JPMorgan Chase: A Case That Demonstrates Its Strong Risk-Management Culture

Summary:

• JPMorgan Chase has been subpoenaed for documents relating to its sale of preferred shares in Diamond Sports to Sinclair Broadcasting Company.
• Diamond Sports has since filed for bankruptcy, and the sale may be declared illegal by the court. Investors should not be alarmed, however.
• The assets were guaranteed by Sinclair, so it, not Morgan, would be liable for restitution for any illegal preferential transfers.
• The case instead is a testament to JPMorgan’s strong risk-management culture, as it ensured its guarantee had recourse to Sinclair’s assets, not just those in the subsidiary. And those assets are sufficient to pay what Morgan is owed.
• Morgan’s decision to underwrite and fund Sinclair’s RSN merger 4 years ago has been vindicated – it reaped substantial returns on a deal others were afraid to touch, without compromising its strong risk management. Bank leadership deserves credit.

Lawsuits are just part and parcel of being a company with a twelve-figure market capitalization. Or even just a ten-figure market cap.

Still, the case of Diamond Sports has attracted some attention – and frankly, in my view, should be attracting a whole lot more given its potential implications – for the highly unusual financial dealings and even corporate governance issues it has raised. The news that JPMorgan Chase (NYSE:JPM) has been roped into such a case may, at first glance, make some investors at least a little nervous. They might be even more nervous when they remember assets being disputed were thought even when they were first bought to signal a potential weakening in JPMorgan’s strong risk-management culture.

They shouldn’t be. In fact, as someone who has been following this particular story of these particular preferred shares for over four years, pretty much since the day they were issued, let me tell you something: being subpoenaed like this, in a story where there certainly were some highly unusual financial dealings, actually makes me want to go out and buy JPMorgan stock. And my confidence in Morgan’s risk-management is stronger than ever.

They’ve Been Served

It was actually a few months ago now that we learned Sinclair Broadcasting Company (SBGI) had purchased $200 million of preferred shares in another company, Diamond Sports, from JPMorgan for about $190 million. The deal was just the latest in a series of transactions over the preceding three years and change that saw Sinclair purchase over $1 billion of Diamond preferred equity…somewhat daunting considering that Sinclair’s whole market cap as a company only comes to $870 million as of this writing.

Even at the time, I thought this was a pretty big story, but I was just about the only one who thought so. Now, comes the official word that JPMorgan Chase has been subpoenaed for all documents and communications relating to those preferred stock repurchases. You see, since the deal was consummated, Diamond Sports has filed for bankruptcy, and it’s getting ugly. I mean both the numbers and the testimonies.

The source of the subpoena is of course the Diamond Sports bondholders, who are doubtless hoping to haul JPMorgan bankers into bankruptcy court and get all the sordid details of some sort of skullduggery that would get some of their money back.

They may yet be disappointed, since it’s not clear that Diamond bondholders have any recourse at this late hour, even though I think it’s obvious that what Sinclair did was…highly unusual, at least. But whatever the details and regardless of whether Sinclair’s management is found to have any liability or not, there is practically no danger of JPMorgan Chase being hit with any liability at all.

The Backstory

I’ll make this part as quick as I can, but there’s no way to explain what I just said without providing some background. It all starts back in 2019.

Disney (DIS) had just closed its Fox (FOX) merger, but it was ordered by the DOJ to sell Fox’s collection of RSNs as a condition of approval. No problem, everyone figured; the assets were highly coveted and valued at $22.4 billion. And JPMorgan was looking forward to collecting fees on said sale.

Except, when Disney opened the asset’s books and showed them to everyone, they all ran for the hills. Comcast (CMCSA) might not have gotten approval to buy the largest collection of RSNs anyway as they already owned the second-largest collection, but Viacom, WarnerMedia, DIRECTV, Charter (CHTR) and Discovery (WBD) didn’t want them either. Even Fox itself passed on the chance to reacquire them for half what they’d sold them for just a few months prior.

Ultimately, the only one willing to step into the void and do a deal was a little affiliate broadcaster named Sinclair Broadcasting. Being little though, it had some trouble raising the cash. Even after an extremely aggressive leveraged buyout strategy that saw their new RSN subsidiary Diamond Sports leveraged almost four to one, Sinclair could not come up with the full (though Disney probably wouldn’t use that word) $10.6 billion it had agreed to pay for the RSNs.

Not wanting to lose the deal and the fees it would generate, JPMorgan Chase took what many at the time believed to be a serious and perhaps even foolhardy risk: it took $1.025 billion of preferred equity in Diamond Sports onto its own books to close the capital gap and permit Sinclair to finally seal the deal with Disney. It was, however, compensated with a very rich dividend rate, at least; the preferred carried a rate of 8% over LIBOR, with a 0.5% per annum increase starting in 2022! And remember, these shares were agreed to years before the Fed rate hike, back when a 6% rate was considered almost lucrative.

From Sweet To Sour

Even so, the juicy rate didn’t stop eyebrows from being raised, and there was a certain amount of disquiet. Even minus the YES Network, which the Yankees exercised their first-refusal right to take back for themselves, Sinclair was seen by many at the time to have scored a substantial coup by purchasing the RSN fleet at a substantial discount. Meanwhile, JPMorgan was seen as somewhat of a no-win situation: either the investment panned out and their non-convertible preferred had no way to capture upside, or it didn’t and Morgan was on the hook for far more than the fees the deal generated.

At the time, most considered the former scenario to be far more likely. But even so, the whole thing was a little too pre-Great Recession, “irresponsible bankers,” for some people. But few thought the deal would actually go south, so mostly the concern expressed was about what it said about the philosophy at JPMorgan, and the possibility that the sort of irresponsibility it had so adroitly avoided to stay out of the 2008 housing crash might be starting to creep in. The asset itself was probably fine, right?

For myself, however, my alarm bells immediately went off: there was a reason Disney had not found any other buyers for these RSNs besides Sinclair’s low-ball bid. And now JPMorgan was exposed to the tune of $1 billion, for probably only a fraction of that in fees. But yes, JPMorgan is a colossus, with a capital cushion many times the size of the money it had put at risk. So while it was a bad bet by Chase, or at least appeared to be, there was no real way to bet on that deal individually in the market. So all my subsequent analysis was really focused on Sinclair, since their stock price was far more directly pegged to the deal’s outcome.

Fast forward four years (and my many, many articles warning investors to stay away) later, and the jig is up: Diamond Sports has officially filed for bankruptcy and the equity of the company will be almost completely wiped out to issue new shares to Diamond’s bondholders – who, by the way, are almost completely wiped out as well even with the new shares. Recoveries for bondholders will almost certainly be in the low single digits.

Something Is Strange….

Now, let me make sure we all got that: Diamond Sports losses are so ridiculously high that its bondholders are looking at pennies on the dollar, and its shareholders are getting nothing at all.

So some might understandably have been confused to read that just three days before Diamond Sports filed for bankruptcy, and when their parent company certainly would have been aware they planned on doing so, Sinclair bought the last $200 million of Diamond’s preferred shares from JPMorgan Chase, and paid 95 cents on the dollar for them. Those preferred shares became worthless less than a week after Sinclair bought them…as Sinclair must have known they would.

This means that at a time when shareholders and bondholders alike are being wiped out, JPMorgan Chase will recover all but $10 million or so of its $1.025 billion investment…which it was paid a ludicrously high rate of return on in the meantime, while also collecting the original deal fees for good measure.

This despite being well down the absolute order of priority for recovery in bankruptcy.

…But JPMorgan Isn’t The One Sweating

Why in the world would Sinclair do such a thing? Simple really, and maybe you’ve already guessed it: Sinclair had guaranteed the preferred issued by JPMorgan Chase back in 2019, when everyone thought the deal was a sure thing. Buying them back before the filing was just a way to do a payout they’d have to do anyway without the judicial hassle of it all.

This is also, in a way, what the case is about that Diamond bondholders are now waging. As I noted at the time, because Sinclair had guaranteed the preferred shares it was repurchasing from JPMorgan Chase, using Diamond subsidiary cash to buy them back from JPMorgan and close them out was essentially a way of reducing their own exposure to a Diamond bankruptcy by increasing Diamond bondholders losses.

The subpoenas are almost certainly with the purpose of establishing that the purchases of the preferred shares meet the legal standard of preferential transfers for the benefit of management and other insiders; which, if demonstrated, would make the transactions illegal under federal bankruptcy law. Assuming the bondholders won – admittedly, a big if – not just the last $200 million but the entire $1 billion-plus could be retroactively deemed illegal.

So, shouldn’t Morgan investors be alarmed that if that happened, Morgan might have to give $1 billion in cash back and take worthless preferred shares in exchange for them?

No, certainly not. Again, these assets were guaranteed. The lawsuit, assuming it gets off the ground at all, will not argue that JPMorgan Chase should not have been paid. Rather it will argue that the payment should have come off of parent company Sinclair’s balance sheet instead of subsidiary Diamond’s. Even if that argument prevails, it is Sinclair’s money, not Chase’s, that Diamond bondholders will be coming for. They aren’t subpoenaing Morgan as a potential defendant. Rather, they almost certainly want to use Morgan as a witness, with Sinclair and its management in the role of defendant.

The legal mechanism, if the bondholders actually won, would look something like this: a note would arrive from the bankruptcy court which, stripped of the legalese, would essentially say “here’s the preferred equity we owe you, and you owe us $1 billion in cash.” But when Morgan got that note, it would simply turn around and deliver exactly the same message to Sinclair. Heck, they might even just cross out the names and reuse the same paper.

Rubber Meets The Road

That would be useless, of course, if Sinclair had nothing to pay them with. If Sinclair also wound up filing for bankruptcy JPMorgan would be on the hook: a guarantee of a bankrupt company from another bankrupt company isn’t worth very much.

But this is where JPMorgan’s risk-management culture shows it hasn’t worn off at all. Sinclair has the resources needed to pay the guarantee it owes, if need be.

The deal, like many mergers, was structured from the beginning with Sinclair putting the RSNs into a bankruptcy-remote subsidiary, the aforementioned Diamond Sports. Being bankruptcy remote, Diamond bondholders, even if they win on the novel legal question of subsidiary-funded extinguishment of a parent company guarantee, definitely do not have recourse to Sinclair’s other assets in the parent company. Only the limited amounts spent on share repurchases.

But because Morgan’s guarantee comes from the parent, not the subsidiary, JPMorgan Chase does have recourse to all the assets Sinclair owns, not just the ones in the RSN subsidiary. And those assets are sufficient to cover the guarantee.

Which, presumably, is the only reason JPMorgan agreed to the deal four years ago in the first place.

Vindication For Morgan

To be sure, the Diamond deal is still what it always was: too small to matter for JPMorgan’s own balance sheet that much. But in my opinion it should still matter to JPMorgan investors because it speaks to the risk-management culture at the bank; which contrary to the fears some once held does not seem to have been weakened at all. JPMorgan did its usual due diligence and realized that while Diamond Sports the subsidiary did not have the necessary assets to cover the loan, Sinclair the parent company did. It obtained a sufficient guarantee that it is just about the only one of the deal’s many parties that is going to be walking away from this with its principal intact and a nice rate of return.

This is the very definition of sound risk-management.

Investment Summary

This article was an in-depth look at one particular JPMorgan transaction, and the resulting legal issues it has raised. Most analysis of a bank focuses on the big picture of dividend yield, capital structure, balance sheet, etc. And that is as it should be. However, I do believe that watching how a specific deal plays out can be beneficial, even if it’s a small part of the whole. It speaks to the culture of the institution.

And certainly, JPM investors may be reassured to know that JPMorgan’s role in whatever legal drama is to come is almost certainly to be more in the role of witness than defendant. And it’s risk-management apparently remains rock solid.

This is also a particular court case that we may be reading more about in the weeks and months to come. While JPMorgan has little to no liability to any of this, there are serious questions about corporate governance as a whole that have been raised by this case, and some background understanding of it may be useful to you even outside of the context of JPMorgan.

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