EXCLUSIVE – Investors scoop up bonds at heart of SEC fraud case

6 min read
Americas
Joy Wiltermuth, Andrew Park

Investors are snapping up pieces of a bond at the center of a new US legal battle, betting it will deliver huge profits if regulators can prove it was part of an elaborate fraud.

The case revolves around three collateralized loan obligations (CLOs) put together by Wall Street veteran Lynn Tilton and her private equity firm, Patriarch Partners.

The US Securities and Exchange Commission alleges that Tilton defrauded investors with the deals – Zohar I, II and III and got some US$200m in fees to which she was not entitled.

The SEC charged Tilton in March and she counter-sued in April, saying the Commission’s administrative process, which will begin hearing the case on October 13, is unconstitutional.

Meanwhile Nord LB, one of Germany’s biggest banks, is seeking at least US$44m in damages over what it alleges was “false” and “misleading” information about Zohar II and III.

Yet, as the legal battle unfolds, investors are buying senior tranches of the US$1bn Zohar III deal at discount levels, betting that Tilton will lose – and that they will win big.

Some traders reckon the underlying loans – worth US$1.12bn, according to the bond’s trustee – will be more than enough to repay the US$556m senior tranches of Zohar III.

Because they are senior in the CLO structure, moreover, they are likely to recoup at least some of the US$200m that the SEC wants to get back from Tilton if it prevails in the case.

“The charges are black and white, with basically no wiggle room,” one broker, who has been urging clients to buy Zohar III, wrote in a note to clients earlier this month.

“The long and short of it is that Patriarch has no chance.”

The broker has a point – the SEC won 100% of the hearings before its own judges in 2014 – which is one reason why Tilton wants her case heard in a regular US court.

“The SEC can sue you in their own private court, where they get to choose the judges that work for the SEC,” she said in a video made public on YouTube. “It’s just not a fair fight.”

The queen

Patriarch’s website – which bills Tilton as the “Turnaround Queen” – says she is “passionate about saving American jobs by saving American companies”.

Tilton, a former banker at both Morgan Stanley and Goldman Sachs, buys companies in deep distress, loans them money and implements a turnaround strategy.

She has investments in 75 companies, according to the website, including names like Rand McNally and Spiegel – once some of the most well-known brands in American business.

The three CLOs raised US$2.5bn between 2003 and 2007, when such securities were all the rage in the market before the financial crisis kicked in.

The SEC alleges that Tilton lied to investors about the value of the assets – primarily the loans made to the companies underpinning the three Zohar CLOs.

It says many of the companies have made only partial repayments on the loans, and that she defrauded investors with a “deceptive scheme” that overstated the assets’ actual worth.

By not writing down the valuations and using non-standard accounting measures, she stayed within parameters in the bonds’ documentation such as the overcollateralization (OC) ratio.

That allegedly allowed her to keep control of the funds – and pocket the fees for managing them.

“Zohar II and Zohar III would have failed the OC Ratio test by at least the summer of 2009,” the SEC said in its filing, if Tilton had not miscategorized the poorly performing assets.

But she said in her April court filing that Zohar’s original buyers were “the most sophisticated of institutional investors” and demanded a jury trial to prove her innocence.

She acknowledged that Patriarch “frequently deferred or forgave” payments from the distressed companies, but said the investors had been told those loans likely would be amended.

“This was fully disclosed to noteholders,” the filing said.

Tilton’s spokesperson declined to comment for this story.

Smart bet?

One thing Tilton clearly has said, however, is that holders of Zohar I are facing significant losses when the notes mature in November - unless she can get the maturity date extended.

Performance reports on Zohar III seen by IFR meanwhile offer little in the way of concrete detail about the state of the loans.

And one former Tilton colleague who declined to be named said the situation of the loans was anything but clear.

“These companies are un-analyzable,” the person said. “It’s like shooting in the wind.”

In addition, Moody’s and Standard & Poor’s initially gave Zohar III’s senior tranches their highest AAA rating – but then downgraded them before rescinding the ratings altogether.

Yet with the bonds currently trading at about 60 cents on the dollar – for a yield of some 20%, according to some estimates – Zohar III may seem to be a reasonable bet.

Two dealers told IFR that a number of investors are now making that very bet, scooping up the senior-most tranches at a fraction of face value.

One of them said at least 13 investors have purchased parts of the deal, four of them in the last six weeks alone – in other words, since the SEC filed the fraud charges.

“Z1 and Z2 do not represent an opportunity,” said the broker in his pitch to clients. “All opportunity is in Z3.”

Lynn Tilton