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June 20, 2012 Articles

CDOs: Bankruptcy-Remote, Not Bankruptcy-Proof

In-house counsel should always keep the risk of an involuntary filing in mind.

By Adam Lavine and Sunny Thompson

In a decision with significant implications for the distressed CDO (collateralized debt obligation) market, the U.S. Bankruptcy Court for the District of New Jersey has held that CDO issuers may, in fact, be debtors under the Bankruptcy Code. While the decision may come as a surprise to some investors, it serves as a reminder that there is a reason why these types of entities are characterized as “bankruptcy-remote” and not as “bankruptcy-proof.”

A CDO is an investment-grade security backed by a pool of assets, such as bonds or loans. CDOs are uniquely structured to represent different types of debt and credit risk. The different types of debt are often referred to as “tranches” or “slices” and have different maturities and associated risks—the higher the risk, the higher the payout. Typically, a CDO issuer issues various tranches of securities in the form of notes, and a contract called an indenture governs both the terms of the notes, including the interest rate and maturity date, and the respective rights of the various tranches of noteholders.

In In re Zais Investment Grade Limited VII, 455 B.R. 839 (Bankr. D.N.J. 2011), a group of senior secured noteholders, led by Anchorage Capital Group, filed an involuntary-bankruptcy petition against Zais, a Cayman Islands-organized issuer of CDOs. Prior to filing, the senior noteholders had solicited votes on a prepackaged plan under which the collateralized obligations owned by Zais would be actively managed with an eye toward liquidation of the portfolio. The proceeds of the liquidation would go to the senior noteholders, thereby wiping out the more junior tranches of noteholders. The debtor, Zais, did not challenge the involuntary filing, and the bankruptcy court entered an order for relief.

The junior noteholders, however, were not happy by this turn of events. Although an event of default had occurred in March 2009 when the notes became severely under-collateralized, the indenture trustee had continued to hold the portfolio, collect proceeds from the securities, and make periodic distributions to the noteholders. Under the indenture, the trustee was required to hold the portfolio intact unless two-thirds of all noteholders (both senior and junior) directed a sale or liquidation of the securities. Given the two-thirds requirement, the junior noteholders could block any attempt by the senior noteholders to force the sale or liquidation of the portfolio.

Some professionals and investors working in the distressed CDO market have assumed that such indenture provisions would present an obstacle to liquidating a CDO—even in bankruptcy. The senior lenders thought otherwise; their plan was to use the prepackaged-plan process to bypass the indenture’s consent requirements, set up two classes of creditors (senior and junior), obtain acceptance of the plan by the senior noteholders, and cram down the plan on the junior noteholders.

The Junior Noteholders’ Motion to Dismiss
In response to the bankruptcy filing, a group of junior noteholders, led by Hildene Capital Management and Hildene Opportunities Master Fund, filed a motion asking the bankruptcy court to dismiss the Chapter 11 case or, alternatively, abstain from presiding over the case (even though no other proceeding with respect to Zais was pending before any other court). In the words of the bankruptcy judge, this set the stage for “tranche warfare.” Indeed, the court noted that the case “[r]eminds one of the line by Maj. T.J. “King” Kong (played by Slim Pickens) in Dr. Strangelove, ‘Well, boys, I reckon this is it—nuclear combat toe to toe with the Rooskies.’”

Zais’s junior noteholders argued that the court should dismiss the case or abstain from hearing it for the following reasons, among others:

  1. The interests of creditors and the debtor would be better served by abstention under section 305(a)(1) of the Bankruptcy Code;
  2. sufficient cause exists to dismiss the case under section 1112(b) of the Bankruptcy Code;
  3. Zais is not an eligible debtor under section 109(a) of the Bankruptcy Code; and
  4. the petitioning creditors were not eligible to file an involuntary petition under both section 303(b) of the Bankruptcy Code and the indenture itself.

As detailed below, the court held that none of these arguments had any merit, and thus it denied the junior noteholders’ motion to dismiss.

The Decision

Section 305(a)(1) of the Bankruptcy Code provides that a court may dismiss a case or abstain from asserting jurisdiction over it if “the interests of creditors and the debtors would be better served by such dismissal.” Courts typically consider the following factors when determining whether to dismiss a case:

  1. the economy and efficiency of administrating the case
  2. whether another forum is available
  3. whether federal proceedings are necessary
  4. whether there is an alternative means of equitably distributing the assets
  5. whether the debtor and creditors can do an out-of-court workout
  6. whether a non-federal insolvency proceeding is far advanced, and
  7. the purpose for which bankruptcy jurisdiction has been sought.

The court made short shrift of the junior noteholders’ arguments with respect to the first six factors. Specifically, the court noted that (i) there is no other forum capable of granting relief, (ii) there are no other proceedings pending, and (iii) there is no prospect for an out-of-court workout or settlement given the indenture’s requirement that any sale or disposition of assets meet with the supermajority approval of all noteholders.

The court more carefully considered factor seven—the purpose for which bankruptcy jurisdiction has been sought. After all, as noted by the court, “[m]ovants’ essential contention is that the petitioning creditors are trying to use the Bankruptcy Code to avoid the limitations of the indenture, and that is an improper purpose for seeking bankruptcy jurisdiction.”

The court ultimately rejected the junior noteholders’ argument that Anchorage’s purpose in filing an involuntary petition was to improperly circumvent the indenture’s restriction on the disposition of Zais’s assets absent the supermajority approval of all noteholders. To support its conclusion, the court noted that “sections 365(a) and 1123(b)(2) of the Bankruptcy Code specifically permit the rejection of an executory contract,” which indicates that certain circumstances may justify overriding a “burdensome contract.” In this case, the court viewed the indenture as an example of such a “burdensome contract” because it prevented the collateralized securities from being actively managed for the benefit of noteholders. In addition, the court found that the true purpose behind the filing was to liquidate the assets of the debtor and that a liquidation is an appropriate purpose for a Chapter 11 plan if it maximizes the value of the estate.

Under section 1112(b) of the Bankruptcy Code, a court may dismiss a bankruptcy case for “cause” if it was filed in bad faith. Some courts have found bad faith where creditors have filed a petition merely to obtain a tactical litigation advantage. Relying on such cases, the junior noteholders argued that Anchorage filed the petition merely to obtain an advantage over other creditors by circumventing the indenture’s restrictions on disposing of assets without the consent of a supermajority of noteholders.

In rejecting this argument, the court concluded that even if it dismissed the case, the junior noteholders likely would never receive any payments under the indenture. The court reached this conclusion because the indenture provides that once an event of default has occurred, senior noteholders must be paid in full before distributions are made to junior noteholders, and, in this case, the collateral securities are so severely distressed that the senior noteholders likely would not receive payment in full. Because senior noteholders would not be paid in full outside of bankruptcy, the junior noteholders would not receive distributions under the indenture even if the court dismissed the case. Thus, according to the bankruptcy court, the filing of the petition cannot disadvantage the junior noteholders because “[r]eceiving zero under the plan is no worse than getting nothing” outside of bankruptcy. More importantly, though, the bankruptcy court noted that the junior noteholders still had the right to challenge confirmation of the plan, and they could raise arguments about valuation of the portfolio in the context of objections to confirmation of the plan.

Courts may also dismiss a bankruptcy case on the basis of “bad faith” if the petition does not serve a valid bankruptcy purpose. As previously discussed, the court held that Anchorage’s goal of avoiding the restrictions of the indenture did not constitute an impermissible bankruptcy purpose. (Indeed, although not noted by the bankruptcy court, isn’t every prepackaged case filed to avoid the consent requirements under debt agreements?) The court ultimately concluded that “the petitioning creditors have shown good faith in their desire to realize the greatest present value of the Collateral Securities for the benefit of the [senior noteholders] without negatively impacting junior creditors who have no prospect of recovery under the status quo.”

Another device used to keep CDO issuers out of bankruptcy involves structuring CDO issuers as foreign-registered special-purpose vehicles with no employees and no assets in the United States other than collateral held in trust for the benefit of noteholders. The court, however, held that this structure did not prevent Zais from being an eligible debtor under section 109(a) of the Bankruptcy Code. Zais satisfied the eligibility requirements of section 109(a) both because Zais has a place of business in the United States and because Zais has property in the United States.

With respect to having a place of business in the United States, the court held that the “major portion” of Zais’s operations are performed in the United States, including services provided by the collateral manager, the collateral administrator, and the indenture trustee on behalf of Zais. According to the court, that these services were conducted by independent contractors and not employees of the debtor was irrelevant because “a person has a place of business in the United States if . . . business is conducted in the United States on the person’s behalf.” In reaching this conclusion, the court relied on In re Petition of Brierley, 145 B.R. 151, 161–62 (Bankr. S.D.N.Y. 1992), in which the Bankruptcy Court for the Southern District of New York found that an England-based debtor had a “place of business” in the United States, in part, because the debtor used an accountant in the United States who maintained the debtor’s books and records.

With respect to whether Zais had property in the United States, the junior noteholders argued that neither the securities pledged as collateral nor certain cash collateral held in bank accounts in the United States could be considered property of the debtor because such property belonged to the indenture trustee, which held such property for the benefit of noteholders. The indenture trustee, however, submitted a declaration disclaiming any beneficial interest in the cash or securities held as collateral. The court rejected this argument and held that the collateral constituted property of the debtor. If not, imagine the implications for other debtors with secured creditors holding collateral “in trust” asserting that such collateral does not constitute property of the estate.

Involuntary Provision
Section 303(b) of the Bankruptcy Code provides an exclusive list of who may file an involuntary-bankruptcy petition. The senior noteholders (led by the Anchorage entities) filed their petition under section 303(b)(1), which permits three or more entities holding claims totaling at least $14,425 more than the value of any collateral securing the claims to file an involuntary petition. In other words, the petitioning creditors collectively have to hold unsecured claims of at least $14,425 to be considered eligible petitioning creditors. Although petitioning secured creditors holding recourse claims will often waive a part of their secured claim so that they collectively hold at least $14,425 in unsecured claims or may assert that the value of their collateral is such that they collectively hold deficiency claims in an amount equal to at least $14,425, courts are divided on the issue of whether the holder of a non-recourse secured claim may be considered an eligible petitioning creditor. In their motion to dismiss, the junior noteholders argued that the Anchorage entities were not qualified to file an involuntary petition under this section because the notes are non-recourse. In other words, they argued that the senior noteholders, as secured non-recourse creditors, could never have claims greater than the value of the collateral, and thus they were ineligible to file an involuntary petition under section 303(b)(1).

Without addressing the merits of the junior creditors’ argument, the bankruptcy court held that the junior creditors could not challenge the qualifications of the petitioning creditors under section 303(b)(1). To support its holding, the court cited In re QDN, LLC, 363 F. App’x. 873, 875–76 (3d Cir. 2010), a Third Circuit case holding that a creditor does not have standing to contest an involuntary bankruptcy filing. According to the Third Circuit, only the debtor has standing to contest an involuntary petition, and, in this case, Zais never objected to the filing of the petition prior to the entry of the order for relief. Indeed, no party—not even the junior noteholders—objected to the entry of the order for relief.

In addition, the court held that certain clauses in the indenture, which expressly prohibited junior noteholders from filing an involuntary-bankruptcy petition, did not apply to the senior noteholders. Although many indentures purport to restrict all noteholders from commencing an involuntary petition, this was not the case in Zais. Therefore, it remains to be seen whether a court would enforce such contractual restrictions among creditors, especially if the creditors challenged the filing prior to the entry of the order for relief.

The Settlement 
Following the court’s decision on the motion to dismiss, the “tranche warfare” between the parties continued as the junior noteholders filed both an appeal and a competing plan of liquidation. Ultimately, however, the parties reached a settlement as a result of a court-supervised mediation process. The settlement provided the junior noteholders with a one-time payment of $4.375 million and was approved by the bankruptcy court along with the plan of liquidation. Under the plan, senior noteholders are expected to recover $152.5 million.

The Big Picture
While Zais may be the first example of a high-profile CDO issuer in Chapter 11, it is just one of many cases suggesting that involuntary-bankruptcy filings are on the rise—at least with respect to high-profile debtors. Amidst such an environment, in-house counsel should always keep the risk of an involuntary filing in mind, for even “bankruptcy-remote” entities seem to be finding their way into Chapter 11.

Keywords: litigation, corporate counsel, collateralized debt obligations, CDOs, bankruptcy remote entities, intercreditor agreements, indentures

Sunny Thompson and Adam Levine are associates with Weil, Gotshal & Manges LLP.