“Economic Equivalence” of Reference Obligations in a CLO

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Defense counsel for a major bank retained Cornerstone Research in a case arising from a synthetic collateralized loan obligation (CLO) transaction.

Defense counsel for a major bank retained Cornerstone Research and Steven Grenadier of Stanford University in a case arising from a synthetic collateralized loan obligation (CLO) transaction between the bank and the plaintiff, a hedge fund. Under the contract, the bank agreed to pay insurance premiums to the hedge fund, while the hedge fund agreed to compensate the bank for credit losses, if corporate borrowers defaulted on their senior secured obligations referenced in the CLO.

After a corporate borrower undertook a leveraged buyout (LBO), one of the reference obligations was no longer outstanding and had to be replaced. The bank substituted the old loan with a new senior secured obligation from the post-LBO borrower. Because the borrower ended up in default two years later, the hedge fund owed the bank an insurance payoff. However, the hedge fund sued the bank, alleging that the bank had inappropriately substituted the old loan with the new loan as a reference obligation.

In his report, Professor Grenadier opined that both loans shared similar characteristics on the substitution date.

The plaintiff claimed that substitution was invalid because the new loan was substantially riskier and did not preserve the “economic equivalence” of the parties’ delivery and payment obligations under the insurance contract. Professor Grenadier analyzed the plaintiff’s allegations and reviewed its expert’s report.

In his report, Professor Grenadier opined that both loans shared similar characteristics on the substitution date, including:

  • Collateral and seniority in the capital structure
  • Credit ratings by Moody’s and Standard & Poor’s (S&P)
  • Expected loss given default using contemporaneous information from Moody’s and S&P models
  • LIBOR spreads

In his analysis of the plaintiff’s expert report, Professor Grenadier identified several flaws, most critically the expert’s failure to use market pricing data in assessing economic equivalence. Specifically, the plaintiff’s expert failed to account for fluctuations in market risk premiums over time when comparing the LIBOR spreads of the two loans. Professor Grenadier also found that the expert relied on hindsight and information that was not known at the time, and ignored contemporaneous third-party analyses.


For more information on this case, contact Sasha Aganin.

Case Expert

Steven R. Grenadier

William F. Sharpe Professor of Financial Economics,
Stanford Graduate School of Business;
Senior Advisor, Cornerstone Research

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Alexander “Sasha” Aganin

Senior Vice President