December 28, 2018
Corporate Trust Alert
Author(s): Robert J. Coughlin
The United States Bankruptcy Court for the Southern District of New York dismissed a widely watched involuntary bankruptcy petition filed by senior noteholders seeking to force a restructuring of a CDO via chapter 11 reorganization. This alert discusses what indenture trustees need to know.
On November 8, 2018, the United States Bankruptcy Court for the Southern District of New York dismissed an involuntary bankruptcy petition filed by senior noteholders seeking to force a restructuring of a collateralized debt obligation (CDO) by a Chapter 11 reorganization. The case was widely watched by securitization market participants and should be of keen interest to CDO indenture trustees. The decision hopefully removes concern that similarly situated senior noteholders might seek to push other CDOs into Chapter 11 bankruptcy.
In June of 2017, an involuntary Chapter 11 petition was filed in the U.S. Bankruptcy Court for the Southern District of New York against Taberna Preferred Funding IV, Ltd, (Taberna IV)—a CDO collateralized by trust preferred securities. The petition was filed by three holders of notes who collectively held all of the Class A-1 Notes (the most senior class) and a large percentage of the second priority Class A-2 Notes.
Prior to filing, an event of default had occurred as a result of a payment default on the Class B Notes. The senior Class A noteholders exercised their right to accelerate all of the notes and sought to liquidate the collateral, but were stymied by an indenture restriction requiring consent of 66 2/3% of each note class. After several unsuccessful attempts to work around the restriction, three of the Class A noteholders filed the involuntary bankruptcy petition seeking to force a liquidation.
The petition immediately drew market attention because the Taberna IV CDO was structured as a bankruptcy-remote special purpose entity (SPE), as is typical of securitization transactions. A bankruptcy-remote SPE is designed to give investors confidence that the payment priorities specified in the indenture will not be subject to restructuring in a bankruptcy proceeding. The Bankruptcy Code allows creditors to force a debtor into bankruptcy by filing an involuntary petition against it, if certain conditions are met.
Opposing parties objected to the petition filed against Taberna IV on a variety of grounds, including a challenge to the petitioning noteholders’ statutory eligibility to file an involuntary petition as unsecured creditors, arguing that because the Taberna IV Notes are nonrecourse by their terms (typical of CDOs), they cannot, by definition, constitute unsecured claims (notwithstanding that the petitioning Class A noteholders had filed, to no avail as it would turn out, a partial waiver of lien in an attempt to solidify their eligibility as holders of unsecured claims).
Bankruptcy Court Judge Mary Kay Vyskocil ruled that because the notes issued under the Taberna IV indenture are nonrecourse, the petitioning creditors hold claims only against the collateral pledged under the indenture, not against Taberna IV itself, and thereby fail to meet one of the eligibility requirements of Bankruptcy Code Section 303(b). Section 303(b)(1) provides in relevant part that an involuntary case may be commenced against a debtor “… by three or more entities, each of which is either a holder of a claim against such person that is not contingent as to liability… if such noncontingent, undisputed claims aggregate at least $15,775.00 more than the value of any lien on property of the debtor securing such claims held by the holders of such claims.”
Judge Vyskocil found that the Taberna IV indenture unambiguously established that the petitioning creditors’ notes were nonrecourse, rejecting arguments that language elsewhere in the indenture was sufficient to establish an affirmative payment obligation, or that the indenture does not render the notes nonrecourse until after all of the collateral is exhausted. The court ruled that lacking any obligation to repay the notes from any assets other than the collateral pledged under the indenture, Taberna IV did not bear personal liability on the notes necessary to satisfy the requirements of Section 303(b)(1).
In what is perhaps the most interesting part of the decision, after rejecting a variety of alternative arguments raised by the petitioners, the court went on to say that even if the petitioning noteholders were eligible under Section 303(b), “cause exists to dismiss the petition because no bankruptcy purpose was served by this filing … in the Court’s view it would be an injustice to find that the Petitioning Creditors, sophisticated business entities who analyzed and bargained for Taberna’s current liquidation scheme, are prejudiced by the contractual terms and conditions they freely sought out and entered … [i]t is undisputed that Taberna IV is not an operating business, and therefore no rehabilitative objective can be served by allowing a bankruptcy case to proceed.”
Continuing, the court said there is “no need for bankruptcy protection” in this circumstance because the Taberna IV indenture “independently establishes the parties’ agreements as to liquidation,” citing the indenture’s articulated priorities of payment, and that the petitioning senior noteholders’ “stated goal, which they were unable to achieve through a series of earlier initiatives, is to rewrite the terms of the Indenture agreement, thereby enabling Petitioning Creditors to alter Taberna’s governance structure…with the ultimate goal of forcing an accelerated liquidation-- not a reorganization.”
The court concluded by saying that the “Petitioning creditors seek bankruptcy solely as a means to alter the terms of a contract they freely entered” not as a “genuine attempt to reorganize the putative debtor so that it can reemerge from bankruptcy as a viable on-going business.” Rather, the court said, the case is “nothing more than a last-ditch effort by a senior sophisticated noteholder to further its personal, tactical and pecuniary aims and to coerce a redemption of its notes to the detriment of junior creditors” and that “if the Petitioning Creditor’s tactics were permitted and rewarded with an entry of an order for relief, this would create significant uncertainty across the capital markets.”
The petitioning noteholders did not appeal the decision.
Although decided on narrow grounds, Judge Vyskocil went out of her way to reject resoundingly the senior noteholders’ petition. As a result, in addition to being welcome news to other market participants, her decision should greatly reassure CDO and collateralized loan obligation (CLO) indenture trustees—standing as a strong disincentive to other senior class investors in other transactions who might have been considering a similar strategy.
CDOs and CLOs in default follow well-defined procedures for the exercise of remedies, including liquidation of collateral, as specified in the indenture. As a result, the administration of defaulted CDOs and CLOs for many years has been, by and large, predictable and stable. Were a different ruling to have been forthcoming in this case, it might have encouraged senior noteholders in other transactions to pursue involuntary bankruptcy as a strategy to circumvent indenture restrictions, potentially introducing a dramatic and unexpected change in the administration of defaulted CDOs and CLOs for indenture trustees—a change that parties who originated the deals, including investors, specifically intended to avoid.
The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.