Vol 12 (2015) - Issue 3

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The Limits of Limited Recourse Protections Post-ARM Asset Backed Securities

1. Introduction
The case of Re ARM Asset Backed Securities SA sounds a cautionary note on the structuring of insolvency remote entities and, in particular, the effectiveness of limited recourse provisions.
Insolvency remote entities play an important role in a variety of transactions. In a capital markets context, for example, rating agencies will often expect issuers to be insolvency remote before accrediting the securities a high rating. Standard & Poor’s ratings criteria require limited recourse language and non-petition language in relation to rated debt. The rationale for these requirements is to minimise the costs and uncertainty that insolvency proceedings entail as a result of, amongst other matters, a court process, the involvement of officeholders and their advisers, as well as a statutory moratorium on enforcement. Insolvency remoteness should thus result in an issuer’s assets retaining greater value for distribution to creditors according to the relevant contractual waterfall provisions.
Additionally, insolvency remoteness protects directors from difficult decisions as a result of their duties or obligations, depending on the jurisdiction, to place an insolvent company into an insolvency process in order to avoid or mitigate any personal liability.
Methods of achieving insolvency remoteness
The various issues to be considered when structuring an insolvency remote entity include the use of limited recourse provisions which were the subject of the decision in ARM Asset Backed Securities and on which this article will focus. Other considerations include nonpetition clauses which purport to prohibit a creditor from taking legal action or commencing insolvency proceedings against an issuer and covenants which purport to prevent an issuer from undertaking activities or incurring liabilities outside those contemplated by the relevant transaction documents.

Limited recourse provisions
Limited recourse provisions usually take one of two forms: contractual provisions which purport (a) directly to limit liability, as considered in ARM Asset Based Securities; and (b) indirectly to limit liability such as post-enforcement call options (PECOs), as considered in BNY Corporate Trustee Services Ltd v Eurosail.
Direct limitations only permit noteholders to recover sums due under the relevant securities to the extent that an issuer has the available funds. Thus, if that issuer does not have the available funds or if the value of the assets is insufficient to satisfy the noteholders’ payments, the terms of the securities will prevent the noteholders from recovering the otherwise outstanding sums. Indirect limitations such as PECOs involve an option which allows an associate company to purchase all of the securities from the noteholders for nominal value once all available assets of the issuer have been realised and distributed and there thus are no further amounts available to be paid out to the noteholders. The associate company is then required to release the issuer from its liabilities under the acquired securities.
Direct and indirect limited recourse provisions therefore take different routes in order to achieve a similar outcome. Whilst direct limited recourse provisions automatically extinguish liabilities in excess of available assets at a prescribed point, indirect limited recourse provisions have no effect on an issuer’s liabilities until the associate company holding the option releases the issuer.