By:
Anthony J. Coleby
London
The trading market in the debt and securities of financially distressed companies is very significant in terms of volume both in the United States and the United Kingdom/Europe. Most recent figures show annual trading volume in the U.S. market at US$25 billion. For various reasons, the most important of which is the need to establish the unconditionality of asset transfers for accounting and regulatory purposes, the remedies of sellers and purchasers under the sale agreements governing trades in that markets are confined to the recovery of damages for breach of warranty and related indemnities.
There are significant differences in how the U.S. and U.K. markets deal with this remedial straitjacket. These differences centre on the extent to which preceding transactions in the same asset are relevant to a particular trade. Access to the benefit of warranties given by previous sellers in particular may mitigate the limitation of contractual remedies referred to above by giving the purchaser a choice of people to sue if a representation proves untrue.
What follows summarizes the position in both the U.S. and U.K. contexts (with the approach of both vendor and purchaser being deliberately polarized to highlight the various differences that exist) and then briefly analyses the reasons for the differences between them.
General Position in English Law and Practice
The vendor's position is that antecedent transactions in the asset are the vendor's concern alone.
The vendor also argues that the purchaser should accept the warranties that the vendor feels able to give as a "snapshot" of the period of time that the vendor has held the asset. Increasingly, as a fallback position, vendors seek to cap their potential warranty liability to an amount not exceeding the amount of purchase price they receive.
If the vendor has held the asset for a short time only, the vendor will give "objective" warranties (as to title, etc.) solely in respect of its period of tenure and, if required to abandon that limitation, will only give such warranties beyond its period of ownership on the basis of "best knowledge," etc. in respect of the period of tenure of its predecessor-in-title ("PIT"), preferably with no duty of enquiry in respect of facts beyond that time (also, PITs are rarely identified by name).
If the vendor's warranties prove to be incorrect and liability is asserted against the vendor, then the vendor will argue that it is the vendor's decision, and nobody else's, as to whether an action is brought against its PITs and, if it is, that only the vendor may instigate such action.
The purchaser will usually be given rights to onsell assets, but on the basis that it keeps confidential the terms of its assignment agreement with the vendor. Assignment of rights under that assignment agreement (including the benefit of vendor warranties) is strongly resisted or granted only on the basis that assignee (purchaser's buyer) assumes the purchaser's obligations under the original assignment agreement at the same time or, at the very least, it is clearly understood that the purchaser continues to be fully obligated to the vendor under the original assignment agreement.
he vendor will resist the possible alternative (originating from the U.S.) that the vendor should agree to accept a retransfer of assets adversely affected by a breach of warranty at the original purchase price plus purchaser's cost of funds, arguing that to agree to this would mean that the "true sale" required by its regulators to remove the assets from its balance sheet would fail. The vendor will generally not go beyond a disgorgement indemnity to purchaser where the purchaser is required by law to pay back amounts received in respect of the assets under the avoidance provisions of the applicable insolvency regime (although such a requirement would give the purchaser the right to claim for breach of warranty where the vendor has given a "claim impairment" warranty).
General Position under New York Law and Practice
If the vendor is not able to give full warranties in this way, then the purchaser must have recourse to all parties who can. Generally, a cap on potential vendor warranty liability is not acceptable to purchasers -- the original purchase price may not represent the potential quantum of purchaser's loss (note, though, that under both English and NY law there is an issue here on commercial benefit -- if the vendor's liability can substantially exceed in money's worth the benefit it derives from the transaction, the transaction could be subject to stockholder/third party creditor/ liquidator/trustee challenge pre- or post- insolvency; these are similar to rules governing fiduciary/trustee sellers and their duty to obtain the best deal.)
Best knowledge basis in respect of PIT tenure for vendor warranties is acceptable only if the purchaser secures an equitable assignment of immediate PIT's warranties.
The purchaser will want to pursue PITs for warranty claims (and will seek to do so by perfecting its equitable title); in doing so, the purchaser may allow the vendor to join in if the vendor pays its own litigation costs and the choice of litigation counsel remains with the purchaser; at the very least, it will wish to direct any proceedings that the vendor may bring against PITs. The purchaser will generally be prepared to concede a right of subrogation vis-à-vis PITs for the vendor if the vendor pays out in full, together with a re-assignment to the vendor of title to the benefit of the PIT warranties.
The purchaser will seek a full assignment of rights under the preceding assignment agreement (plus, for participations, an acknowledgment that it retains the benefit thereof). In relation to this, it will expect to see all upstream documents, the only non-disclosed detail being the purchase rate/purchase price under the prior transactions.
Analysis of differences
The difference between the two approaches stems from three principal sources:
(1) the comparative lack of structural sophistication in the U.K. market compared with the U.S. In the U.K., annual market turnover remains a fraction of that found in the U.S. The emergence of the broker in trades in the U.S. market was largely a function of high market activity. By comparison, the broker is relatively a new player in the U.K. forum. The culture of the U.K. market continues to be based on principal to principal trades, with assets being purchased for investment (note, though, that the much less demanding capital adequacy requirements under the EU Capital Adequacy Directive for assets held in the trading book of investment banks, compared with those applicable to assets on the banking book, will likely mean this approach will change for economic reasons).
Hence, in the U.K. market, assets are generally held for longer, leading vendors to expect objective warranties from themselves alone to be sufficient protection for purchasers -- the significance of upstream documents is thereby much reduced: the vendor maintains, "if they don't need to see 'em, they won't see 'em."
The principal to principal structure persists in the U.K. market -- brokers introduce and do not intermediate themselves as first tier buyers. Thus, the related issue of recourse to PITs arises far less often in the U.K. market than in its U.S. counterpart;
(2) A deep-rooted need to counterbalance the requirement under U.S. securities laws for the purchaser to concede that it is a sophisticated buyer and has reached an independent investment decision to buy by extracting as much upstream comfort as it can from the vendor and its PITs in respect of the assets. In both U.K. and U.S. practice, it is understood that recourse by the purchaser to the vendor must be limited to claims in breach of warranty and under the related indemnities; however, the additional emphasis provided by applicable U.S. securities laws on the purchaser's independent appraisal of the transaction overall and its independence of the vendor in turn places greater significance on the extent to which the purchaser may obtain contractual comfort in respect of the pedigree of the Transfer Assets concerned; and
(3) The U.S. investor's perception of distressed debt assets as just another category of "paper," along with bonds, commercial paper, futures, options and bills of exchange. Recourse to PITs in the U.S. market is regarded as a form of credit enhancement, very similar to rights to the benefit of leveraged or collateral LCs and against the acceptors and endorsers of commercial bills. In the U.S. broker dominated market this perception further distinguishes the market from its U.K. counterpart where, for 10 years, traders in distressed debt have sought to develop an efficient means of debt title transfer and all that has been achieved is the Transfer Certificate or Novation Notice with title passing by transfer in the books of the facility agent -- but the reasons for the U.K. market persisting in the use of such a lumbering beast with which to complete trades are part of another story.
