U.S. bankruptcy laws locate guidelines for the recovery and distribution of CDO and CLO assets in the affair of default.
A corporate intent declares bankruptcy when deprived of its dexterity to recompense creditors. The legal course can be petitioned voluntarily by the corporate debtor or involuntarily by its creditors seeking to retrieve implied losses. CDOs and CLOs (otherwise accepted as collateralized Obligation obligations and collateralized loan obligations) are structured financial instruments with a debtor-creditor affinity male to U.S. bankruptcy laws.
The "automatic stay" provision of the U.S. Bankruptcy Code was designed to protect debtor assets from accelerated and abstract seizure by creditors. While senior sign holders of CDOs and CLOs are considered secured creditors, they may but face protracted delays in realizing valuation due to the stay provision of the decree. Also all the more, the bitter end size recovered may be a fraction of their infant investment.
Everyone tranche represents a sure continuous of investment risk, a inured scale of answer and precedence to claims on cash flow and collateral in the fact of default or bankruptcy. Senior Obligation letter holders own head precedence speak on cash flow and assets followed by mezzanine-debt indication holders and fairness investors. The Dependence of divulge rights, commonly referred to as the waterfall corollary, has the most adverse bump on fairness investors, who are the latest to be repaid (provided at all), in the affair of bankruptcy.
Delay of Payment
Priority of Claims
CDOs and CLOs derive their cost from an underlying pool of assets such as residential mortgages, corporate bonds, commercial loans and other financial obligations that work an wealth stream to investors. The CDO or CLO can buy the assets outright or be exposed to them synthetically, such as in the dispute of credit default swap contracts, which are complementary to insurance policies.The credit ratings of assets held by a CDO or CLO are not alike, on the other hand rather stratified into segments called tranches.Bankruptcy Remoteness
Creditors may experiment to settle claim on the assets of a CDO or CLO as part of insolvency proceedings against its parent holding company. To mitigate bankruptcy risk, CDOs and CLOs are often legally structured as special purpose vehicles and considered "bankruptcy-remote" entities. This legal designation minimizes the universe of potential creditors and isolates the assets of the CDO or CLO from those of the parent company. The use of bankruptcy-remoteness protection effectively shrinks the pool of creditors who can stake legal claims against the collateral assets.
Priority Flips and International Courts
Credit default swap contacts (associated with synthetic CDOs) typically recognize the swap counter party's (protection buyer) claim right as superior to those of note holders, unless it forfeits that right by defaulting on its obligations. When this happens, the priority of rights are reversed, or flipped, from the counterparty to the senior note holders.
The case is further convoluted if international courts are involved. For instance, the Chapter 11 bankruptcy filing of Lehman Brothers Special Financing Inc. and its guarantor, Lehman Brothers Holding Inc. clearly demonstrates opposing judicial viewpoints between U.S. and British courts. A British Court of Appeal upheld the priority flip on grounds that the Lehman bankruptcy filings constituted a default event, and further cited the timing of the filings and the holding company's limited and conditional interest in the collateral assets of the CDO as additional justification. However, a U.S. Bankruptcy Court judge disagreed and ruled that subordination cannot be triggered solely on the basis of the bankruptcy filing of either Lehman entities.
