law Section’s 2022 Hybrid Spring Meeting, the CLE program “There’s a New Sheriff in the Beltway: Potential Areas of Focus of Director Chopra’s Fair Lending Regulatory Agenda” (now available for viewing as on-demand CLE) identified and discussed Director Chopra’s fair lending and anti-discrimination priorities and how they may impact financial services providers of all stripes, from traditional financial institutions to fintechs and Big Tech players. A panel of experts offered their views on Director Chopra’s priorities in this space, including their predictions for supervisory, enforcement, and rulemaking activity on AI-based underwriting, digital marketing, fair lending compliance in the PPP program, and small business lending; opportunities for collaboration with state and federal authorities; and potential legal headwinds and opportunities.
This article is based on a CLE program that took place during the ABA Business Law Section’s 2022 Hybrid Spring Meeting. To learn more about this topic, view the program as on-demand CLE, free for members.
In November 2021, ASTM International (formerly known as the American Society for Testing and Materials) published its E1527-21 (-21 Standard), its 2021 update to its Standard Practice for Environmental Site Assessments: Phase I Environmental Site Assessment Process. The -21 Standard is intended to satisfy the requirements of the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA)’s All Appropriate Inquiries Rule (AAI). The ASTM submitted a formal request for the Environmental Protection Agency (EPA) to reference the -21 Standard as compliant with AAI.
On March 14, 2022, the EPA published both a preliminary rule and a direct final rule setting forth the EPA’s intent to amend AAI to permit use of the -21 Standard in satisfaction of the AAI. Had the EPA not received adverse comments on the rule, the direct final rule would have gone into effect on May 13, 2022. The EPA did, however, receive adverse comments and, therefore, withdrew the direct final rule on May 2, 2022. It now intends to address adverse comments in a subsequent final action.
Of the adverse comments received, the majority objected to the rule permitting the -13 standard to remain as an acceptable alternative to comply with AAI. In other words, under the proposed rule, Phase I studies conducted under either the -13 standard or the -21 standard would be deemed sufficient to satisfy AAI. Because ASTM’s -21 standard improves upon the shortfalls of the -13 standard and brings the practice in line with “good commercial and customary practices,” as required by AAI, permitting the continued use of the historical (-13) standard does not make a great deal of sense. As noted in the comments, EPA attempted this method when it proposed the -13 standard as complying with AAI by providing that the then-current standard (E1527-05) would also be sufficient to satisfy AAI. After similar adverse comments, EPA eventually removed its reference to the -05 standard. Given this, it is likely that EPA will remove similar reference to the -13 standard in its final regulation.
Updating “Good Commercial and Customary Practice”
In developing its published -21 Standard, the ASTM sought input from users and environmental consultants nationwide. One of the ASTM’s primary goals in crafting the -21 Standard was to ensure production of quality Phase I Environmental Site Assessments (ESAs) and their resulting reports. The ASTM’s objectives in crafting the -21 Standard were threefold:
Clarify and improve existing language
Update the standard to reflect current customary practice
Strengthen the deliverable (report)
The ASTM has clearly met these objectives.
What Are the Significant Changes from E1527-13?
The -21 Standard contains revised and new definitions, making the requirements stronger and clearer than those in the 2013 version, such as:
Rewording the definition of Recognized Environmental Condition (REC). The prior definition of REC covered three examples, two of which used the term “likely,” without defining it, leaving it to a wide array of interpretations. The -21 Standard now defines the word “likely” to mean “that which is neither certain nor proved, but can be expected or believed by a reasonable observer based on the logic and/or experience of the environmental professional, and/or available evidence, as stated in the report to support the opinions given therein.”
Clarifying that Historical Recognized Environmental Conditions (HRECs) and Controlled Recognized Environmental Conditions (CRECs) are only those conditions that affect the subject property, and that current regulatory standards be considered to determine whether the controls meet those standards as concerns unrestricted use.
Replacing E1527-13’s use of the broader term “property use restrictions” (which was not previously defined) with the term “property use limitations,” to capture a wider variety of risk-based mitigation end points.
Providing a definition of “significant data gap,” which E1527-13 required to be identified, but failed to define.
The -21 Standard includes clearer emphasis on property identification, specifically by:
Providing that the subject property is defined by its current boundaries (boundaries commonly change throughout the years).
Pointing out that properties may be different in use, size, configuration, and/or address than in the past.
Providing that research of additional addresses may provide further information to meet objectives.
The -21 Standard also specifies two methods users may employ to satisfy their responsibility to search for environmental liens and activity and use limitations:
Method 1 provides that a user may satisfy its requirements by relying upon customary title insurance documentation such as preliminary title reports or title commitments.
Method 2 provides an alternative process, whereby a user may rely upon title search information reports such as condition of title, title abstracts, and activity and use limitation/environmental lien reports as long as the information identifies environmental covenants, environmental easements, land use covenants and agreements, environmental liens, and other environmental land use restrictions and controls. Search information reports must review land titles records dating back to 1980. If judicial records are not reviewed, the report must include a statement that the law of custom of the jurisdiction at issue does not require a search for judicial records in order to identify environmental liens.
Further, the -21 Standard:
Requires that the subject property’s use be more specifically identified. For example, if the subject property’s purpose is retail, industrial, or manufacturing, additional standard resources must be reviewed if they are likely to identify a more specific use and are reasonably ascertainable.
Provides additional clarity with respect to identification of RECs and discusses the multi-step process for identification of CRECs and HRECs. The -21 Standard includes a helpful appendix that breaks down their definitions and provides a flowchart diagram and simple examples.
Requires more specific information in connection with historical research of the subject property, adjoining properties and the surrounding area. This puts a clearer emphasis on current property identification, more specific information on property use, etc.
Requires review of aerials, topographic maps, fire insurance maps, and city directories, if reasonably available, and if not, requiring a reason for that omission.
Adds a new section addressing historical research of adjoining properties. In particular, during research of the subject property, obvious past uses of adjoining properties must be identified to evaluate the likelihood that past uses may have led to RECs. If aerials, topographic maps, fire insurance maps, and city directories have been researched for the subject property, if they provide coverage for the adjoining properties, and if that research is likely to be useful in meeting the objective, those documents must also be reviewed for the adjoining properties.
Significantly, adds “Emerging Contaminants” to the list of non-scope considerations, the most currently significant of which are per- and poly-fluoroalkyl substances (PFAS), many of which are likely to be brought within CERCLA’s definition of hazardous substances in the near future. Given this, prudence would suggest that Phase I ESAs include assessment for PFAS and other emerging contaminants, such as 1,4 dioxane, where appropriate.
Which Standard Should Be Applied?
Of course, until the -21 Standard is officially adopted, ASTM E1527-13 remains the applicable standard. Assuming the EPA revises its proposed rule to remove reference to the -13 standard, upon its adoption of the -21 standard, the -13 standard will become a historical one. Until then, there is no requirement that the -21 Standard be employed; however, it is the author’s preference that environmental professionals use and cite ASTM E1527-13, but ensure (and note in the report) that the Phase I ESA also satisfies the requirements of the -21 Standard.
This year, the American Bar Association has chosen “a more perfect union” as the theme for Law Day. In furtherance of this theme, the Business Law Section has asked attorneys to volunteer to talk about the rule of law in some forum. I am excited to be part of this conversation and to share some perspectives from the book Law and Poetry: Promises from the Preamble, which was published by the Association earlier this year. The book is an anthology that explores the themes presented in the Preamble to the United States Constitution. The anthology includes the work of poets from around the world.
In preparing the anthology, I had the opportunity to connect with many of these poets and to learn more about them. Cecil Rajendra was one of the poets who impressed me most. Mr. Rajendra is both a poet and an accomplished human rights attorney. Below, you will find his poem “The Dark Side of Trees,” together with some introductory information and a short biographical sketch that provides a little bit more information about Mr. Rajendra. This material is reproduced from the anthology.
This poem resonated with me for the way in which it emphasizes the responsibility we as individual citizens have to hold our government accountable. We are called upon to notice—and not to turn away—when our legal system and our institutions of government are threatened. In doing so, we help to uphold the rule of law, and, ultimately, we help to build a more perfect union.
The poem below was reprinted in the June 1984 issue of the International Commission of Jurists’ journal The Review. The ICJ is a non-governmental organization, founded in 1952 in Geneva, which is focused on international human rights. Mr. Rajendra’s poem followed updates on human rights throughout the world, from East Timor, to Haiti, to Japan, Pakistan, South Africa, and Western Sahara. As you read this poem, you might consider the world-wide applicability of its themes.
~ The Dark Side of Trees
Cecil Rajendra
The truth burns so they turned their faces away from the sun . . . When small liberties began to fray . . . When their constitution was being chipped away When their newspapers were shut down . . . When their rule of law was twisted round . . . When might became right and their friends Were carried off screaming in the pitch of night . . . They chose silence feigned blindness pleaded ignorance. And now when the shadow of the jackboot hangs ominous over their beloved land they walk as zombies unable to distinguish right from wrong from right their minds furred with lichens like the dark side of trees. The truth burns so they turned their faces away from the sun . . .
Cecil Rajendra is a poet, lawyer, and human rights activist who has lived by the mantra, “Seek out the little guy and help if you can.” He was born in 1941 in Penang, Malaysia and received his formal education at St. Xavier’s Institution, the University of Singapore and Lincoln’s Inn (London) where he qualified as a barrister-at-law. Throughout his lengthy and distinguished career, he has earned numerous distinctions in poetry, law, and human rights. As an attorney, in 1980 he co-founded the Penang Legal Aid Centre (PLAC), which was the first rural legal aid clinic in Malaysia. In 2000, he created Malaysia’s first-ever mobile legal aid clinic. For this work, Rajendra earned the Malaysian Bar’s 2019 Lifetime Achievement Award as well as the International Bar Association’s 2019 Pro Bono Award. As a poet, he has published dozens of volumes of poetry and was nominated for the 2004 Nobel Prize in Literature for his collection By Trial & Terror. His work has been published in more than fifty countries and translated into a number of languages. As a human rights activist, he has initiated campaigns against detention without trial and in support of an independent judiciary. He was awarded the first-ever Malaysian Lifetime Humanitarian Award in 2004, in recognition of both his outstanding work in law and his exemplary poetry; and in 2015 was declared a Living Heritage Treasure by the Penang Heritage Trust.
From Hour of Assassins and Other Poems by Cecil Rajendra. London: Bogle- L’Ouverture Publications, 1982.
I am always struck by the universality of the images and themes that Mr. Rajendra raises in this poem. Here are a few examples that come to mind:
When small liberties began to fray . . . . In St. Petersburg, Florida, where I live, the Florida Holocaust Museum has a permanent display that I have always found to be particularly important, as a lawyer, because it reminds me that the law can be used to cause great harm. This display includes a timeline showing how the laws in pre-war Nazi Germany were changed over a period of six years to disenfranchise, restrict, persecute, and isolate Jewish people. The first wave of what would ultimately be more than four hundred antisemitic laws and regulations was focused on restricting Jewish citizens from civil service and other aspects of public life.
When their newspapers were shut down. Thomas Jefferson recognized the importance of the free press to American democracy: “No government ought to be without censors: and where the press is free, no one ever will.” Even prior to the pandemic, more than twenty percent of the newspapers in the United States went out of business during the prior fifteen years, according to an article in the New York Times. In addition, the past few months have brought attention to the serious crackdown on independent media and access to online information in Russia.
When might became right and their friends were carried off screaming in the pitch of night. Every day, we read about individuals in Ukraine being forcibly deported to Russia. In our own country, more than one hundred thousand Japanese Americans were forced to leave their homes to be incarcerated in internment camps that were euphemistically called “relocation centers” during World War II.
These images—both historical and contemporary—are so bleak and so painful that sometimes, hope is in short supply. Mr. Rajendra reminds us that our hope is in not turning away, even when “the truth burns.”
In preparing this anthology, I found—and was inspired by—a number of examples, both historical and contemporary, of what not turning away might look like. Some of these voices come from the past and are quite famous: Elizabeth Barrett Browning denounced slavery at great personal and professional cost. Langston Hughes powerfully invoked images of crushing poverty. Edna St. Vincent Millay dared to suggest that “America the beautiful” could become an America that is “beautiful nowhere” if apathy toward the American “cause” continues to prevail. Other voices may be unfamiliar to many readers but are, thankfully, still with us: Naomi Ortiz and Stephen Lightbown are strong voices in the disability justice movement. John Brandi challenges us to see incarcerated persons as persons. Dee Allen requires us to reckon with homelessness through the eyes of a person who has experienced it.
As we continue to have conversations about what it means for us to strive toward “a more perfect union,” I hope some of these voices will serve to inspire and challenge you, as they have me.
Almost every bankruptcy practitioner has counseled a client who was on the receiving end of a complaint seeking to avoid a transfer as a preference.[1] But one of the little-heralded aspects of the Small Business Reorganization Act of 2019 (SBRA)[2] was an amendment to 11 U.S.C. 547(b) that places additional pre-suit burdens on trustees, debtors-in-possession, committees, or any other plaintiff in a preference case.[3]
Specifically, Congress amended § 547(b) to include the italicized language below:
(b) Except as provided in subsections (c), (i), and (j) of this section, the trustee may, based on reasonable due diligence in the circumstances of the case and taking into account a party’s known or reasonably knowable affirmative defenses under subsection (c), avoid any transfer of an interest of the debtor in property—
As Collier has noted, “it is unclear whether the ‘reasonable due diligence’ requirement is an element of the preference claim.”[4] Since the SBRA became effective on 20 February 2020, a few courts have had an occasion to review what the new language means and how it affects the prosecution and defense of preference claims.
One of the first cases to consider this issue was Husted v. Taggart (In re ECS Refining, Inc.).[5] The court found that the new language in § 547(b) “now requires that the trustee satisfy a condition precedent, i.e., reasonable due diligence and consideration of known or knowable affirmative defenses.”[6] The court analyzed these conditions as having three prongs: “(1) reasonable due diligence under ‘the circumstances of the case’; (2) consideration as to whether a prima facie case for a preference action may be stated; and (3) review of the known or ‘reasonably knowable’ affirmative defenses that the prospective defendant may interpose.”[7] The court also noted that the section “is silent on whether satisfaction of the condition precedent is an element or an affirmative defense and on whether satisfaction is a pleading requirement.”[8] The court further noted that the due diligence requirement was in the same section which gave rise to the trustee’s substantive claims[9] and that Congress had specifically laid the burden of proving the avoidability of a transfer at the feet of the trustee under § 547(g).[10]
Accordingly, the court held that “due diligence and consideration of affirmative defenses, is an element of the trustee’s prima facie case.”[11] Turning to the pleadings themselves, the court found that the trustee’s “use of pre-Iqbal/Twombly notice style pleadings and a very general nature of the allegations in the First Amended Complaint suggest a lack of pre-filing due diligence,”[12] and that reasonable inferences did not suggest that the trustee had fulfilled the three prongs required by the new statutory language. Based on that and other deficiencies, the court granted the defendants’ motion to dismiss the trustee’s claim with leave to amend.[13]
The court in Sommers v. Anixter, Inc. (In re Trailhead Engineering)[14] took a slightly different path. In its motion to dismiss, the defendant contended that the complaint had no allegations regarding the trustee’s due diligence, or review of the defendant’s affirmative defenses, and therefore failed to plead all of the elements of a preference claim.[15] The court found that it did not have to determine whether “reasonable due diligence” was an element of a preference claim because the complaint contained sufficient allegations.[16] The court noted that the complaint specifically alleged that the trustee had examined documents including the debtor’s bank records, invoices between the parties, correspondence, and the operative contract.[17] The trustee had also included a chart of the relationships between the relevant entities.[18]
Accordingly, the court found that the complaint contained sufficient allegations relating to the trustee’s reasonable due diligence. So, while the court did not explicitly find that the new language created a new element, it nevertheless implicitly found that the complaint needed to contain sufficient allegations to satisfy the requirement.
The decision in Faulkner v. Lone Star Car Brokering, LLC (In re Reagor-Dykes Motors, LP)[19] covered three complaints filed against separate defendants; all three defendants filed motions to dismiss, contending that the trustee failed to allege sufficient facts to carry its burden of “reasonable due diligence.” The court acknowledged that the SBRA was intended to deter the filing of abusive lawsuits.[20] It also recognized the lack of clarity regarding the new requirement: “Whether the due diligence language creates an additional pleading requirement is unclear. But a trustee (or debtor-in-possession) must, in bringing a preference action, exercise due diligence and consider the party’s ‘known or reasonably knowable affirmative defenses under subsection (c).’ § 547(b).”[21]
As to the first defendant, the court cited to Sommers and noted that the complaint at issue contained some allegations relating to that defendant’s prepetition relationship with the debtor.[22] These allegations included “a description of the relationship between the Debtors and [Defendant] Lone Star—transport services on credit—and details of the specific transactions….”[23] The court declined to dismiss the complaint against that defendant because the “allegations—or lack thereof—do not reflect an abusive filing. Lone Star has not answered the suit; its affirmative defenses are unknown.”[24] As for the other two defendants, however, the court noted that the complaint failed “to provide any information beyond conclusory allegations that the Trustee performed reasonable due diligence under the circumstances and that the transfers were for antecedent debt.”[25] The court stated:
The transfers lack context—what kind of services or goods did either Earl Owen or Meyer Distributing provide? How were these business relationships structured? It appears the Trustee considered only what was reflected on a bank statement. Were these transfers on account of ordinary business practices, simultaneous value, a cash on delivery agreement, or was new value provided for these transfers? None of those questions can be answered with any certainty since there is no information in the complaints about the nature of these transfers.[26]
The court then dismissed the complaint against those two defendants, granting the trustee leave to amend.[27]
Weinman v. Garton(In re Matt Garton & Associates, LLC)[28] followed the Husted court’s reasoning and stated that “[a]rguably, the new due diligence requirement is an element of a preference claim under Section 547.”[29] In the operative complaint, the trustee alleged he had: reviewed pleadings and conducted an informal interview with the defendant; listened to the defendant’s views on the litigation; conferred with counsel for the debtor’s bank (from which some of the transfers had been made on behalf of the defendant); reviewed the books and records of the debtor; subpoenaed bank and credit card statements and other materials; and, after the filing of the initial complaint, undertook additional investigation and requested additional documents after identifying new potential transfers.[30] The court found that these allegations satisfied the trustee’s burdens under § 547(b).[31]
In Insys Liquidation Trust v. Quinn Emmanuel Urquhart & Sullivan, LLP (In re Insys Therapeutics, Inc.),[32] the court followed Sommers and Weinman and declined to rule on whether the revisions to the statute created a new element for preference claims. The court did find, however, that if the new statutory language regarding due diligence was an element, it was met by the trustee. Here, the trustee allegedly sent a letter to the defendant prior to initiating the complaint demanding return of the transfers at issue and invited the defendant to advise the trustee of its defenses; the trustee further alleged that, to the extent any defenses were presented, the trustee took them into account while also reviewing the debtor’s books and records.[33]
The court in Arete Creditors Litigation Trust v. TriCounty Fam. Medical Care Group, LLC (In re Arete Healthcare LLC)[34] also declined to decide whether due diligence is an element for a claim under 547(b); however, the court did note that if due diligence is an element, then the allegations in that particular complaint were insufficient.[35] The court found that “[t]he Trust merely stated that it had performed ‘reasonable due diligence’, ‘investigat[ed] into the circumstances of the case’ and ‘[took] into account the Defendant’s reasonably knowable affirmative defenses under 11 U.S.C. § 547(c).’ The Amended Complaint also ‘acknowledges that some of the transfers might be subject to defenses.’”[36] The court then dismissed the amended complaint, stating: “If due diligence is an element, merely paraphrasing the element will not satisfy Rule 8.”[37]
Taken as a whole, courts have uniformly required trustees to allege facts reflecting their due diligence. This is likely to differ from case to case because some debtors have records that are in much better shape than others. Simply filing suit against every entity that received a check from the debtor in the last 90 days prepetition would be problematic under any of these cases; something more is now required. Whether that “something” is the minimally accepted allegation in Lone Star, or the more fulsome descriptions in Sommers and Weinman, may vary from court to court.
From the defense side, however, it is unclear whether the trustee’s obligation to conduct due diligence truly presents a new and fruitful line of defense on its own. The authors could not identify any cases where a defendant sought sanctions under Rule 11 for a trustee’s failure to allege due diligence. It is notable that only two of the three defendants in In re Reagor-Dykes Motors prevailed on their motion to dismiss; and in each of those actions, the trustee filed amended complaints that the defendants ultimately answered and filed motions for summary judgment. Neither motion, however, made any mention of the trustee’s duty to conduct due diligence.
It seems highly unlikely that “due diligence” alone could be the basis for a motion for summary judgment. Even if a court was inclined to grant summary judgment based on the trustee’s lack of due diligence, the court necessarily would have to be entering summary judgment on whatever grounds the trustee should have discovered but for its lack of due diligence. Ultimately, if defendants keep pressing trustees to meet this new burden, the real measure of its effectiveness will be how many adversary proceedings are not filed.
Plenty has changed since January 2022, when we last examined developing trends in the SPAC market. Since then, the macroeconomic environment shifted dramatically due to rising inflation, increasing interest rates, and the war in Ukraine; the PIPE market collapsed; traditional IPOs dried up; and the SEC came out with a set of controversial proposed SPAC rules.
All these factors have led to a drastic slowdown in SPAC activity. We’ve seen more withdrawals, an increase in liquidations, longer SEC review periods, more extensions and delays, more lawsuits, more bankers scaling down their SPAC operations, more attorney fees to address market uncertainty, and more negative shifts in sponsor economics and target valuation.
Still, this is not the time to throw your arms up in frustration and jump off the SPAC ship; it’s a time to learn, examine, correct, and improve.
With these goals in mind, we’ve identified a few interesting trends that may inform current and future plans for our SPAC clients and friends.
1. The number of securities class actions is holding steady.
When it comes to SPACs, Securities Class Actions (SCAs) are the elephants of lawsuits. These suits are the heavy hitters in terms of time spent and defense costs incurred. They are what companies most look to avoid and what ultimately drive their decisions on Directors and Officers (D&O) insurance. We track them closely because they inform the terms and pricing in the D&O insurance market and the structuring of the D&O policies we offer to our clients.
Despite a larger number of deals in the market, and taking into consideration the lag between the merger and the filing of the lawsuit, the number of these suits is holding steady as compared to 2021. If the current trend continues, the number of SCAs should be about the same this year as what we observed in 2021.
2. The likelihood of a SPAC getting hit with an SCA post-merger is also holding steady.
A common question we hear is about the percentage of all de-SPACs that get hit with lawsuits. According to our data, 16% of companies that went through a de-SPAC in 2020 and 14% of companies that went through a de-SPAC in 2021 have been sued so far.
Interestingly, if we look at companies that went public via a traditional IPO, about 3% of those that IPOed in 2020 and 5% of those that IPOed in 2021 were sued within the first year of the IPO. That percentage is significantly lower than the rate at which de-SPACed companies are being sued. This means that it is considerably more likely that a de-SPACed company will be caught up in an SCA in its first year out of the gate than a traditional IPO company.
Why? Increased negative media and regulatory attention on SPACs might have something to do with it. Rushed deals at the height of the SPAC craze in 2020 and 2021 could have contributed to a few colorful SPAC missteps. A new, lucrative avenue of activity for the plaintiffs’ bar could also be a reason.
SPACs have also been targets of many short sellers’ reports. Many of these reports spurred an SCA shortly after their publication. In 2021, thirteen of the thirty-three SCAs filed that year (40%) stemmed from a short-seller report. By mid-May of this year, five out of sixteen suits (31%) have been based on short-seller activity.
It is worth noting that while these suits have been filed against SPAC entities in larger numbers than in previous years—whether prompted by a short-seller report or not—few of them have gone far enough through the legal process to determine whether they have merit.
3. The SPAC’s team is named in two-thirds of SPAC lawsuits.
Although there have been instances of SCAs brought against SPACs prior to the merger, most are filed after the merger. Many of our clients ask whether the SPAC’s original team of directors and officers is home free (meaning out of danger of a lawsuit) once the merger is closed. The response to that question is usually not.
In fact, about two-thirds of the SCAs filed in 2021 and 2022 named directors and officers of the SPAC entity as defendants in the lawsuit. Here is where the tail (aka run-off) on the SPAC’s D&O insurance policy comes into play.
As many of our readers know, the insurance policy that covers the SPAC is claims-made in nature. That distinction means that if the policy is not in place when the lawsuit is filed and the claim is made, it won’t respond. Since many of the lawsuits are filed after the merger, terminating the SPAC’s policy at the time of the merger without electing tail coverage leaves the SPAC’s directors and officers exposed.
How often are they exposed? Two-thirds of the time. Here are the numbers.
4. RWI for a SPAC could lead to post-merger D&O enhancements/savings.
More and more SPACs are looking to address claims of insufficient or shoddy diligence through the representations and warranties insurance (RWI) policy placement process.
At its core, the RWI policy is designed to protect the buyer (in this case, the SPAC) against two things: (i) the seller’s (in this case, the target’s) breaches of reps in the merger agreement and (ii) the target’s fraud. However, a valuable side benefit of these policies, especially now that the number of SPAC cases alleging insufficient diligence is growing, is the insurer’s close examination of the SPAC team’s due diligence.
This second layer of diligence by a disinterested third party over the SPAC team’s diligence is important for at least two reasons. First, it either validates the SPAC team’s diligence process or points out potential problems that could be corrected and properly disclosed between the signing of the merger agreement and the close of the deal.
Second, it is conducted by an experienced underwriting team and their top-tier legal counsel, who are usually well versed in the industry of the target and very knowledgeable about the array of potential risks present in that industry.
Many SPAC teams have explored and obtained RWI policies in the last two years. Some of the deals that come to mind include the acquisitions of Utz, Opendoor, and Paysafe. And recently, D&O insurers have started taking note of teams and deals that are willing to go through the process of obtaining an RWI policy.
Like any additional vetting, diligence, or compliance process, the steps involved and the willingness of the team to go through them signal the maturity, veracity, and sophistication of the SPAC team and its acquisition target. All those factors reduce litigation risk and add to the comfort level of the insurer that is looking to insure the post-merger entity.
In fact, very recently, at least one of the leading SPAC D&O insurers, realizing the benefits of an RWI policy for a SPAC, has started to offer price reduction options on D&O premiums for SPACs that choose to obtain an RWI policy ahead of their merger. Additional D&O insurance breaks and better terms for the post-merger combined company may also become available.
Like the ever-evolving SPAC market, the insurance market for SPACs is also evolving and adapting. We are expecting to see additional new, creative solutions to SPAC risks before the year is out.
An earlier version of this article appeared in the Woodruff Sawyer SPAC Notebook.
We know it’s essential to keep as up to date as possible in the reps and warranties (RWI) market, which is both relatively small and rapidly developing.
This month we witnessed a very substantial drop in pricing as well as an equally substantial increase in the number of quotes and competitiveness of the market. In this article, we will update the data and look at emerging trends.
What New RWI Deal Activity in April Means Going Forward
Although the M&A market continues to flourish, we saw a drop in activity in the first quarter. That is entirely common in the M&A cycle, with the first quarter traditionally being the slowest. You will see below the Euclid Transactional submission rate analysis for the first quarter. This shows a marked decrease from 2021 last quarter but slightly above par with 2021 first quarter.
However, we do believe that around mid-March an air of hesitancy entered the market, which we believe is due to interest rate–related financing concerns and geopolitical instability. As reported by Paul Weiss, “March was the second consecutive month of decline in the number of transactions.” M&A at a Glance (April 2021) | Paul, Weiss (paulweiss.com)
Comparing Year over Year and Quarter to Quarter: An Historical View of Trends
The RWI Statistics
As we can see from the below data, the market has responded with alacrity to this change in conditions. While the activity may be on par with the first quarter of 2021, underwriters and markets ramped up in response to the growing activity last year and so face the level of activity in 2022 with more capacity and more staff.
Overall, the news was very good for our clients and those needing reps and warranties insurance. The average number of quotes went through the roof and the premium prices we are seeing are on par with the beginning of 2021, if not slightly more competitive.
The lowest quote we saw was 2.98%, a return to early last year in terms of pricing. Unlike last month this low number was not as much of an outlier as previously seen. We are pretty much in the 3.5–4.5% range for most quotes right now.
The average quote was down from 5.1% to 3.5% which is a substantial decrease and shows the market’s ability to quickly adapt to changing circumstances. To put this in context, if you bought a $10 million policy in March, you would have paid roughly $510,000, and if you bought that same policy in April, it was more likely to cost $350,000.
The average number of quotes went from just over four to ten per risk, showing the continued excess supply of underwriting capacity either due to reduced deal flow, increases in human capital, or new entrants to the market.
As we saw above, the lowest price came in at 2.98%, which is a significant drop. What’s just as noteworthy is that the highest pricing has also dropped from 5.9% in March to 4% in April, again a substantial saving for deals priced this month as opposed to the previous month.
Trends in RWI “Heightened Risk” You Should Know
Anyone experienced in the process of placing an RWI policy should be familiar with the areas of heightened risk listed on every NBIL. These are the deal-specific areas on which underwriters will focus during their review of the diligence conducted by the buyer’s team of advisors. Should diligence be lacking in one of these areas, underwriters will likely seek to incorporate an exclusion in the policy for that portion of the risk.
Ukraine and Russia continue to be an area of heightened risk. However, we have seen underwriters drop the blanket approach and focus on those deals where it’s likely to be an actual issue rather than wanting to dig deep on every deal.
Three Cases of RWI Litigation
Arbitration as the first port of call is standard in RWI policies. Litigation around RWI has historically been difficult to find. There are currently three active cases in the court system right now. They have been around for a while, but we think it’s worth exploring them a little.
The three cases are:
Novolex Holdings, LLC v. Illinois Union Ins. Co, Index No. 656825
This dispute centers around the seller’s knowledge of the intention of its third-largest customer to significantly reduce business. This is currently pending a decision on the Insured’s summary judgment motion.
WPP Group USA, Inc. v. RB/TDM Investors, LLC, Index No. 656825
This case centers on whether financial projections were misrepresented and is currently in discovery. It’s interesting to note that in the WPP case the insured had the right to decide between arbitration and litigation and chose litigation.
None of these cases are resolved at this point, and extensive discovery is expected. We, therefore, anticipate that unless a settlement can be achieved quickly or through arbitration, long-term disputes are likely to be the norm.
All relate to claims of more than $10 million. We would expect to see litigation come into play for higher limit claims and don’t see this trend moving down to smaller claims. All three cases relate either to the accuracy of financial statements or material customers. We hear from the market that claims around material customers are much more prevalent and rising recently. While this is not relevant to the above, we expect this cause of conflict to continue. Material contract claims are where we see Covid issues materialize in the sense that Covid is often the inciting incident leading to a failure of a supplier or the customer to be able to maintain existing conditions.
What does this mean for you? While these go through the courts, it will be interesting to see how this impacts the buyer’s desire to maintain the right to litigate in court, whether expressly or by remaining silent on venue options. We imagine insurers will resist, because by and large they want to arbitrate as the first port of call. In some cases, arbitration is the only method of dispute resolution.
Going Forward: RWI Trends to Keep an Eye On
The market has returned to early 2021 levels in terms of pricing and competition. We imagine this will continue into the foreseeable future as the war in Ukraine and domestic economics play out, affecting the M&A market and the number of submissions.
The market has come to terms with the Ukrainian situation far more nimbly than it did COVID-19 and we also expect this to continue.
We anticipate more negotiation and pressure on dispute resolution clauses and more diligence on material contract reps going forward.
An earlier version of this article appeared in the Woodruff Sawyer M&A Notebook.
On May 25, 2022, the Federal Trade Commission (“FTC”) filed in the U.S. District Court, Northern District of California, a Complaint against Twitter, Inc., and a Joint Motion For Entry Of Stipulated Order (signed by representatives for both parties), for civil penalties, permanent injunction, monetary relief, and other equitable relief. The primary underlying problem stemmed from Twitter’s allegedly deceptive use of account security data for targeting advertising: Twitter asked users to provide their phone numbers and e-mail addresses in order to protect the user’s account, and then Twitter profited by allowing advertisers to use this customer data to target specific users. As discussed below, Twitter, among other things, agreed to pay a $150 million penalty and agreed to stop profiting from its deceptively collected user data.
As alleged in the Complaint (¶27), “Twitter has prompted users to provide a telephone number or email address for the express purpose of securing or authenticating their Twitter accounts. … Twitter collected telephone numbers and email addresses from users specifically for purposes of allowing users to enable two-factor authentication, to assist with account recovery (e.g., to provide access to accounts when users have forgotten their passwords), and to re-authenticate users (e.g., to re-enable full access to an account after Twitter has detected suspicious or malicious activity). From at least May 2013 through at least September 2019, Twitter did not disclose, or did not disclose adequately, that it used these telephone numbers and email addresses to target advertisements to those users through its Tailored Audiences and Partner Audiences services.”
The Complaint references a 2011 FTC settlement Decision and Order concerning Twitter in which Twitter settled allegations that it had misrepresented the extent to which Twitter protected the privacy and security of nonpublic consumer information. That FTC Order, among other things, prohibited Twitter from misrepresenting the extent to which Twitter maintains and protects the security, privacy, confidentiality, or integrity of any nonpublic consumer information. Premised on that 2011 FTC order, the Complaint alleges (¶29): “More than 140 million Twitter users provided email addresses or telephone numbers to Twitter based on Twitter’s deceptive statements that their information would be used for specific purposes related to account security. Twitter knew or should have known that its conduct violated the 2011 Order, which prohibits misrepresentations concerning how Twitter maintains email addresses and telephone numbers collected from users.”
In addition to the $150 million penalty, the Agreed Stipulated Order provides, among other things:
Prohibitions against Twitter misrepresenting its data collection purposes and practices.
Limitations on Twitter of the use of phone numbers or e-mail addresses specifically provided by users to Twitter to enable account security features.
Requirement of notices to consumers concerning “Twitter’s Use of Your Personal Information for Tailored Advertising” alerting them that Twitter misused phone numbers and email addresses collected for account security to also target ads to the consumers, and to also provide information about Twitter’s privacy and security controls.
Requirement that multi-factor authentication options be made available to access the customer’s Twitter account. There are many other widely adopted industry authentication options that do not require the consumer to provide a phone number (e.g., authentication apps, security keys, etc.).
Requirement that Twitter maintain a comprehensive privacy and information security program that protects the privacy, security, confidentiality, and integrity of certain personal information (“Covered Information” as defined in the Order, ¶B) from the customer (e.g., first or last name, geolocation information, e-mail address, phone number, photos/videos, Internet Protocol address, User ID, Social Security number, driver’s license or other government issued ID, financial account number, credit/debit information, date of birth, biometric information, any combination of the above).
Twenty (20) years oversight by the FTC.
The bottom line is this FTC Stipulated Order should serve as a caution to businesses: (1) be crystal clear about the purposes for which they are requesting consumer information; (2) only collect such information consistent with applicable privacy laws; and (3) have strong internal compliance controls in place to ensure that the use of that information is limited to those lawful purposes.
The Loan Syndications and Trading Association was formed more than twenty-five years ago, and since that time its mission has been to create a fair, orderly, efficient, and growing corporate loan market that provides leadership in advancing and balancing the interests of all market participants. As part of that core mission, the LSTA’s legal team works to standardize agreements that are typically used by loan market participants. Over the years, the LSTA’s suite of documents has grown, and it currently stands in excess of 200 documents, all of which are available to members on the LSTA website.
The agreements in that library must, of course, periodically be updated to reflect the latest legal, regulatory, and market trends and developments. At times, the LSTA staff initiates a project to create or update one of the LSTA’s forms, and at other times, ideas percolate up from members. That is how the project to update the LSTA 2017 Form of Revolving Credit Agreement (the “Revolver”), which includes a letter of credit subfacility, arose. Once an idea is approved as a new project, the LSTA then works with one of its committees, comprised of interested members, to create or update a form. The process is typically lengthy because all members have a voice in the project. Once the committee has agreed to the draft, it is circulated as an Exposure Draft to all individual LSTA members (currently, about 25,000 people). At that stage, no substantive comments are expected, but often numerous questions about the form are submitted to the LSTA. After about approximately six weeks, the draft agreement is then published in final form.
Antitrust Concerns
As the LSTA is a trade association, LSTA staff are very aware of antitrust concerns as they work with members, many of whom are competitors in the loan market, to develop a new form, because the courts have deemed trade associations to be possible “hotbeds of conspiracy.” The antitrust laws are designed to ensure that business is conducted in an open, competitive atmosphere and that competition is not unreasonably restricted. The challenging aspect of complying with antitrust laws is that the general language in which the statutes are written does not specify the exact conduct that would be considered a violation. When the LSTA works to create a new form for members, it is well aware of these concerns and always bears them mind as the consensus-building process gets underway.
New members often query how we can create and agree on new forms without violating the antitrust laws. LSTA members are permitted to negotiate and even ultimately agree on the language in a finalized LSTA form and view the published language as acceptable. However, they are always free to negotiate that form for their individual deals. That is the key distinction, and that is why we can successfully standardize language and agreements for the market and not violate antitrust laws.
The Updated Revolver Letter of Credit Subfacility
The 2017 Revolver was the first complete credit agreement published by the LSTA. The real impetus to update that form came from an LSTA member who was also Chair of the American Bar Association Business Law Section’s Letters of Credit Subcommittee. Working closely with him and other LSTA members, the LSTA was able to agree on certain letter of credit–related modifications to the form. At the April 2022 CLE program on this topic presented at the ABA Business Law Section’s Hybrid Spring Meeting (now available for viewing as on-demand CLE), the panel explained the background as to how letter of credit subfacilities came to be included in syndicated revolving credit agreements and reviewed the modifications. Among other things, the modifications address a greater recognition of the role of the Issuing Banks as distinct from the Administrative Agent, Swingline Lenders, and Lenders, and emphasize the independence of letters of credit as separate from the credit agreement and other loan documents. The letter of credit–related modifications also include clarification of the availability of letters of credit for subsidiaries of the main borrower and provide express mention of the separate entity or branch separateness doctrine that treats branches of banks as if they were separate legal entities for certain purposes, including with respect to letters of credit.
LIBOR SOFR Transition
In addition, the LSTA form includes very important modifications to reflect the termination of LIBOR and the adoption of Term SOFR in the loan market. The form includes various options to allow for usage of spread adjustments for Term SOFR, when applicable and selected. Drafters have provided new definitions of Term SOFR and changes to operational provisions to reflect the rate change. Standard yield maintenance provisions, such as the breakage indemnity, increased cost provision, inability to determine rates section, and illegality provision, have been updated as a result of the usage of Term SOFR. Finally, the Term SOFR–referencing form includes updated benchmark replacement language (in the unlikely event that Term SOFR ceases or becomes non-representative).
This article is based on a CLE program that took place during the ABA Business Law Section’s Hybrid Spring Meeting 2022. To learn more about this topic, view the program as on-demand CLE, free for members.
The modern enterprise has access to large amounts of user data collected through numerous user mediums, databases, products, and servicing efforts. This vast data tranche is only as valuable as its use and application. Data can undoubtedly help engage more customers (or appropriate customers) with products tailored to need, but it can also mitigate risks, including preventing fraud loss, leftfield marketing, or personal bias in the underwriting process.
Cue in algorithms, including artificial intelligence (AI) and machine learning models, which are assisting in driving customer behavior. AI involves borrowing characteristics from human intelligence and applying those characteristics as algorithms in an automated fashion. Machine learning, a subset of AI, involves algorithms designed to identify data patterns to create rules, which improve over time based on continued experience.
Tech and financial services firms have only scratched the surface of the benefits that leveraging AI and machine learning bring to the industry. However, as AI further develops, entities must exercise caution, as data output is only as good as the input framework, and appropriate guardrails must be put in place.
Models are trained on historical data and may lack the ability to exercise judgment or apply context within environments in which they are initially deployed. In certain cases, it may not be possible to create a model that is intelligent enough to understand all possible scenarios and data. Despite intention, models that utilize AI and machine learning risk amplifying previously biased decision-making. This can create disproportionately negative effects on certain communities, particularly in credit underwriting. Complex relationships between seemingly unrelated variables, and the potential failure to understand the models’ conclusions, further lead to this risk.
It is paramount for institutions not only to understand AI-related risks, but also to develop appropriate governance, including processes and controls designed to effectively identify and manage risks and address adverse effects.
Dedicating sufficient resources to design, test, and manage AI and machine learning capabilities is table stakes. This requires a top-down approach, starting with the board of directors and senior management to ensure appropriate investments, commensurate with the size and complexity of the organization, are being made in capabilities that support AI and machine learning as well as risk management. Independent risk management functions (the second line of defense) and internal audit (the third line of defense) will be increasingly important.
Regulatory AI strategy continues to take shape, while still lagging behind industry use. In March 2021 the federal banking agencies issued a Request for Information seeking to better understand how AI and machine learning are used in the financial services industry and to identify areas where additional “clarification” could be beneficial. The Federal Trade Commission (FTC) has also issued guidance on the use of AI tools, such as in an April 2020 blog post, in which the FTC highlighted the importance of AI transparency. More recently, in October 2021, the White House Office of Science and Technology Policy announced the development of an “AI bill of rights,” designed to protect consumers from harmful AI consequences. In light of the growing regulatory focus, enterprises should understand risk around using AI and ensure appropriate governance.
Incorporating alternative data in each area of the product life cycle continues to provide important insight on identity, authentication, financial behavior, and collections potential. Although AI holds incredible promise, especially in financial services, there are also risks that each firm must be aware of and account for. These risks are both surmountable, and worth the effort. As regulator eyes continue to focus on AI, those building the algorithm, along with those governing its use, must sharpen the pencil to prevent blind spot results and promote equitable outcomes.
Views expressed are the authors’ alone.
This article is based on a CLE program that took place during the ABA Business Law Section’s 2022 Hybrid Spring Meeting. To learn more about this topic, view the program as on-demand CLE, free for members.
On February 24, 2022, Russia launched what President Biden aptly termed “a brutal assault on the people of Ukraine without provocation [and] without justification.” The conflict has cost thousands of lives—countless civilians among them—and displaced millions, including almost two-thirds of Ukrainian children, according to UNICEF.
The war has also “caused severe economic dislocation” across global markets, with “record” U.S. gasoline prices, European gas six times dearer than last year, and skyrocketing food costs that risk the “greatest global food security crisis of our time.”
Now, the crisis may take on an additional dimension with Russia nearing a historic default on its sovereign debt.
Following the invasion, the United States, its NATO allies, and other nations around the world punished Russia with “unprecedented” sanctions, all but cutting it off from the global economy. One linkage between Russia and the financial system has remained, however: Russia’s sovereign bonds—contractual obligations to make payments to investors, largely based in the U.S. and Europe.
Prices for Russia’s bonds have collapsed, trading below 25 cents on the dollar, down from above 105 at the start of the year. In less than three months, Russia has already been on the brink of default twice, making payments with less than a day to spare earlier in May.
The situation is unique for a host of reasons—not least of which is the fact that Russia has the money. Sanctions, however, have circumscribed its ability to make payments to limited safe harbors, the most crucial of which allows U.S.-based investors to receive interest payments from Russia. That provision expires May 25, and the U.S. Treasury has indicated that it will not be renewed.
With Russia’s next interest payments due May 27, subject to a thirty-day grace period, a default appears increasingly likely. Such a default on foreign debt would be Russia’s first in over a century; in 1998, it defaulted, but only on domestic currency debt.
This article analyzes Russia’s debt structure, including certain key bond provisions; describes the interplay between sanctions and Russia’s payment obligations; and previews potential issues arising from a default—if one comes to pass.
Russian Debt Overview
Russia has total sovereign debt of just under $300 billion—a relatively “ low” level, in the IMF’s view, corresponding to about twenty percent of its $1.5 trillion GDP. (U.S. sovereign debt, by comparison, totals about 123.4 percent of GDP.)
Like many sovereigns, Russia has both so-called “local,” domestic-currency denominated debt, and foreign debt, denominated in U.S. Dollars and Euros.
The vast majority of Russia’s debt, totalling about $250 billion, is Rouble-denominated. In addition, as detailed in the table below, Russia has about $37.3 billion of foreign debt, with $31.7 billion denominated in dollars and 5.25 billion in Euros. The USD debt was issued across ten different series, maturing between 2023 and 2047; the Euro debt is in four series, maturing between 2025 and 2036.
Russia has about $37.3 billion of foreign debt, with $31.7 billion denominated in dollars and 5.25 billion in Euros. Source: Bloomberg data, CBonds data, and review of underlying bond documents.
Before February’s invasion—and notwithstanding sanctions after its 2014 annexation of Crimea—Russia was considered a reasonably safe credit, with a “still-strong balance sheet and increasingly robust external position.” This in large part reflected Russia’s $600 billion of foreign reserves, in theory more than sufficient to repay all of the nation’s debts.
Then, in one day, everything changed.
The chart below, based on Bloomberg data, shows the impact of Russia’s February 24 invasion (denoted by the red oval) on prices of sovereign bonds issued by Russia (in white), Belarus (blue), and Ukraine (gold). All three sets collapsed following Russia’s invasion.
Bonds issued by Belarus, Russia’s close ally, have been hardest hit, falling from near-par in January to 14.53 cents on the dollar by mid-May. Ukraine’s bonds fell below thirty cents on the dollar in early March, but subsequently recovered to the mid-40s by May. Russia’s obligations—many of which traded above par pre-invasion, reflecting relatively generous coupons—collapsed towards the thirties by mid-May and fell further this week.
Sovereign bonds issued by Russia, Belarus, and Ukraine all collapsed following Russia’s invasion (denoted by the red oval). Chart based on Bloomberg data.
According to IMF estimates, about three-fourths of Russia’s debt is held by domestic investors, still leaving nearly $75 billion in the hands of foreign financial institutions.
Based on Bloomberg data, the single largest holder of Russian debt is Allianz, the German insurer and asset manager, with nearly $3.2 billion across rouble, Euro, and USD-denominated bonds. The next four largest are U.S.-based investment complexes: Capital Group, with $1.31 billion, Vanguard ($868 million), Legg Mason ($837 million), and Western Asset Management ($807 million).
Dozens of prominent European, Canadian, and Japanese investment groups—including, somewhat paradoxically, many ESG-focused vehicles—have respective exposures in the hundreds of millions. Because of this, a potential Russian default will impact investors around the world.
Key Contractual Provisions
“These are the worst-written contracts I have ever seen on the international markets,” observed a preeminent sovereign debt scholar. Indeed, the “booby-trapped” agreements include materially off-market provisions, appearing to, all things being equal, confer significant advantages to the issuer. For instance, “the bonds lack a waiver of sovereign immunity and, while they are nominally governed by U.K. law, they don’t appear to submit to a jurisdiction,” making enforcement much more difficult.
For our purposes, the contracts’ most distinctive provisions concern the relevant payment currency. Typically, this dimension of sovereign bonds is not much of a moving target, with the applicable currency clearly specified. Indeed, while intensive sovereign debt–related conflicts are not uncommon, the fracas usually center on other provisions, such as Argentina’s now-infamous pari passu clause.
Russia’s bonds, however, contain a relatively unique “Alternative Payment Currency Event” provision. The language purports to allow Russia to make payments in a currency different than the one specified in the event of “reasons beyond its control.”
In this respect, Russia’s outstanding obligations can be separated into three sets: (i) bonds predating the 2014 Crimea invasion, without any “Alternative Currency” provision; (ii) post-2014 bonds allowing for USD payments to be made in European currencies; and (iii) post-2018 bonds, contemplating payments in roubles.
Specifically, the second set of “post-Crimea invasion” bonds provide the following language:
[I]f, for reasons beyond its control, the Russian Federation is unable to make payments of principal or interest (in whole or in part) in respect of the Bonds in U.S. dollars (an “Alternative Payment Currency Event”), the Russian Federation shall make such payments (in whole or in part) in Euros, Pound sterling or Swiss francs (the “Alternative Payment Currency”) (emphasis added)
The post-2018 vintages go a step further, providing that:
“[N]otwithstanding any other provisions in the relevant Conditions, if, for reasons beyond its control, the Russian Federation is unable to make payments of principal or interest (in whole or in part) in respect of the New Bonds in U.S. dollars, the Russian Federation shall make such payments (in whole or in part) in euros, Pound sterling or Swiss francs or, if for reasons beyond its control the Russian Federation is unable to make payments of principal or interest (in whole or in part) in respect of the New Bonds in any of these currencies, in Russian roubles on the due date at the Alternative Payment Currency Equivalent (as defined in the relevant Condition 7) of any such U.S. dollar-denominated amount. (emphasis added)
In other words, the post-2018 vintage USD-denominated bonds provide two sets of fallbacks, essentially stating that: (i) the obligations should be paid in USD, unless (ii) “for reasons beyond its control” Russia cannot use USD, in which case the payments will be made in “Euros, Pound sterling or Swiss francs”; unless (iii) for additional “reasons beyond its control” Russia cannot use those currencies, in which case the payments will be made in Russian roubles.
One impact of these provisions is that bonds with the Rouble fallback were determined ineligible as “deliverable obligations” by the Credit Derivatives Determinations Committee.
It is difficult to parse the evolution of this language without inferring a degree of premeditation in respect of anticipated future sanctions—why else would one include such oddly specific provisions?
Post-Invasion Sanctions
Following Russia’s invasion of Ukraine, the U.S. led a plurality of the world’s advanced economies in enacting a sanctions regime against Russia “unprecedented to a scale and scope that we haven’t seen since the Cold War.”
The restrictions span everything from terms of trade to asset ownership and participation in cultural events, such as the Eurovision competition, which Ukraine won. Along with the Russian state, the sanctions also target related entities, leading to financial stress at a range of companies, such as steelmaker Severstal.
Prior to the invasion of Ukraine, Russia stockpiled vast reserves totalling $630 billion, with nearly $500 billion in foreign currencies and the balance in gold. Indeed, in late January, before the invasion, The Economistobserved that Russia’s cash pile was “more than enough to weather sanctions.”
However, in a strategy “beyond comparison to previous sanctions regimes, particularly involving a major power like Russia,” the U.S. and its allies deployed sanctions targeting Russia’s central bank and its assets worldwide, precluding Russia from utilizing as much as half of its total reserves.
The sanctions regime is largely made operable through directives to financial intermediaries, in this case essentially prohibiting them from transacting on behalf of the Russian central bank.
The interplay between the sanctions regime and Russia’s bond payment obligations has raised unique legal and commercial considerations.
Following its invasion of Ukraine, Russia had two sets of payments due on its foreign bonds—both of which were ultimately paid following down-to-the-wire acrobatics.
The first set of payments was due on March 16. Russia was able to make the payment using its now-frozen foreign reserves.
The second payment, due April 4 for a total of about $2 billion in principal and interest, came far closer to default, following the U.S. Treasury’s decision to block Russia from using its foreign reserves to make the payment. Russia initially tried to pay in roubles; however, this was deemed impermissible. At the very end of the bonds’ thirty-day grace period, Russia made the payment in dollars, avoiding a formal default by the narrowest of margins.
Interest Payments Carve Out Expiration
Thus far, investors have been legally permitted to receive payments on Russia’s bonds because of a carve-out to the sanctions regime. According to the U.S. Treasury FAQ regarding Russian debt transactions:
GL 9A also authorizes U.S. persons to receive interest, dividend, or maturity payments on debt or equity of the Central Bank of the Russian Federation, the National Wealth Fund of the Russian Federation, and the Ministry of Finance of the Russian Federation through 12:01 a.m. eastern daylight time on May 25, 2022.
On Tuesday, May 17, the U.S. Treasury indicated that this safe harbor would not be extended. “After May 25, 2022, U.S. persons would require a specific license to continue to receive such payments” in respect of Russian bonds. Treasury Secretary Yellen stated that “[w]e’re actively involved in an evaluation of the risks and impact of not renewing the license.”
This is particularly significant because Russia has two payments due on May 27. Though the contracts include a customary interest payment grace period, it is not clear how Russia would be able to deliver the payments.
The chart below, from the Bloomberg Terminal, shows Russia’s sovereign CDS curve as of May 19 (green) and a week prior (yellow). Two observations are particularly notable. First, the term structure is highly inverted, with near-term credit default swaps much more expensive than longer-dated protection, suggesting market perception of a near-term risk. Second, the change between the two lines illustrates the impact of the waiver expiration, with the market now pricing in a much higher likelihood of a Russian default.
Russia’s sovereign CDS curve as of May 19 (green) and a week prior (yellow). The change between the two lines illustrates the impact of the expiration of the safe harbor permitting U.S. investors to receive payments on Russia’s bonds. Chart from the Bloomberg Terminal.
What happens next? If Russia indeed defaults on its debts, a fight with its creditors appears almost certain. However, the outcome would be far from clear, in no small part due to the bonds’ distinctive provisions—as well as the unique dispositions of the debtor.
An additional, potentially underappreciated conflict may also loom. Many commentators have suggested using Russia’s frozen reserves to help rebuild Ukraine—which the Kremlin has decried as “theft.” Yet, those assets would, at least ostensibly, also represent a viable source of payment for bondholders, creating the risk of a zero-sum outcome with potentially profound normative and policy implications.
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