Mike Kerrigan, partner, Hunton Andrews Kurth LLP, and manager, Magis Analytics LLC, is coauthor of this article.
In an earlier post, I mentioned
three rules for driving change in the loan market:
- Rule #1: What can be standardized must be standardized.
- Rule #2: What has been standardized must be automated.
- Rule #3: Go back to Rule #1, and then to Rule #2.
Then, I explained how those rules can be applied to
“demystify” the LSTA Purchase and Sale Agreement for Distressed Trades (PSA). When we consider that the PSA is mostly data, it helps us understand how trade settlement systems like ClearPar can view the PSA more as a data-driven output than a manually
drafted document. Finally, I promised a discussion on two remaining topics: inventory management and upstream review. Let’s begin that discussion now.
Get with the Platform: Inventory Management
First, inventory management. A key task the seller needs to undertake when settling a distressed trade is to identify which parts of its position and the chain of title, commonly known as upstream inventory, it will assign to the buyer. These “upstreams”
include not just the PSA and Assignment & Acceptance Agreement (AA) by which the seller acquired the loans, but all PSAs and AAs preceding that purchase. That chain can reflect months or, indeed, years of distressed trading. Identifying and delivering the
upstream chain of title of the distressed loan being transferred allow the buyer to commence its due diligence.
Today, this delivery of upstreams is anything but user-friendly. Seller does it by emailing large, unsorted attachments (in PDF format) that often consist of hundreds of digital pages worth of static data. Unfortunately, that’s just the tip of the iceberg.
Generally speaking, inventory itself is managed on credit-specific spreadsheets maintained by each institution, whether in-house or by external counsel. The spreadsheets are revised manually as inventory is acquired, assigned to buyers, or modified due
to facility ledger events such as paydowns or PIKs. To complicate matters further, an institution’s inventory spreadsheets often are accessed by multiple team members as well as external parties. This makes it very difficult to track the history of changes
or, indeed, maintain one “golden record.”
The labor-intensive, manual processes for managing inventory create risk affecting all distressed loan market participants. What if an institution’s positions are not kept current, or inventory is mistakenly allocated twice? This happens all too often
within distressed loan inventory management, with real world consequences for trade counterparties and beyond.
It doesn’t have to be this way. Much of these data already exist in a trade platform like ClearPar for purposes of settling par trades. It is a natural step forward to maintain distressed inventory the same trade settlement platform and address these risks.
We have built intuitive tools to manage inventory at the facility level (what do I own, and how much do I own?) and provide history and transparency within positions, cataloging prior upstreams and the data and documents connected with them.
When a platform manages inventory, all actions impacting available amounts, from prior allocations of inventory to ledger events themselves, such as paydowns and PIKs, are updated in real time. It’s not only easier, it’s safer. All historical actions affecting
available amounts are easily reviewed, greatly reducing institutional risk.
With online inventory management addressing the risks of today’s manual process, we can turn our attention to the final piece of the puzzle, upstream review. Traditionally, buyer’s review of the distressed chain of title has been the domain of legal professionals.
For this reason, this next section is authored by Mike Kerrigan, a partner with Hunton Andrews Kurth LLP (Hunton) and a manager in Magis Analytics LLC (Magis), a wholly-owned subsidiary of Hunton and our partner in designing our distressed settlement solution.
The Pièce de Résistance: Solving for Upstream Review
Make no mistake, distressed upstream review is the highest hurdle to clear. As anyone familiar with the diligence knows, the process is labor-intensive and time-consuming. Seller’s counsel must assemble bulky upstream information for delivery, confirming
first that it sufficiently covers the present value principal amount for sale.
Then buyer’s counsel must review each link in every chain of title of the distressed loans being sold. It first must compare the documents provided against the chains listed and amounts allocated on the Annex to its PSA. This confirms at the outset the
connectivity of each upstream chain and sufficiency of each upstream amount.
This “simple” review is repeated for each loan transfer, in every chain and for every trade allocation. But the substantive work has only just begun. After connectivity and sufficiency checks, each data field in every upstream PSA must be checked against
its antecedent or relevant data for accuracy and completeness. More on those last two checks below - let’s get back to the logistics of what is reviewed.
Consider a chain of over 30 transfers. It isn’t hard to imagine, when a buyer can receive upstreams from a selling fund manager that has allocated from 30 different managed funds. That is 30 different legal entities making 30 distinct transfers, all to
settle “one” trade. When that buyer becomes a seller, the chain of title listed on its PSA Annex may list 30 different upstream sellers, even though it may be only the second transfer of those loans!
As you can see, complexity grows exponentially with each subsequent transfer and trade allocation. While frequent trading of distressed loans is not a new phenomenon, more frequent trade allocation by fund managers is. Manual upstream delivery and review
perhaps made sense before these allocations proliferated, but it no longer does. The “new normal” of recurring trade allocation in the loan market has forever altered the risk profile.
Put simply, upstream review must be automated because it can be automated. It can be automated because each step in upstream review – each check of connectivity, sufficiency, accuracy, and completeness – follows logic. Each step entails review of a finite
set of factual answers – missing data - called for by blanks in the standardized PSA.
Wait a minute – review of a finite set of variables, each built upon the prior transfer and answerable with data? This sounds familiar. Like PSA creation, upstream review is largely about data. It’s about verifying pre-existing information that trade
settlement systems like ClearPar already hold, information already entered and confirmed through the system by trade counterparties.
Indeed, the connectivity, sufficiency, accuracy, and completeness checks inherent in PSA completion
simultaneously review those data against all relevant upstream fields and platform data, all the way up each and every upstream chain.
In a sense, PSA completion is upstream review. Automation collapses the two tasks into one workflow. When a system like ClearPar generates the PSA, it either indicates no exceptions were raised on review or generates an exception report (incorporated
into the PSA) that allows for automated remediation if necessary.
Making the Magic Happen: Automating Upstream Review
That's a big step we've just taken, heralding the era of automation of upstream review. But we do it confidently, for it fits squarely within the three rules mentioned above for driving change in the loan market. Rule #1, as you’ll recall, states that
what can be standardized must be standardized. How does this principle apply to upstream review?
- First, upstream diligence can be (and so it must be) standardized.
- Next, description of exceptions can be (and so it must be) standardized.
- Finally, remediation for any raised exception can be (and so it must be) standardized.
After standardization, the magic can begin, particularly as it relates to the accuracy and completeness checks so time-consuming in the manual world. This is where Rule #2 comes in:
What has been standardized must be automated.
Here, we apply principles of loan market automation that have been in place and widely accepted for over a decade. Whether it’s in the context of trade confirmation and AA generation, PSA completion or upstream review, the same principle applies: It’s
just data which must be populated in a standardized fashion and, hence, can be automated. It’s not par data or distressed data. It’s just data.
Don’t overthink upstream review of a standardized document like a PSA. The principal amount of traded loans is either factually correct or incorrect. The description of the traded tranche is either factually correct or incorrect. Based on the nature of
the upstreams, step-up provisions either are or are not required. The majority of data diligenced are essentially binary – either factually correct or incorrect.
You see where this is going: factually correct data can be expressed in logic. Then, by definition, any data other than that factually correct data raises an exception.
With automation, the only workflow left is clearing the raised exceptions. Even that can be a click-through task allocating risk of loss. Of course, the network effect of settling distressed trades online – where mistakes are so much harder to make – means
precious few exceptions are raised in the first place.
But that’s not all. When exceptions are raised, the exception report is more likely to be used by trade counterparties as an early warning system than a risk allocation tool – a shield rather than a sword.
When inventory management, PSA creation and upstream review all collapse into one seamless workflow, settlement can occur as quickly as parties desire. The number of inputs in the three phases of distressed loan settlement – inventory management, PSA creation
and upstream review - have been reduced to the bare minimum. Everything else is an output.
The Future is Now: Making Distressed Loan Settlement Like Par
Once you understand how platform technology applies logic to gather, distribute and validate data in one seamless workflow, you quickly see how distressed loan settlement on a platform like ClearPar can be made to feel just like par settlement. This means
distressed loan settlement can become dramatically more efficient and less risky. Everybody wins.
The time is now to bring the same settlement efficiency enjoyed for years by the par loan market into distressed.
Note: Notwithstanding Magis’s involvement in the promotion and development of this technology or any reference to Hunton in this article, Magis’s assistance and consultation with IHS Markit and assistance and participation in such promotion shall not be
and shall not be construed to be the practice of law or the rendition of legal advice, whether oral, written or otherwise, IHS Markit and ClearPar users shall not be and shall not be deemed to be clients of Magis or Hunton by virtue of such assistance, consultation
and participation by Magis, ClearPar users and prospective users are advised to consult with their own counsel to determine independently the utility of the technology, and the technology does not reflect or provide legal advice.