Opinion ID: 614511
Heading Depth: 2
Heading Rank: 3

Heading: The deal

Text: On July 18, 2002, Montgomery, Beal, and attorneys from De Castro participated in a conference call in which Montgomery presented the results of his due diligence and recommended that Beal invest in a portfolio of unsecured Chinese NPLs. The parties also discussed the potential tax benefits to Beal that would result from the partnership-based transaction structure proposed by De Castro. Beal explained on the call that the Bank was not in a position to invest in the NPLs. Montgomerywho up until this time had been acting in his capacity as an employee of the Bank asked Beal to release him from his obligation to the Bank so that he could continue to pursue the deal in an individual capacity. Beal agreed. He also told Montgomery that he might be interested in pursuing the investment personally, outside of the Bank, and asked Montgomery to come back to him once Montgomery had finalized a deal. That same day, Montgomery formed Montgomery Capital Advisers, LLC (MCA), a single-member limited liability company through which Montgomery could continue to pursue an investment in Chinese NPLs. By late July, Montgomery had settled on a particular portfolio of approximately 24,000 of Cinda's most severely distressed unsecured NPLs. The loans had a face value of approximately $1.145 billion. Montgomery anticipated that most of the portfolio's actual value would come from the discovery of a few nuggets within the pool, loans whose values would prove to be many multiples of their acquisition prices. Based on his experience investing in severely distressed unsecured NPLs in the United States, Montgomery believed that the nuggets would make the portfolio of Chinese NPLs worth, at a minimum, 1-3 percent of its face value. To confirm this belief, Montgomery commissioned Zhongyu, a Chinese valuation firm, to provide a valuation analysis of the NPLs. Zhongyu was tasked with estimating the total value of the portfolio based on a statistically valid sample of about 35 percent of the loans in the portfolio. Zhongyu was to report its findings to Montgomery by mid-August. MCA also retained the services of Haiwen, a Chinese law firm, to perform legal due diligencethat is, to confirm that the loans were legally valid and enforceable, that Cinda owned the loans, and that Cinda had the ability to transfer the loans to an American entity. This due-diligence report was due by the end of August. Eager to close the deal, Montgomery decided to move forward with Cinda before he received the results of the two due-diligence reports he had commissioned. On July 31 and August 1, 2002, Montgomery and Cinda consummated a series of five transactions. First, Cinda formed Eastgate, a single-member limited liability company organized under Delaware law. As a wholly owned subsidiary of Cinda, Eastgate was created for the purpose of acting as Cinda's United States investment vehicle for NPL transactions. Second, Cinda contributed to Eastgate the portfolio of NPLs selected by Montgomery. Cinda contributed the NPLs to Eastgate pursuant to a contribution agreement in which it made a series of warranties and representations stating that Cinda had not written off, compromised, or made a determination of worthlessness as to any of the NPLs. Third, MCA (Montgomery's single-member LLC) and Eastgate formed and organized Southgate as a limited liability company under Delaware law. Upon formation, Eastgate contributed the NPLs to Southgate pursuant to a virtually identical contribution agreement. In exchange, Eastgate received a 99 percent ownership interest in Southgate and an initial capital account balance of $19,420,000 (an amount roughly equal to 1.7 percent of the NPLs' face value, which reflected the parties' negotiated determination of the loans' fair market value). Montgomery contributed cash and a promissory note worth $196,162 in exchange for a 1 percent ownership interest in Southgate. Montgomery was appointed as Southgate's sole manager. Fourth, Montgomery entered into a brokerage agreement with Deutsche Bank. Montgomery agreed to pay Deutsche Bank $50,000 for its services as the exclusive placement agent for Cinda's NPLs. In addition, Montgomery agreed that he would pay an additional fee to Deutsche Bank if and when an investor purchased Cinda's interest in Southgate. The fee, which was tied to the percentage of the face value of the loans in Southgate's portfolio, came to about $8.5 million. Montgomery anticipated that Beal (or some other investor) would satisfy this obligation. Finally, Southgate and Cinda signed a loan-servicing agreement (LSA) in which Southgate agreed to pay Cinda 25 percent of net collections in exchange for servicing the NPLs. The LSA was critical to the investment strategy in two respects. First, it reduced the up-front purchase cost of the NPLs. Cinda had initially proposed an acquisition price of between $34.36 million and $40.08 million (that is, between 3 and 3.5 percent of the portfolio's face value). However, Montgomery's due diligence had revealed that Cinda was required to use 99 percent of the acquisition price it received for the NPLs to service the bonds it had used to purchase the loans. But any fees it earned as a loan servicer it was free to retain for its own operations. Montgomery thus was able to negotiate the acquisition price of the NPLs from 3-to-3.5 percent down to 1.7 percent by agreeing to have Southgate enter into an LSA that paid Cinda a more generous fee than it otherwise would have been willing to pay. The second reason the LSA was critical to Montgomery's business plan was that it increased the likelihood of realizing value on the loan portfolio. By retaining Cinda as its loan servicer, Southgate was able to take advantage of Cinda's statutory super powers, which increased the likelihood of successful collections. And by shifting some of the total value that Cinda would receive in the transaction out of the purchase price and into the LSA's fee structure, Montgomery hoped to incentivize Cinda's efforts to service and collect on the loans. These transactions positioned Southgate as a tax-friendly investment vehicle. Southgate was holding NPLs with a built-in loss of more than $1.3 billion, all of which was allocable to Cinda. [19] An investor who purchased Cinda's interest in Southgate would step into Cinda's shoes and be positioned to claim the tax losses that Southgate generated as it disposed of the loans in its portfolio for pennies on the dollar. Southgate thus stood to generate more than $1 billion dollars in paper losses, losses that would arguably be of ordinary-income character. [20] To a high-net-worth individual paying a marginal tax rate of 35 percent, the ability to deduct these losses would be of tremendous value. The final pieces of the deal fell into place over the next month. In mid-August, Zhongyu reported the findings of its valuation analysis to Montgomery. Zhongyu estimated that Southgate's portfolio of NPLs was worth between $44.67 million (3.90 percent of face value) and $111.8 million (9.76 percent of face value). Around the same time, Montgomery traveled to China and got a preliminary report from Haiwen that the NPLs were valid loans. On August 25, 2002, Montgomery sent a memo to Beal summarizing the results of his due diligence and enthusiastically recommending that Beal purchase a portion of Cinda/Eastgate's interest in the Southgate partnership. Beal readily agreed to do so. He formed a single-member Delaware LLC, Martel Associates, through which he would invest in Southgate. By the end of the week, Haiwen's final legal due-diligence report came through and confirmed that all but a tiny sliver of the loans in the portfolio were legally enforceable and had not been compromised, written off, or discharged in bankruptcy. On August 30, 2002, Beal paid Cinda $19,407,000 in exchange for 90 percent of Eastgate's interest in Southgate. Beal thus wound up with an 89.1 percent ownership interest, leaving Cinda with a 9.9 percent interest and Montgomery's 1.0 percent share unchanged. Beal also assumed Montgomery's obligations under the brokerage agreement with Deutsche Bank and paid the $8.5 million placement fee. With the deal papered, the parties turned to developing a collection strategy that would be responsive to both profit-and tax-driven concerns. On the business side, Montgomery and Cinda decided to focus on identifying a small number of loans (between 15 and 25 percent of the portfolio) that held enough profit potential to merit further review. The goal was to focus collection efforts on nuggets that would eventually be identified within this smaller pool. The balance of the portfolio would be packaged into smaller groups and sold off to small Chinese collection firms; the proceeds of the sales would provide Southgate with working capital. Consistent with the three-year term of the LSA between Southgate and Cinda, Montgomery and Cinda decided to aim for resolving about 25 percent of the NPLs in 2002, 50 percent in 2003, and 25 percent in 2004. It just so happened that this collection strategy would create losses in amounts tailored to the amounts of personal income against which Beal sought to claim deductions. Ultimately, Southgate proved to be a failure as an investment venture. The primary cause of Southgate's poor performance was Cinda's disappointing performance as a loan servicer. The value of many of the loans that Southgate identified as nuggets derived from the fact that they were backed by a Chinese-government guarantee. Cinda's initial efforts to collect on these loans and enforce the guarantees generated push-back and fallout in China. Political pressure from the Chinese government led to Cinda's repeatedly selling off NPLs that Southgate had identified as high-value nuggets. These sales were in direct breach of both the Southgate Operating Agreement and the LSA and cut the legs from Southgate's business plan. The total net collections on Southgate's NPL portfolio were approximately $10.69 million, far less than Zhongyu's valuation report had projected.