I told you this was coming: Late Thursday, the creditors committee of the bankrupt mortgage lender Residential Capital asked U.S. Bankruptcy Judge Martin Glenn of Manhattan to grant creditors permission to sue ResCap’s former parent, Ally Financial. The committee, represented by Kramer Levin Naftalis & Frankel, argues that in its short, unhappy existence ResCap functioned first as a cash magnet to boost Ally’s failing auto-lending business and then as a shield against Ally’s liability for toxic mortgages. Ally’s opportunistic manipulation of its captive onetime subsidiary, the committee said, exposes the troubled bank to ResCap’s entire $20 billion liability to creditors.
As the committee explains in its filing, ResCap has agreed to cede control of litigation against Ally to the creditors. Normally, this kind of fraud claim in a Chapter 11 bankruptcy would belong to the debtor. And in fact, before it entered bankruptcy, ResCap made a deal with Ally to resolve any of its potential claims against its former parent for $750 million. But in a dramatic turnaround earlier this year, ResCap renounced the $750 million deal and threw in with the creditors, who have been agitating for more money from Ally from the moment the bankruptcy was filed in May 2012. In Thursday’s brief, the creditors assert that ResCap can’t now sue Ally because it is “subject to the disabling conflicts of the flawed deal” and focused on developing a wind-down plan. Moreover, the creditors argue, they’ve already seen millions of documents through an evidence-sharing agreement with the court-appointed Chapter 11 trustee, so they’re positioned to jump right in to a suit against Ally.
The tale laid out in the committee’s brief is of a devious parent company that has abused its subsidiary since birth. ResCap was spun off from Ally in 2004, when mortgage lending was a much more profitable business than Ally’s traditional auto-loan financing. (Ally began its existence as the financier of GM loans.) According to the brief, however, the spinoff was never really separate from its parent. ResCap’s leadership substantially overlapped with Ally’s, and executive compensation depended on Ally’s performance. And though Ally had created the strategy of loosening mortgage-underwriting standards in the housing boom, the creditors contend that Ally used ResCap to cabin off liability for deficient loans.
“The committee has examined a series of transactions, beginning in 2006, that display a common pattern of behavior by (Ally Financial): moving assets out of ResCap and/or dumping liabilities into it, often without fair consideration or procedural safeguards to ensure arm’s length terms, with the ultimate goal – once the RMBS mess surfaced – of isolating AFI from the catastrophe it created,” the brief said. “AFI kept ResCap barely alive through this period with measured capital infusions and loans – not in a serious attempt to rehabilitate ResCap’s business, but only to prevent a premature bankruptcy that would cut short the harvesting of value and drag AFI down as well.”
The brief described a series of protests by ResCap advocates against Ally’s supposed asset-stripping, including a “stinging critique” by ResCap’s general counsel of one transfer of assets to Ally and concerns expressed by ResCap lawyers from Skadden, Arps, Slate, Meagher & Flom about a deal that effectively ended ResCap’s interest in Ally. Both of those transactions, as well as others disadvantageous to ResCap, nevertheless went through, according to the brief. Then when the housing bubble burst and loose mortgage underwriting returned to haunt Ally and ResCap, Ally forced its former subsidiary to bear all of the liability, according to the creditors. In an $800 million deal with Fannie Mae and Freddie Mac, for instance, ResCap entities “were made to shoulder the entire burden of the settlements, even though they were insolvent at the time (and) a significant portion of the underlying liability pertained to loans originated, underwritten, or acquired by Ally Bank. Finally, on the eve of ResCap’s bankruptcy filing, Ally supposedly engineered an $8.7 billion settlement between ResCap and investors in private-label mortgage-backed securities. That deal, according to creditors, served Ally’s interests at the expense of ResCap’s creditors.