Finally, it could be cautioned that quasi-securities not only queer the pitch for security mechanisms but they may also fail to work well themselves. In the case of retention of title clauses, it has been suggested that even claimants with the strongest cases face a formidable series of obstacles to recovery, that those insolvency practitioners who act as administrative receivers or liquidators enjoy huge expertise and ‘repeat player’ advantages over claimants and that the overall result is that only 15 per cent of claimants succeed in recovery.261 It is, accordingly, conceivable that, as presently operated, a device such as the retention of title clause achieves the worst of both worlds: it is perceived (wrongly) as a huge threat by holders of floating charges and this escalates credit costs, but the device fails, at the end of the long and legally uncertain day, to deliver real protection to the quasi-secured creditor.

The ‘new capitalism’ and the credit crisis

Over the last twenty years the above building blocks of borrowing may not have altered but the modes of arranging corporate financing on the basis of these foundations have changed radically. In the world of the socalled ‘new capitalism’262 borrowing relationships, credit arrangements and involved actors have all mutated dramatically and there has been a movement from ‘managerial capitalism into global financial capitalism’.263 The developments comprising this movement should be noted here since they are of considerable significance for insolvency law – not least because they involve an explosive fragmentation of debt.

The first such development has been the massive growth in the use of financial derivatives, and, notably, in credit derivatives.264 The latter are

261Wheeler, Reservation of Title Clauses, p. 178. See also Spencer, ‘Commercial Realities of Reservation of Title Clauses’, in whose survey half of respondents said that their clauses had been challenged by receivers or liquidators. In practice the insolvency practitioner not only will consider whether the wording of the ROT clause establishes a prima facie claim but also will be influenced by the bargaining position of the supplier: see Leyland DAF Ltd v. Automotive Products plc [1993] BCC 389; A. Belcher and W. Beglan, ‘Jumping the Queue’ [1997] JBL 1 at 17–19.

262See e.g. M. Wolf, ‘The New Capitalism’, Financial Times, 19 June 2007.

263Ibid. This section builds on V. Finch, ‘Corporate Rescue in a World of Debt’ [2008] JBL 756.

264The total volume of outstanding credit derivatives contracts stood at £31,300 billion at

the end of 20 07 – a n ear d ou bl in g o n 200 6 fi gures – and an indication t credit crunch had not halted the rise of the credit derivative market. That market is ten

times the size it was in 2004: see G. Tett and P. Davies, ‘Upsurge in Credit Derivatives Defies Fears’, Financial Times, 16 April 2008. See also G. Tett, ‘Should Atlas Still Shrug? The Threat that Lurks behind the Growth of Complex Debt Deals’, Financial Times,

134 the context of corporate insolvency law

derivative contracts that transfer defined credit risks in a credit product or bundle of credit products to a counterparty – a market participant or the capital market itself. The trading of credit risk is a process that has been advanced by the growth of structured financing techniques and the securitisation of such risks.265 Securitisation is the process involving the rendering of a credit derivative into an investment product – as where a bank places loans in a special purpose vehicle (SPV)266 which then issues new securities such as bonds – allowing investors to buy credit-linked notes and to gain credit exposure to an entity or group of entities.267 The credit product itself might be the risk interest in a loan or a generic credit risk, such as an insolvency risk.268

Complex structuring may take place when securitisation involves an SPV issuing an asset-backed security (ABS) secured over a wide range of assets, loans and receivables or issuing a collateralised debt obligation (CDO) involving a portfolio of bonds, loans and swaps.269 Buyers, in such markets, are able to purchase exposure to particular risks; bundles

15 January 2007, noting that global liquidity is made up of 75% derivatives, 13% securitised debt, 11% broad money and 1% bank funds. The volume of high-risk traded

debt has ris en s harply i n r ecent y ears. In 20 03 £ 500 mi lli on of bo nd s rating were issued but this had risen to £2.2 billion in 2005: see G. Tett, ‘High Risk Debt

Issuance has Grown Sharply’, Financial Times, 4 December 2006. On derivatives see further J. Benjamin, Financial Law (Oxford University Press, Oxford, 2007) ch. 4.

265See generally Fuller, Corporate Borrowing, ch. 7; V. Selvam, ‘Recharacterisation in “True Sale” Securitizations’ [2006] JBL 637; J. K. Thompson, Securitization (OECD, Paris, 1995); L. R. Lupica, ‘Asset Securitization: The Unsecured Creditor’s Perspective’ (1998) 76 Texas L Rev. 595; J. Flood, ‘Rating, Dating and the Informal Regulation and the Formal Ordering of Financial Transactions’ in M. B. Likosky (ed.), Privatising Development (Martinus Nijhoff, Netherlands, 2005) p. 147.

266The use of a special purpose vehicle (SPV) involves use of a paper company where a bank places other mortgages or assets to remove them from its balance sheet. On SPVs see further N. Frome and K. Gibbons, ‘Spectrum – An End to the Conflict or the Signal for a New Campaign?’ in Getzler and Payne, Company Charges, pp. 122–9, 132.

267See G. Aggarwal, ‘Securitisation – An Overview’ (2006) 3 Int. Corp. Rescue 285. In a securitisation the underlying assets are a pool of assets producing regular cash flows. Another type of asset-backed security is the repackaging, in which the underlying assets are a pool of bonds and a swap arrangement (under which the investor agrees to pay cash flows from bank bonds back to the bank in return for a different set of cash flows): see Fuller, Corporate Borrowing, pp. 108–9.

268See V. Kothari, Credit Derivatives and Synthetic Securitisation (Vinod Kothari, India, 2002).

269In 2002 the then head of the Financial Services Authority, Sir Howard Davies, warned the City that synthetic CDOs were being described by some investment bankers as ‘the most toxic element of the financial markets today’: see J. Treanor, ‘Toxic Shock: How the Banking Industry Created a Global Crisis’, The Guardian, 8 April 2008, noting estimates that in 2007 about a third of the £300 billion CDOs sold contained US subprime mortgage loans.

of risks of different types; or an index of credit risks, covering risks in a generalised, diversified index of names. They are, additionally, able to

trade in tranches representing risks of different levels or slices of risk in a given market (e.g. the first 3 per cent of risk and so on).270

A second important development has been the exponential growth of the hedge fund and the private equity group271 as vehicles for making investments in companies (especially troubled companies).272 These funds are largely unregulated entities that invest in a wide variety of domains and often use high levels of leveraging and complex financial arrangements in order to increase their returns.273 They are prominent in credit derivative trades – which are in the main unregulated and offer opportunities for short trades in credit that are not permitted by the bond market. In such a world ‘the whole landscape of leveraged lending has changed’274 with resort to complex mixes of asset classes, bonds, derivatives, loans and equities and the use of newly devised and tailor-made

270Fuller, Corporate Borrowing, pp. 116–18.

271Rod Selkirk, Head of the British Venture Capital Association, has described the difference between the hedge fund and the private equity group as follows: hedge fund investors are experts in trading in public securities and derivatives whereas in private equity the expertise lies in investing in companies and management teams: see P. Smith, ‘Private Equity Groups are “Distinct From Hedge Funds” ’, Financial Times, 27 November 2006. The term ‘private equity’ encompasses investment types ranging from venture capital focused on financing early stage businesses to leveraged buyouts that employ debt to buy more mature companies. The growth equity segment of the private equity industry (a fast-growing sector focused on supporting the expansion of established growth companies) typically employs little or no leverage. For an outline of the private equity industry see D. Walker, Guidelines for Disclosure and Transparency in Private Equity (BVCA, London, 20 November 2007) pp. 7–11.

272Hedge funds and non-bank credit investment groups held over 50 per cent of all lending

273See T. Hurst, ‘Hedge Funds in the 21st Century’ (2007) 28 Co. Law. 228, estimating that ‘several hundred’ funds hold around US $1.3 trillion in assets and account for 40–50 per cent of all market trading activity. Private equity is now said to own businesses employing around one in six of UK private sector workers: see J. Pickard and P. Smith, ‘Myners

W arns of R isks fr om the G rowth o f ’P, rivateFin a Equitync a l Ti mes , 21 February 20

274See G. Tett, ‘Deals Galore in a World Awash with Cheap Money’, Financial Times, 27 September 2006.

136 the context of corporate insolvency law

instruments such as payment in kind notes (PIKs) and ‘hybrid financing’ deals using highly structured CDOs and ABSs. Low interest rates have encouraged such heavily leveraged approaches in recent years as has the dramatic globalisation of the credit derivatives market.

A third change has taken place in the traditional role of the bank – which has shifted from that of primary lender to that of ‘originator and distributor’.275 Instead of arranging loans and retaining these on their own books, the banks have moved towards arranging and then selling on the loans and loan risks to other investors.276 The change has been from commercial long-term lending and durable client relationships towards investment banking and arm’s-length trading. When companies encounter difficulties in this new world they are increasingly likely to turn not to commercial banks but to hedge funds and private equity funds or to other sources of ‘alternative capital’.

The sanguine view of such developments is that such active financial trading swiftly identifies and attacks pockets of inefficiency and imposes rigorous market disciplines on managers; that it places economically inefficient operations in the hands of those who can extract value most efficiently; and that it allows capital to flow easily around the world to those places where it will work best.277

Sceptics, however, focused on a number of concerns even before the credit crisis of 2007–8.278 The first was that the system leads to risk taking that is unsustainable. It does so, they fear, because lending standards tend to loosen as credit derivative markets encourage banks to believe, excessively optimistically, that they can use credit derivatives to offset the risks of loans. This, it is thought, leads such banks to lend more to companies than they would otherwise do – and at lower rates to higher-risk borrowers.279 Such a problem is allegedly compounded because the credit

275See J. Gapper, ‘Now Banks Must Relearn their Craft’, Financial Times, 30 July 2007.

276As noted, the use of a special purpose vehicle (SPV) removes loans from its balance sheet.

277See Wolf, ‘New Capitalism’.

278See, for example, F. Partnoy and D. Skeel, ‘Credit Derivatives: Playing a Dangerous Game’, Financial Times, 17 July 2006. In April 2008 the Governor of the Bank of England commented on the failure of the major banks to create incentives for their staff that are conducive to the reasonable control of risks.

279The Finance Director of Northern Rock argued early in 2007 that securitising its loans had reduced its risks and allowed it in turn to make more loans: see Tett, ‘Should Atlas Still Shrug?’ Months later Northern Rock was experiencing a liquidity crisis and was approaching the Bank of England for a £13 billion loan as lender of last resort. On the 2008 collapse of Lehmans with an estimated $400 billion CDS debt on its books see Financial Times, Editorial, 16 October 2008.

derivatives market reduces the incentives for banks to monitor corporate behaviour and managerial performance.280 This tends to take out of play those institutions that, traditionally, are best placed to monitor directorial prudence. A related worry is that the investors in sold-on risks – often the pension and insurance funds – are unlikely to carry out such monitoring as they have no hands-on relationship with the corporate borrower. The upshot pointed to is that this involves a moral hazard on the part of borrowers who are not subject to rigorous financial disciplining. In sum, both lenders and borrowers are excessively encouraged to bear risks and this increases threats to solvency.281

A second fear relates to the systemic risks involved with credit derivatives. The new concern is that the regulatory challenges of controlling such a complex global credit market are extremely severe and that the monetary tools of central banks do not work well to control credit conditions.282 This has for some time given rise to worries regarding the stability of the system and in turn for the welfare of companies – who may face liquidity crises that are driven by global factors beyond their control. As for risk spreading and systemic risks, the traditional view is that dispersing risks encourages resilience and financial stability. In the wake of the credit crisis of 2007–8, the charge is that opacities within the derivatives system made it difficult, in the pre-crisis period, to trace risks and risk bearers so that concentrations developed in a manner that made the general system highly vulnerable to shocks.283 Another problem encountered was that of contagion, a process in

280See F. Partnoy and D. Skeel, ‘The Promises and Perils of Credit Derivatives’ (U. Pa. Law School Working Paper 125, 2006): the banks that financed Enron laid off $8 billion of risk. See also the evidence of the Governor of the Bank of England to the House of Commons Treasury Select Committee on 29 April 2008 regarding the failure of the banks to create incentives for their staff that are conducive to the reasonable control of risks: reported in G. Duncan and G. Gilmore, ‘Mervyn King: Banks Paying Price for their Greed’, The Times, 30 April 2008.

281See e.g. J. Plender, ‘The Credit Business is More Perilous than Ever’, Financial Times, 13 October 2006.

282On the challenges of regulating hedge funds see Financial Services Authority, ‘Hedge Funds: A Discussion of Risk and Regulatory Engagement’ (FSA Discussion Paper 05/4, London, June 2005). On the Bank of England and the Financial Services Authority’s

prime Loans, Inter-bank Markets and Financial Support’ (2008) 29 Co. Law. 22.

283On the causes of the credit crisis see e.g. R. Tomasic, ‘Corporate Rescue, Governance and Risk-taking in Northern Rock’ (2008) 29 Co. Law. 297; Technical Committee of the International Organisation of Securities Commissions, Report on the Subprime Crisis:

Final R eport (May 2008), www.iosco.org/librar y/pubdocs/pdf/i oscoPD 273.pdf.

138 the context of corporate insolvency law

which ill-informed parties afflicted whole areas of investment. When unmonitored expansions of credit were encouraged by low interest rates, when there were high levels of leverage and speculative trading, when there was unprecedented demand for high-risk subordinated loans, and when information flows were impeded by hugely complex contractual fragmentations, crashes resulted when ‘the music stopped’ on the risk shifting.284

The third general concern – again expressed before the 2007–8 crisis and repeated following it – relates to information flows and levels of transparency. The intricacies of credit derivative arrangements and the sophistication of the various vehicles for credit structuring mean that the relevant contracts are difficult to understand and it is extremely hard for regulators to ensure that processes are transparent and conducive to the supply of full and accurate information on risks.285 This is an area lacking standardised performance information.286 Investors, accordingly, may be poorly placed to evaluate the risks that are associated with opaquely packaged products.287 Such opacity may underpin the propensity of the risk-shifting process to move risk into the hands of investors who are ill-equipped to handle it.288 As has been commented: ‘The theory is that risk would be shifted to those best able to bear it. The practice seems to have been that it was shifted onto those least able to understand it.’289 A further effect is that investors in the company tend to

284See P. Smit and G. Tett, ‘Buyout Deals Raise Alarm on Debt Levels’, Financial Times, 20 June 2006; Hurst, ‘Hedge Funds’; G. Tett, ‘Credit Turmoil Shows Not All Innovation

Has Been Benefi ’cial, Fin an ci a l T imes , 11 S eptember 200 7.

285 See E. Ferran, ‘Regulation of Private Equity-Backed Leveraged Buy-out Activity in Europe’, ECGI Working Paper 84/2007; J. Harris, ‘International Regulation of Hedge Funds: Can the Will Find a Way?’ (2007) 28 Co. Law. 277. On FSA consideration of proposals to give companies powers to compel hedge funds to declare secret stakes see J. Mackintosh, ‘Secret Hedge Fund Stakes Could be Flushed Out’, Financial Times, 11 October 2007.

286See R. Pozen, ‘Reporting Standards for Hedge Funds must be Raised’, Financial Times, 12 January 2006.

287On deficiencies in the performance of credit ratings agencies see S. Jones, G. Tett and P. Davies, ‘CPDOs Expose Ratings Flaw at Moodys’, Financial Times 21 May 2008; P. Davies and G. Tett, ‘Moody’s Talks of Ratings Reform’, Financial Times, 18 September

2007. On the difficulties of valuing credit derivative transactions see D. Summa, ‘Credit Derivatives: An Untested Market’ (2006) 3 Int. Corp. Rescue 249. See also Flood, ‘Rating, Dating’, pp. 157–64 on the effects of the ‘pernicious complexity’ of securitisations and the questionable credibility of the ratings agencies’ evaluations.

288See G. Tett, ‘Credit Trading Shows Not All Innovation Has Been Beneficial’, Financial Times, 11 September 2007.

289M. Wolf, ‘Questions and Answers on a Sadly Predictable Debt Crisis’, Financial Times, 5 September 2007.

find it difficult to adjust their credit terms when they do not know whether a lender – for example, the company’s bank – has hedged its position with derivatives.290 The more general worry for those concerned with corporate financial health is that intrinsically volatile systems that involve poor transparency and appreciation of risk can, and, in 2008 did, lead to financial instabilities, excessively risky managerial strategies and solvency crises.291

A final worry relating to insolvency risks is the possibility that the popularity of derivatives may impede recoveries in times of corporate trouble because the hedge funds or other holders of credit will enforce debts rapidly against defaulters. In the world of the ‘new capital’ the troubled company may have no friendly ear at the bank to turn to and creditors who have purchased derivatives may possess few motivations to explore turnaround possibilities. They may even have incentives to encourage corporate default and actively to enforce the terms of the loan agreement even where this destroys corporate value.292 These are matters to be returned to in chapter 7 below when discussing informal rescue strategies and practices.

It is perhaps too early to draw conclusions on the full effects of the new capitalism. This is not least because regulatory responses to the 2007–8 credit crisis are yet to fully emerge. Even in early 2008, however, steps were in train, for instance, to improve the transparency with which the hedge and private equity funds operate.293 It remains to be seen whether regulators will institute radical new steps that are designed to reduce the complexity and opacity of credit derivatives and credit markets. Possibilities being canvassed in late 2008 included: the creation of a

290Ibid.

291On the difficulties of using mathematical models to predict the performance of the

securitised credit markets see A. Gangahar and K. Burgess, ‘Hedge Funds Brace for

More Pain ’ , Fi nancial T imes , 1 3 August 20 07. On some hedge funds’ ill-suite management policies and weak operational controls leading, inter alia, to misstate-

ments o f the net asset value (NAV) of the fund s ee M. Penner, ‘ Hedge F Management and Valuation “Red Flags”’ (2007) Recovery (Winter) 30.

292See Partnoy and Skeel, ‘Promises and Perils’, p. 22.

293In January 200 8 the hedge fund industry’ s Hedge Fund Working Grou p (HF representing leading hedge fund managers based mainly in the UK and chaired by Sir

Andrew Large, announced that agreement had been reached on voluntary standards intended to codify best practice for the industry: see Mackintosh, ‘Big Hedge Funds Agree Voluntary Code of Practice’. (The HFWG was loosely modelled on the committee drawing up a voluntary code for the private equity industry under Sir David Walker, which published Guidelines for Disclosure and Transparency in Private Equity on 20 November 2007.)