Noisy Signals The following was excerpted from Third Eye Capital Management Inc.’s Q1 2019 Investor Letter

The latest credit outlook survey of the International Association of Credit Portfolio Managers (“IACPM”), a global membership of more than 100 banks, insurance companies and asset managers, indicates that recession fears have eased. The IACPM’s index was at a neutral -3.3 in Q1-2019 compared to the previous quarter index score of -38.4. Members changed their credit outlook by the largest amount in nearly four years. During the financial crisis, the index reported a low of -69.1. The biggest reason for the improvement was the dovish signal by the U.S. Federal Reserve (“Fed”) on rates, which likely reduces volatility in credit markets and the impact on access to financing.

LCD, a unit of S&P Global, released its Q1-2019 default survey of buyside credit managers, which saw default rate forecasts being trimmed after the Fed’s surprise reversal on monetary policy normalization: 1.82% for the end of March 2020, down from 2.12% in the Q4-2018 survey. Investor sentiment has improved since the end of 2018 but it is not expected to last. The same LCD survey showed 75% of managers predicting loan defaults to climb above the historical average of 3.1% in 2021 – this is up from 42% in the previous quarter. No respondents expected it would take longer than 2022 for the default rate to eclipse the historical average; this is a sharp contrast from the previous read when 17% of credit managers were more optimistic. Default conditions remain benign for the time being, but LCD notes more dispersion in pricing and terms based on actual credit risks.

In the broadly syndicated markets, the share of issuers rated B+ or lower accounted for half of all U.S. leveraged loan issuance over the past six months, down from a high of 68% in the third quarter. In Q1-2019, 80% of non-bank institutional volume of issuers rated B+/B was priced at spreads 350 basis points or more above LIBOR. This is close to double the percentage volume for similar spreads on average in 2018. Looking at issuers in the S&P/ LSTA Leveraged Loan Index that file results publicly (approximately 18% of the index), weighted-average leverage fell and cash-flow coverage increased in the first quarter of this year.

In direct lending markets in the U.S., large non-bank players have reported higher spreads and better documentation as a result of the Q4-2018 volatility. At last, it appears that lenders are becoming more discerning. Maybe not.

Borrower-friendly conditions are not positioned to change despite the first quarter “noise” in the credit markets. Already, in April 2019, the share of deals in the leveraged loan markets that saw interest rates and fees be cut in favor of borrowers, reached a one year high. This is symptomatic of a market where lender demand for deals overwhelms supply.

We think the Fed’s recent shift will amplify the already extreme speculation in credit markets. Investors have, not surprisingly, become complacent in thinking that that Fed will save them from the negative financial consequences of bad investment decisions. The GFC did not end because of the Fed – it began because of them. Intense yield-seeking speculation in mortgage-backed securities by investors seeking cover from a prolonged monetary policy of low interest rates largely caused the last global recession. Now, the Fed’s actions are encouraging even more yield-seekers but this time across diverse securities, mostly illiquid and with greater implications to a larger part of the economy.

Blaming the Victim
An inevitable aftereffect of any credit downturn will be a sorting out of fault and liability for failed borrowers. Lenders will be depicted as one of the primary villains, accused of putting their own interests – to be repaid – ahead of the interests of its borrower, other creditors, employees, shareholders and the community at large. Moreover, because the number of affected parties could be significant, lenders risk being exposed to class action suits. This is not a theoretical scenario – there are several examples of aggressive lender liability claims against lenders following economic and industry recessions. In 1986, for example, the Hunt Brothers of Dallas, Texas filed a $3.6 Billion lawsuit against their lenders on theories, among others, of fraud, breach of fiduciary duty, duty of good faith, and breach of contract after defaulting on a $1.5 Billion loan that was hastened by a collapse in silver markets. After the dot-com crash in 2000, massive litigation was filed against lenders in cases involving Enron, Adelphia and WorldCom. More recently, during and after the GFC, several lenders including Citibank, Credit Suisse, Bank of America, and Goldman Sachs, were sued for various alleged violations such as refusing to advance funds, manufacturing a default, interfering with a contract, and deepening insolvency. Every case involved some attempt by a borrower or its unsecured creditors to blame the company’s lenders for its distress.

Lenders have big targets on their backs because of their deep pockets. It is very common in U.S. insolvency proceedings to see threats of litigation made against lenders. In Canada, this practice is rare, in part because court-appointed receivers and monitors are reluctant to take actions against banks that are regular clients representing long-term recurring business. The same courtesy may not be extended to alternative lenders, especially those without established reputations and track records.
Lenders have typically been swift to settle lawsuits against them to avoid bad publicity. In contrast, we have been more aggressive in defending litigation and do not want to set precedents with borrowers that we can be extorted to reduce legitimate loan obligations and allow defaulted borrowers to obtain a windfall recovery to which they would not normally be entitled. In a case that the courts resolved last year, a CEO who personally guaranteed one of our loans accused us of failing to honor a loan modification and charging usurious rates (the maximum allowable interest rate in Canada is 60%), which the CEO claimed led to the failure of his company. The CEO sought to void our loan entirely. After mounting a rigorous defense and refusing to negotiate any settlement that involved TEC paying out monies or reducing the amount of debt owed, we prevailed against the CEO. The judge rejected the claims because there was no evidence supporting the CEO’s case. The court correctly distinguished between us legitimately trying to protect our risk exposure and acting in bad faith.

 

There are two key reasons why the conduct of alternative lenders will be heavily scrutinized in the next recession. First, there are more of them than in any time of history – banks in the U.S. are outnumbered by a factor of ten. Secondly, alternative lenders generally have private investors, do not publicly report their activities, and are less sensitive to reputational risks. Alternative lenders will be more likely to intentionally interfere with the economic relationships of borrowers that default and take control of their operations and business affairs. Unfortunately, even if their objective is to mitigate losses, alternative lenders found to be acting too earnestly or aggressively will risk being sued and liable. It is rare in the context of any lending relationship that a lender owes a fiduciary relationship to a borrower – their relations are governed by a contract. However, if the lender takes actions that alters the relationship into one that becomes “special” (1) based on excessive control or domination, then the lender will owe greater duties to the borrower than set out in the loan documents.

Alternative lenders tend to be more hands-on about monitoring business operations of its borrowers than their non-bank counterparts. If a lender, in the course of its monitoring, exerts control over the day-to-day operations of a borrower such that it effectively becomes a part of management then a special, fiduciary duty-creating, relationship could exist. Actions that could trigger liability to a lender include board representation, directing which payables the borrower must pay and when, dictating product pricing, and negotiating business contracts. While there are several examples in U.S. jurisprudence whereby courts have found lenders liable for damages resulting from taking control of a borrower’s affairs, the Canadian experience has been much different and more favorable to lenders. In Canada, courts have identified key hallmarks constituting operational control (2):

(i) veto over management decisions; (ii) positioning lender’s personnel in borrower’s management; (iii) ownership of voting shares; and (Iv) effective control over borrower’s business.

Generally, unless all of these facts existed, a lender did not owe a fiduciary duty to the borrower. In our position as primary secured creditor, we have the capacity to exert great pressure and influence – after all, such power is inherent in any lender-borrower relationship. The existence and exercise of such power, alone, does not constitute control. Merely participating in control, even active management, is insufficient. The lender must have absolute control to be liable. Borrowers have the onus of proving that even if lender control is present that such control was misused and caused them harm.

A paramount consideration in assessing lender liability are the contracts governing the lender-borrower relationship, namely the loan agreement and the security documents. Claims against lenders will pose difficulties for borrowers if the lender is acting in accordance with its contractual rights and in the interest of protecting such rights. TEC routinely receives equity in the borrowers that it finances in consideration of the value-added services provided but it does not use this equity to exert control – the purpose of the equity held by TEC is compensation for adding value. Our loan and security documentation provide a broad set of covenants and remedies, and our actions flow from the rights granted by the documentation. It is when a lender deviates from the loan contract that its responsibilities to a borrower and other claimants increase.

We are constructivists. We exert a large degree of influence and prioritize having the best management teams running the companies in which we invest. However, we do not wait for the phone to ring when borrowers want our input; instead, we share ideas, raise issues, challenge assumptions, and ask questions to ensure management teams are stretching their thinking and utilizing our knowledge and networks to maximize value. We engage in collaborative discussions with management but ultimately the borrower is accountable for its decisions and responsible for execution.

As the number of non-performing loans increases from the impending credit market reset, alternative lenders, even the best-intentioned ones, will find themselves in situations where they will have to defend against potential liability risks associated with their decisions. The facts of the particular lender-borrower relationship will be critical in assessing exposure, especially as the chorus of borrowers trying to avoid liability for their debts and divert blame by alleging lender misconduct and fiduciary duty increases. Private debt managers and their investors should re-examine the loan and security documentation underlying their loan portfolios in order to ensure that the contracted rights and remedies match the activities and conduct of the managers.

 

1 Scavarelli v. Bank of Montreal, Ontario Superior Court, 2004. The general rule in Canada is that the relationship between borrower and lender does not give rise to a fiduciary obligation owed by the lender absent “special circumstances.”

2 Royal Bank of Canada v. Woloszyn, Federal Court of Appeal, 1998. The court found that there was no operational control where the lender had a security interest in the assets of the borrower.


Third Eye Capital Management Inc.