CDO market under fire as lawyers face court action

The collaterised debt obligation (CDO) market, on which many highly profitable practices are based, is facing mounting criticism for its volatile and risky nature.

The case of Weil Gotshal & Manges being sued by a client over a CDO highlights the risks involved and has led some to argue that this highly technical and sophisticated product is not an instrument to be trusted.

As first reported in The Lawyer (4 July), the London office of New York-headquartered Weil is facing a claim of up to $100m (£57.4m) from Greenwich Natwest and National Westminister Bank, its founding securitisation clients. This is one of a number of high-profile CDO lawsuits to have been brought this year, prompting questions about the safety of the CDO market.

The claim form for the case alleges that there were problems in the structuring of the disputed transaction, an accusation that has “zero merit”, according to the defendants. Whatever the outcome, as the firm assigned to the deal, Weil would have been involved early on with the structuring process.

Once the investment bank acting as bookrunner has carried out the economic modelling for the CDO, the law firm is instructed. Its areas of responsibility include the acquisition and holding of the underlying assets, the management of the debt portfolio and even drawing up documentation for how the CDO is intended to work economically. Firms must also advise on a number of ‘what if’ scenarios. The ‘what if’ clauses cover the sorts of problems that could appear over the life of the CDO and how these will be remedied.

Specialist CDO lawyers were understandably reluctant to speak on the record to The Lawyer about the potential pitfalls of their products. Many did privately concede, however, that CDOs are highly volatile instruments, with one going so far as to admit that if he were an investor, he would not go near them.

Even before the Weil case emerged, CDO public relations had taken a battering. Barclays Capital was taken to court by the German Landesbank HSH Nordbank earlier this year over the alleged mis-selling of CDOs, while Bank of America and Banca Popolare di Intra came to an out-of-court agreement that ended with the Italian bank receiving e15.5m (£10.6m). The former head of the Financial Services Authority Sir Howard Davies and financier George Soros have both labelled CDOs as “toxic waste” because of the risks linked to the underlying assets, a term that has been appropriated by subsequent critics.

However, director and head of CDOs at Nomura, Neil Basu, claims that the mounting scepticism has had little effect on the market. “Demand has been growing quickly in the CDO market. This year we’ve seen the establishment of new CDO asset classes, deals that are linked to equities and hedge funds,” he says.

This is partly because the recent legal actions involving CDO transactions relate to trades in the early days of the market, when it is largely recognised that there was less commoditisation of the market and fewer checks and balances. Investors’ knowledge of the product has also increased.

The CDO market is relatively new to the UK, with the first transactions being launched in the late 1990s. It is a highly lucrative market, with a small group of top City firms taking the majority of the business (see table). Topping the table is Ashurst, led by CDO star Erica Handling. Handling, then at Weil, worked on Eurocredit, the first-ever CDO in Europe. The Ashurst link with McKee Nelson is grounded in her long-time collaboration with former Fried Frank Harrison Shriver & Jacobson partner Larry Isaacson.

Clifford Chance, Linklaters and Sidley Austin Brown & Wood also have strong structured finance units, and more recently White & Case has positioned itself as a serious CDO player.

Lawyers may argue that problems over the drafting documents are common to all transactions and not just CDOs, but the number of CDO disputes being resolved through the courts is causing real alarm. And the recent losses linked to correlation trades, which involve trading pieces of CDOs, show just how volatile the market can become.

CDO lawyer to issuer rankings 2004-05

Rank Lawyer Volume ($m) Volume (£m) No of deals % share
1 Matheson Ormsby Prentice 2,970 1,690 41 15.5
2 Maples and Calder 674 384 24 3.5
3 Hengeler Mueller 619 353 4 3.2
4 McCann FitzGerald 391 223 7 2.0
5 Sojong Partners 299 170 11 1.6
6 Mourant du Feu & Jeune 213 121 14 1.1
7 Shin & Kim 144 82 2 0.8
8 A&L Goodbody 140 80 2 0.7
9 Ogier & Le Masurier 117 66 9 0.6
10 Lee & Ko 105 60 9 0.5
  Deals included in the tables account for around one-third of total CD volume
Source: Dealogic

CDO lawyer to bookrunner rankings 2004-05

Rank Lawyer Volume ($m) Volume (£m) No of deals % share
1 Ashurst 1,564 890 30 8.2
2 Clifford Chance 1,489 848 25 7.8
3 Sidley Austin Brown & Wood 715 407 6 3.7
4 Linklaters 544 310 24 2.8
5 Milbank Tweed Hadley & McCloy 335 191 11 1.8
6 Lovells 294 167 14 1.5
7 McKee Nelson (New York) 251 143 16 1.3
8 Allen & Overy 215 122 3 1.1
9 Freshfields Bruckhaus Deringer 329 187 17 1.7
10 Gide Loyrette Nouel 188 107 10 1.0
  Source: Dealogic