naked capitalism

A reader provided a link to a post by Institutional Risk Analytics, which in turn cites a merger filing by Bank of America with respect to its plan to acquire Countrywide. The document details what can only be called a scheme by which Bank of America intends to acquire Countrywide (specifically, the FDIC insured entity) but leave the debt behind.

Now I am not a bankruptcy expert, nor am I current on the state of the art in M&A, but the intent of this deal flies in the face of a fundamental precept of well established practice. A huge no no is what is called fraudulent conveyance, and this deal is a clear, flagrant effort to do precisely that.

Wikipedia provides a very good explanation. Forgive me for giving you the long form, but I believe details are important, and reading this (in conjunction with the post from IRA, which follows) should make clear how egregious Bank of America’s plans are. I am not at all impressed with the use of a Delaware LLC “merger sub” to accomplish the asset-stripping. This isn’t a terribly complicated structure, and the intent and the effects are crystal clear.

Even if the regulators sign off (very bad precedent, but anything is possible given the weird reluctance to let CFC fail), expect a lot of private lawsuits. Again, I am no expert, but if the plaintiffs can get their case in front of a bankruptcy judge, I don’t imagine there will be much sympathy for Bank of America’s position.

The problem is that the initial purchase of 20% of Countrywide by Bank of America was a bad move, and they are now trying to throw more money at it to validate their original buy (this phenomenon is called irrational escalation). Remember, CFC was very close to bankruptcy when Bank of America stepped in the first time. But the only valuable and comparatively trouble-free part of the mortgage lender was its servicing business. That would clearly be sold out of bankruptcy to the highest bidder. But rather than have to pay a full price for a good asset (and the business going for a top price now looks doubtful, given how many banks are shedding assets to raise capital), Bank of America instead tried to get control of the situation by taking a blocking position in the form of its stake in Countrywide.

Moral of the story: No one has ever come out a winner trading against Angelo Mozilo.

From Wikipedia:

A fraudulent conveyance, also fraudulent transfer is a civil cause of action. It arises in debtor/creditor relations, particularly with reference to insolvent debtors. The cause of action is typically brought by creditors or by bankruptcy trustees. The usual fact situation involves a debtor who donates his assets, usually to an “insider”, and leaves himself nothing to pay his creditors as part of an asset protection scheme. However, it is not uncommon to see fraudulent conveyance applications in relation to bona fides transfers, where the bankrupt has simply been more generous than they should have or, in business transactions, the business should have ceased trading earlier to avoid giving certain business creditors an unfair preference (see generally, wrongful trading). If prosecuted successfully, the plaintiff is entitled to recover the property transferred or its value from the transferee who has received a gift of the debtor’s assests.

There is an old equitable maxim: “One must be just, before one is generous.”

Fraudulent conveyances or transfers in the United States

In the United States, fraudulent conveyances or transfers[1] are governed by two sets of laws that are generally consistent. The first is the Uniform Fraudulent Transfer Act[2] (”UFTA”) that has been adopted by all but a handful of the states.[3] The second is found in the federal Bankruptcy Code. [4]

There are two kinds of fraudulent transfer. The archetypical example is the intentional fraudulent transfer. This is a transfer of property made by a debtor with intent to defraud, hinder, or delay his or her creditors.[5] The second is a constructive fraudulent transfer. Generally, this occurs when a debtor transfers property without receiving “reasonably equivalent value” in exchange for the transfer if the debtor is insolvent[6] at the time of the transfer or becomes insolvent or is left with unreasonably small capital to continue in business as a result of the transfer.[7] Unlike the intentional fraudulent transfer, no intention to defraud is necessary.

The Bankruptcy Code authorizes a bankruptcy trustee to recover the property transferred fraudulently[8] for the benefit of all of the creditors of the debtor[9] if the transfer took place within the relevant time frame.[10] The transfer may also be recovered by a bankruptcy trustee under the UFTA too, if the state in which the transfer took place has adopted it and the transfer took place within its relevant time period.[11] Creditors may also pursue remedies under the UFTA without the necessity of a bankruptcy.[12]

Because this second type of transfer does not necessarily involve any actual wrongdoing, it is a common trap into which honest, but unwary debtors fall when filing a bankruptcy petition without an attorney. Particularly devastating and not uncommon is the situation in which an adult child takes title to the parents’ home as a self-help probate measure (in order to avoid any confusion about who owns the home when the parents die and to avoid losing the home to a perceived threat from the state). Later, when the parents file a bankruptcy petition without recognizing the problem, they are unable to exempt the home from administration by the trustee. Unless they are able to pay the trustee an amount equal to the greater of the equity in the home or the sum of their debts (either directly to the Chapter 7 trustee or in payments to a Chapter 13 trustee,) the trustee will sell their home to pay the creditors. Ironically, in many cases, the parents would have been able to exempt the home and carry it safely through a bankruptcy if they had retained title or had recovered title before filing.
Even good faith purchasers of property who are the recipients of fraudulent transfers are only partially protected by the law in the U.S. Under the Bankruptcy Code, they get to keep the transfer to the extent of the value they gave for it, which means that they may lose much of the benefit of their bargain even though they have no knowledge that the transfer to them is fraudulent.

Now from “Are Countrywide Financial Bonds Bankruptcy Remote?” from Institutional Risk Analytics:

The announced acquisition of Countrywide Financial (NYSE:CFC) by Bank of America (NYSE:BAC) was in doubt on Friday because of reports that BAC may back away from the deal. Pity CFC shareholders, who are selling at something like 5% of book value (and this for BAC paper), but we wonder how many of the CFC bond holders understand that they may face an equal or greater haircut.

The CFC 6.25%s of 2016 closed at 79.125 on Friday or over a 10% YTM. The pricing reflects the expectation that BAC will assume responsibility for the CFC debt at par. But after hearing from some bankers in the know and reading the “Agreement and Plan of Merger” filed with the SEC by BAC last week, we think that CFC bond holders will soon get the joke.

Usually, when a company acquires another, the former assumes the debt of the latter and agrees to make timely payments of interest and principal as previously contracted. In the case of BAC’s purchase of CFC, however, BAC seems to view the transaction as an option.

Bankers who’ve been briefed by BAC officials tell The IRA that CEO Ken Lewis intends to keep the crippled thrift holding company “bankruptcy remote” by merging CFC with a new vehicle, called Red Oak Merger Corp in the merger plan, and that BAC does not intend to consolidate the entity or take full responsibility for the CFC debt.

According to the plan: “…at the Effective Time, [CFC] shall merge with and into Merger Sub. Merger Sub shall be the Surviving Company in the Merger and shall continue its existence as a limited liability company under the laws of the State of Delaware.” (BAC public affairs officials Kevin Stitt and Pamela Black did not respond to written questions sent by The IRA via email on Thursday.)

The implication is that BAC eventually will take direct ownership of the FDIC insured Countrywide Bank FSB, which now has assets of some $130 billion, leaving the remaining assets of the formerly public CFC and a good chunk of its $105 billion in parent level debt at risk of an eventual default. BAC officials are reported to have said that BAC’s deposit base and debt issuing power offer significant funding advantages to CFC, but also said that BAC will keep the target separate for an “interim period” of indeterminate duration.

FDIC insured banks, you see, cannot file bankruptcy. Were BAC to even contemplate putting the company formerly known as CFC into Chapter 11, it would first need to move Countrywide Bank FSB to a different part of the BAC group. Otherwise, when BAC was about to file the Chapter 11 petition, the Office of Thrift Supervision would intervene and invoke its statutory authority as the bank’s primary regulator to appoint the FDIC as receiver of the bank, potentially stripping BAC of its entire equity investment.

Readers of The IRA will recall our fascination with the televised interview between the money honey, Maria Bartiromo, and CFC co-founder and honcho Angelo Mozillo, the bronze god of affordable housing. Last September, we described (”When Flying to Quality, Be ‘In the Bank’”, September 10, 2007) why the phrase “in the bank” was so significant to investors holding CFC debt and equity.

According to statements allegedly made by BAC officials during private conference calls held over the past two weeks, statements which are nowhere to be found in BAC’s public disclosure filed with the SEC, the CFC debt is expected to be “assumed not guaranteed,” this under the theory that “the biggest risk at CFC was liquidity and that when the deal closes, that risk goes away,” according to a banker involved in the conversations.

The BAC strategy is reportedly to manage the orderly liquidation of CFC, excluding Countrywide Bank FSB, and to guarantee payments of interest and principal so long as the remaining non-bank assets and liabilities of CFC support same. The BAC officials reportedly expressed the view that keeping CFC is a separate subsidiary of BAC insulates the rest of the group from legal liabilities and “arguably prevents them from ballooning out of control,” says the banker.

If BAC officials are keeping CFC “bankruptcy remote” to protect the large organization from legal and financial losses from the ex-bank portion of CFC, which includes the bank’s conduit and non-bank assets, the implications for CFC debt holders – and holders of bank debt generally – are quite grim. If the same fire sale valuations seen in the market for subprime assets are applied to the ex-bank assets of CFC, then the Friday close of 79 cents per dollar of face value of CFC bonds may be a tad on the high side.

More to the point, if the Fed, OCC and OTS are willing to countenance a bank merger transaction where BAC does not explicitly stand behind the parent company debt of CFC, what does this say about the debt of other relatively small bank holding entities such as Washington Mutual (NYSE:WM) and Capital One (NYSE:COF)?

If CFC is to be allowed by regulators to fall into bankruptcy once the insured bank subsidiary is secured, then how about WM and COF? Are the Fed and other regulators indifferent to the systemic implications of such a transaction? More important, don’t investors in BAC and CFC securities have a right to an unambiguous statement from BAC CEO Ken Lewis regarding his intentions with respect to CFC debt?

Unfortunately we cannot participate in the BAC conference call on Tuesday due to a previously scheduled client meeting, but perhaps one of our colleagues in the analyst rat pack will ask BAC to elaborate on the following:

1) Were the statements we describe regarding the acquisition of CFC, in fact, made by officials of BAC?; and

2) If so, why were these statements not immediately made available to all BAC and CFC investors?

We again put those questions to BAC.