Morgan Stanley and Axa sued over CBO management

Jersey-registered collateralised bond obligation (CBO) investor Beaford is suing US investment bank Morgan Stanley and French insurer Axa, along with a number of its subsidiaries, for failing to properly manage three CBOs between 1996 and 2002. Morgan Stanley will contest the allegations, in what could prove a landmark case for CBO arrangers and managers.

Poor management of collateralised debt obligations (CDOs) has become an increasingly contentious issue in the structured finance market. Beaford’s objections significantly predate the more sophisticated managed CDO structuring taking place today. But the issue of how arrangers and CDO managers deal with investors that have seen significant credit events erode the value of their investment pools is still ongoing.

Beaford’s complaints centre around three CBO issues – Aeltus I in 1996, Aeltus II in 1997 and AHI II in 1998 – in which the firm invested a total of $30.5 million. According to New York Supreme Court filings lodged on December 10, Beaford alleged that Morgan Stanley did not make the firm sufficiently aware of the risks of investing in such products, failed to manage the collateral in a manner it initially intimated, and that two of its staff made false promises that the firm would match Beaford’s investments in the three CBOs.

Beaford claimed it had “never heard of CBOs” and had “no idea of the risks involved in such investment[s]” before it was approached by its financial advisor, Morgan Stanley, in the mid-1990s. Beaford alleged that Morgan Stanley employees said they would “very carefully monitor the management of the Aeltus CBOs” and described the portfolio risks as “moderate”.

The investor also alleged that Morgan Stanley knew at the time that the debt securities making up the CBO collateral portfolio were “extremely volatile” and, “because of the risks inherent in all emerging market debt, would require an extraordinary degree of ongoing risk management”. The firm further alleged that to “induce Beaford to purchase the Aeltus CBOs”, Morgan Stanley “would co-invest at least the same amount of money in the CBOs as Beaford”. “This representation was materially false when made, because Morgan Stanley never had any intention of investing in the CBOs”, Beaford alleged.

Beaford claimed it has received only $2.925 million in interest from Aeltus I and $8.922 million from Aeltus II, and had none of its principal returned, as of the date of its court filing.

After it had bought into Aeltus I and Aeltus II, Beaford claimed that Morgan Stanley convinced the firm to invest $9.5 million in another CBO, AHI II. Again Beaford alleged that Morgan Stanley said it would invest an equal amount as the Jersey-registered firm, but this time, the collateral underlying the portfolio would be managed “very carefully” by Alliance Capital Management.

Beaford alleged that an employee of Alliance Capital Management (ACM), an international investment advisor, which is a subsidiary of French life insurer Axa through its Equitable Life Assurance Society of the United States unit, “falsely represented to Beaford that ACM would provide regular information about the AHI II collateral, and that “Beaford would be consulted regularly regarding the portfolio”.

”[This employee] and ACM have failed to manage the AHI II CBO collateral in the manner required in the AHI II offering memorandum, and have allowed the AHI II CBO collateral portfolio to deteriorate greatly in value without taking any of the necessary, prudent and available steps as competent, professional collateral managers to preserve and maintain the value of that collateral portfolio,” Beaford claimed. It further alleged that the employee has been assigned other duties at ACM “due to her terrible record as a portfolio manager of the AHI II investment portfolio”. Beaford said it has only received $1,371 million in interest from AHI II.

ACM’s legal department in New York was unavailable for comment. Morgan Stanley is understood to still be sifting through the legal paperwork related to the case and was unable to comment specifically on the allegations. But a Morgan Stanley spokesman said: “We believe this case is entirely without merit and intend to contest it vigorously.”