Asset Backed Commercial Paper – What Is It? What Happened? What May Be Coming? Lessons to be Learned 


June 2008 - (CCH Canadian Limited's Ultimate Corporate Counsel Guide e-newsletter, No. 18)

CCH Canadian Limited's Ultimate Corporate Counsel Guide e-newsletter, No. 18
Jordan Solway, Patrick Bourk
Asset backed commercial paper ('ABCP') as an investment vehicle grew dramatically from $10 billion in 1997 to $115 billion in 2007.1 $32 billion of this amount (i.e., Canadian non-bank ABCP) is in the process of being restructured under the Companies' Creditors Arrangement Act. This is due to mismatching between the cash flows from the underlying assets (i.e., receivables) and the funds needed to make payments upon maturity of the notes held by investors, and a liquidity crisis that traces its appropriateness of roots to the sub-prime meltdown in the United States that involved securities that are themselves an example of asset backed commercial paper. 

This article focuses on the Canadian features of ABCP, the entities and players involved, the types of claims that may be anticipated if the arrangement proposed is not successful or, in the case of other ABCP, if they are unable to make similar arrangements. We examine the types of issues that corporate counsel may consider in seeking remedies if their company is an investor or in protecting themselves in their company is a target of investors or others sued by investors. Finally based on early indications from the United States, some implications for director's and offcier's liability (D&O) coverage in Canada are also examined. 


Sponsors, namely corporations that made a business of making asset backed commercial paper available to investors, established Special Purpose Vehicles in the form of trusts that, in the context of ABCP, are known as "conduits". These conduits issued debt to investors in series typically on a 365-day commercial paper basis. The different series were designed to reflect different levels of risk. The debt was rated by approved credit rating agencies. It should be noted that both the duration and the rating are requirements for these investment vehicles to be exempted under applicable securities laws in Canada. 

The debt issued by the conduits, in turn, was used to purchase or secure assets from asset providers, which, for the most part, consisted of financial institutions. The types of assets pooled included more traditional financial assets, such as residential and commercial mortgages, corporate loans, and credit card receivables. In the case of the Canadian non-bank ABCP, traditional financial assets accounted for approximately 19 per cent of the underlying assets. The remaining 81 per cent consisted of derivative contracts (sometimes called synthetic assets), mainly in the form of credit default swaps. 1 Of these synthetic assets, the majority (approximately 54 per cent) were leveraged super senior swaps. 2

There was a significant mismatch between the asset backed commercial paper held by the investors, which were short-term, and the underlying assets, which consisted of medium- and long-term financial assets. The whole structure was predicated on investors "rolling over" their asset backed commercial paper. This assumption evaporated in the week of August 13, 2007, when, despite the previous actions of a number of central banks arising from the sub-prime mortgage problems in the United States, there was a sudden liquidity crisis and conduits faced a run by investors who no longer wished to roll over their asset backed commercial paper. This effectively caused the market to freeze, since no one was prepared to hold medium- or long-term financial assets due to the risk of default. Thus, the need to restructure the conduits under the Companies' Creditors Arrangement Act. 

Another series of asset backed commercial paper which were sponsored by Canadian banks did not face this liquidity crisis and were quietly redeemed by the banks. 

In addition to the sponsors, the investors, the conduits, the asset providers, and the rating agencies, a number of other financial intermediaries were involved in the Canadian non-bank ABCP. Liquidity providers (i.e., financial institutions) entered into contracts with the conduits to provide funds to the conduits in the event of the occurrence of certain pre-agreed upon triggers. Broker dealers marketed the asset backed commercial paper to the investors. A number of those involved were affiliated with the sponsors. 

Possible Outcomes of the Proposed Restructing

If the proposed restructuring of the Canadian non-bank ABCP proceeds as the applicants have requested, a multitude of lawsuits will be replaced with a supposedly orderly and long-term solution in which the investors will be required to wait for a period of years before return of their investment, and in which a number of other players have agreed to provide funds and support, also for a prolonged period of time. 

If the restructuring arrangement is not successful, and for other asset backed commercial paper structures that are not able to restructure in a similar fashion, the allegations made by some of the participants in the Canadian non-bank ABCP as well as the experience of the United States in the sub-prime crisis, are suggestive of the type of claims that could be expected. 

In the United States, after a relatively quiet 2006 in the field of securities litigation, 2007 saw 278 sub-prime cases, and the first three months of 2008 saw 170 cases filed. 3 Shareholder derivative class action lawsuits are among the most common and, to the extent that Canada follows suit, our previous article 4 on this topic may be of interest. 

Simply put, investors who suffer loss can be expected to sue. Class actions involving investors can be expected and investor class actions are already prominent in the United States sub-prime litigation scene. Their targets will likely include broker dealers - for inappropriate and negligent advice (i.e., suitability), breach of fiduciary duties, misrepresentation, and, worse, if the broker dealers were affiliated with the architects of the scheme. Conduits that issued the ABCP may be targeted for inadequate disclosure and for other breaches of the securities legislation if the exemptions on which they relied on were improper. Again, to the extent that conduits are affiliated with other actors, they may be involved, and the allegations may rise up the ladder of impropriety. The allegations include acting in conflict of interest, bad faith, and potentially even fraud. 

Investors in the United States have included wealthy individuals, substantial corporations, and pension funds. This has several ramifications. Firstly, the investors can be expected to have the financial wherewithal to mount a well-funded and aggressive lawsuit. Secondly, the investors themselves might become targets if their shareholders, unit holders, or pension plan members feel that the funds of the investor were imprudently invested. 

Defendants in a lawsuit can be expected to join additional defendants as third parties. In the case of the Canadian non-bank ABCP, one of the financial institutions that was extensively involved has indicated publicly that, to the extent that it is sued, it would in turn look to a number of others to enforce its own remedies, including: the rating service, for negligent misrepresentation and breach of contract; the liquidity providers for intentional interference with economic and contractual interests based on breach of contract; the asset providers, for margin calls issued in breach of contractual obligations; sponsors, for negligent misrepresentation; issuer trustees of the conduit, for negligence; as well as counterclaims against the investors for contributory negligence based on their own lack of care in making investment decisions. 

Based on the American experience, directors and officers are also directly in the line of fire. In 2007, 97 per cent of the sub-prime related litigation named them as defendants and, to date this year, 72 per cent of the cases also targeted directors and officers.

Dangers and Pitfalls 

Directors and officers and their corporate counsel should be aware of some of the dangers and pitfalls that might arise in the event that they become targets. Some of these are identified below: 


As a recent Chancery of Delaware Decision 5 underscores, indemnities contained in corporate by-laws can be changed to the benefit of corporate balance sheets and to the detriment of certain directors or officers. Careful directors will have an indemnity agreement in place with the company indemnifying them to the maximum extent permitted by law. Indemnity agreements, of course, cannot be changed without the consent of the director. 

D&O Policies

D&O policies are not standard form policies and the wording varies widely: 

  • Does the policy provide for presumptive indemnification and thereby presume that the corporation is providing indemnification on a broader basis than actually may be the case? If so, there is a gap between the exposure and the policy cover.
  • If fraud is alleged, does the exclusion operate immediately or only after there has been a final adjudication that fraud has occurred? The difference may mean being provided with a defence or not.
  • Are there coverages in favour of the company or entity (for example, for "Securities Claims" ) that would reduce or even exhaust the limits available for coverage for directors and officers?
  • Are there majority shareholder actions that could arise and that might result in claims being excluded from coverage in the policy?
  • Are the claim notice provisions either too short in terms of timing or too onerous in terms of the level of detail required? If the claim notice provisions are too short or too restrictive, a potential claim may not be able to be reported in time. When and on what basis must or can an insured report a claim or a circumstance that could give rise to a claim?
  • The definition of "claim" with a D&O policy should provide enough specificity to identify what is a claim. It is usually any form of written demand for monetary, be it in the form of a demand letter received from plaintiff's counsel or an originating process. In regards to a circumstance that could give rise to a "claim", the trigger point can be less obvious. Most D&O policies will ask that an insured provide as much information regarding the circumstance as possible (e.g. the nature of the circumstance, dates, events, persons, and entities involved). However, there is no guarantee that providing such details will result in the matter being accepted as a notice of circumstance.. As a result, it is most often in the best interests of an insured to simply report the circumstance out of an abundance of caution and include as much detail as possible, and to await a response from the insurer as to whether policy requirements have been met.. The policy should provide that any notice circumstance accepted by the insurer will preserve potential coverage for any subsequent "claim" which is based on that circumstance.
  • Is the policy terminable by the insurer for other than non-payment of premiums?

Companies as Sponsors/Administrators of their Pension Plans

A number of companies are sponsors and/or administrators of their pension plans. This can result in added responsibilities to directors and officers. As such, it is important to ensure that the corporation's insurance program addresses this exposure and eliminates possible gaps in coverage. In the recent Ontario Court of Appeal decision in Slater Steel,6 the litigation centred around a multi-million dollar shortfall in the Slater pension plan at the time of the company's bankruptcy in 2004. The bankruptcy administrator claimed $20 million in damages against the plan's actuary, alleging that deficiencies in actuarial reports contributed to the plan's under-funding. The actuarial company concerned instituted third party proceedings against certain Slater directors and officers, seeking contribution or indemnity on the grounds that they, as the administrators of the plan, were the governing mind of Slater and contributed to the deficit. What was particularly striking about the decision was the Court's ruling that, although certain Slater personnel were appointed to the Audit Committee by virtue of their positions as directors and/or officers, when making decisions in respect of the pension plan's administration, they did so as agents or employees and, according to the Court, not as directors and officers! Therefore, these people were not protected by the stay of proceedings (it only protected directors and officers) and it is highly unlikely that the D&O policy would have responded because they were not being sued in their capacities as directors and/or officers. 

As most D&O policies will also include some form of pension plan exclusion, on the basis that such claims should fall to a specific Fiduciary Liability policy, it is very important to ensure that both policies are in place to make certain that there are no gaps in coverage for situations similar to and beyond those noted in the Slater Steel case.

Risk Management 

Taking Steps Under the Existing D&O Policy 

Some commentators have stated that the number and the size of the lawsuits expected from the sub-prime and the asset backed commercial paper problems will mean that certain corporations and segments may find it more difficult to renew their D&O policies or to maintain the same level of coverage (limits, terms etc). Corporate risk managers and corporate counsel of companies that might fall into these categories should consider what, if any, steps they can and should take under their existing D&O policy to protect themselves for anticipated claims and how they can differentiate their companies from the bad risks as part of the renewal process. The application renewal process requires the utmost good faith on the part of the applicant and material misrepresentations, including by silence, can give rise to significant coverage issues, including the policy being voided for material non-disclosure. Therefore, any presentations to underwriters should be carefully prepared to ensure accuracy and completeness of the information provided. 

In addition to providing complete and accurate information, corporate risk managers and corporate counsel should make sure that they have a comprehensive insurance renewal strategy in place. The underwriting process for management risk insurance lines of coverage is not a purely actuarial or scientific exercise. It involves the building of a relationship between the insurer and the insured whereby by the insurer wants to get a complete picture of how the business operates and the nature of a corporation's potential risk exposure. Underwriters will therefore often ask in-depth questions regarding the health of the corporation, both financial and otherwise. They often ask questions regarding the corporation's strategic business priorities; questions regarding the nature of the corporation's relationships with its finance partners, bankers, customers, and employees; request elaborations on notes to financial statements; and request clarification on accounting methodologies, debt structures, and the operation of customer contracts. 

Given the complexity of the underwriting process, it is important to ensure that the insured is properly prepared for any renewal meetings that take place with underwriters. It may be important for various individuals within the corporation to attend renewal meetings or participate on conference calls. Along with the risk manager, others such as legal counsel, the chief financial officer and/or compliance personnel may be asked to participate. Those businesses that may be closest to the sub-prime crisis, such as financial institutions and/or fund management companies, may also consider having their investment manager and/or fund manager attend, as they can typically speak to the procedural management of the institution's business (e.g., volume and frequency of trading activity). 

The corporation and its spokespeople should ensure that the financial picture that they provide to their insurer properly highlights the successes and clarifies the challenges of the corporation. If confidential information is being provided, the insurer can be asked to sign an appropriate non-disclosure agreement. Because the application for renewal process requires the outmost good faith on the part of the insured and because the consequences for material misstatements can be draconian, it is important that the proper persons are involved in the renewal process. 

The sub-prime crisis in the United States and the related ABCP events in Canada will no doubt take much time, effort, money, and angst to ultimately resolve. Corporate counsel will need to be actively engaged to assist their corporations to identify potential exposure and undertake effective risk management.

1A contract protecting the buyer against a defined credit default. The contract may be unsecured or may require the posting of security. 
2 Credit default swaps for which the amount of credit protection involved is greater than the amount of the collateral posted by the conduit as security. To address this shortfall, the asset provider is entitled to make calls on additional collateral held by the conduit if certain margin triggers were tripped. The margin triggers, in a number of cases, were based on complex proprietary formulas of the asset provider to which the conduit did not even have access. 
3 Sub-prime Related Lawsuits Clogging the Courts by Nicholas Remmel, Financial Week, April 25, 2008 
4 Derivative Actions – Mitigating the Risks, co-written by Frank Palmay, Jordan Solway and Patrick Bourk, Ultimate Corporate Counsel Guide, August 2007 
5 Schoon v. Troy Corp., 2006 Del. Ch., LEXIS 123, 2006; WL 1851481. 
5 The recent Supreme Court of Canada case Jesuit Fathers of Upper Canada v. Guardian Insurance Company of Canada and ING Insurance Company of Canada, 2006 SCC 21, shows that the results can be severe. 
6 Slater Steel Inc (Re), 2008 ONCA 196, currently seeking leave to appeal to the Supreme Court of Canada.