In the wake of the credit crunch, the past year has witnessed a surge in defaulted collateralized debt obligation (CDO) transactions, resulting in an increase of litigation among parties to CDO transactions (including originators, swap counterparties, note holders, rating agencies, and insurers). Notable litigation includes “waterfall” cases, in which ambiguous provisions in governing documents, particularly indentures, have resulted in disputes among noteholders of varying classes, or between noteholders and swap or liquidity counterparties, regarding subordination and priorities of payment stemming from an event of default (EOD), acceleration of maturity, and liquidation of collateral under such indentures.
In response to conflicting claims regarding acceleration of maturity, subordination, and priority of payment, trustees of CDO transactions have recently filed interpleader complaints, seeking direction from courts in light of ambiguous indenture language. In each instance, trustees placed disputed proceeds into escrow accounts to be held until the court provides direction on the application of such proceeds.
An increasing number of CDOs have gone into an EOD as a result of declining value, increased defaults, and ratings downgrades of underlying assets in the portfolio. The controlling class typically wishes to accelerate to trigger subordination terms that may affect cash-flow priorities in their favor, or may decide that the underlying assets of the CDO should be liquidated, causing the most senior classes to be paid first with the proceeds of the liquidation on an accelerated basis, with the remaining proceeds, if any, paying down the other classes of securities. In many situations, however, the liquidation proceeds may be insufficient to provide for much, if any, remaining amounts to be available to pay subordinate classes (and, in some cases, may or may not provide for payment in full to the most senior). In hopes of continuing future distributions on their securities, or future improvement in the value of the portfolio, subordinate classes have often objected to these actions by the controlling party by asserting that an EOD has not occurred or finding possible arguments to contest the acceleration, the application of subordination priorities, or the liquidation of the portfolio.
Some of these conflicts regarding CDO liquidation have arisen from both ambiguous indenture provisions and aggressive arguments of interpretation. One such conflict is discussed in an interpleader complaint recently filed by the trustee in LaSalle Bank Nat’l Ass’n v. UBS AG and Merrill Lynch International, 08 CIV 3692 (S.D.N.Y., filed April 7, 2008). According to this complaint, an acceleration of maturity occurred under each of the three indentures at issue and the trustee was directed by the controlling party to liquidate the collateral securing the transaction and to apply the proceeds in accordance with the indenture, to make termination payments owed to the controlling party as counterparty under certain swap arrangements. Certain non-controlling noteholders claimed that the acceleration by the controlling noteholders resulted in a payment default to such non-controlling noteholders, which meant that any liquidation of the collateral was subject to their consent. The non-controlling noteholders withheld such consent and instructed the trustee not to liquidate the collateral. The non-controlling noteholders also asserted that, if the collateral were to be liquidated, the proceeds should not be used to pay the controlling noteholders under certain swap arrangements but should instead be applied to making other required payments under the indenture, such as paying the notes.
As in LaSalle, disputes sometimes have centered around conflicting interpretations of the priority of payments language and the subordination provisions in the indentures and other documents at issue, where the trustee receives inconsistent directions or demands about how the proceeds are to be applied. In many of these cases, senior holders or senior facility providers claim that they should be paid in full before any distributions to the subordinate holders, as a result of language appearing in the subordination provisions terms, which tie to, or by their terms appear to take effect upon, the occurrence of an EOD and acceleration of maturity, whereas the subordinate holders claim that they are entitled to continue to receive certain payments before the senior holders are paid in full, under the subordinate provisions of the indenture. The crux of these disputes sometimes stems from the fact that the indenture in question fails to provide a separate waterfall for application upon the occurrence of an EOD and acceleration of maturity, which appears in indentures that have often avoided these disputes.
The increase in securitization litigation pertaining to ambiguous document language has not been limited to CDOs and has not been limited to the domestic arena. For instance, in Bank of New York v. Montana Board of Investments  EWHC (Ch.) 1594 (Eng.), the London Chancery Court resolved certain ambiguities in a security agreement (governed by New York law) as to whether a senior class of noteholders of a structured investment vehicle (SIV) has the right to direct the trustee as to time, manner, and place of the sale of the SIV’s collateral following an EOD. In that case, the senior and subordinate noteholders provided the trustee with conflicting direction for the timing and manner of the liquidation of the SIV’s assets. The senior noteholders claimed that they had the right to direct the time, place, and manner of the sale of the collateral, because the subordinated noteholders had agreed to full subordination in payment and that the security agreement required the trustee to enforce the collateral in a manner consistent with full subordination of the subordinated noteholders. The court concluded that, under the security agreement, the trustee had the exclusive control of the collateral after an EOD and right to determine the appropriate time, place, and manner of the sale of the collateral. The court also concluded that the senior noteholder’s direction to sell the collateral “as soon as reasonably practicable” was in conflict with the New York Uniform Commercial Code, which requires the trustee to act in a “commercially reasonable” manner in selling collateral. Although certainly debatable, some might seek to cite this decision as support for an argument that a trustee should wait until market conditions strengthen before extinguishing the interest of the junior noteholders. Of importance, however, is the fact that, among other things, the security agreement at issue gave exclusive rights concerning the time, place, and manner for the sale of collateral to the trustee instead of the senior noteholders and that the decision of the English court interpreting New York law is not binding upon U.S. courts.
Trustees should pay particular attention to those provisions that have spawned past confusion and disputes regarding subordination, liquidation, and priority matters, and should exercise care in handling such provisions. When placed at risk or caught between conflicting claims and demands, trustees should strongly consider available tools and resources. Although the use of litigation as a protective tool must be judiciously applied and may not be suitable for all such situations, in certain situations, litigation may be the only way to avoid risk of multiple liability.
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