CDOs Are Less Bankruptcy Remote than You Thought

The recent decision of the United States Bankruptcy Court for the District of New Jersey in In re Zais Investment Grade Limited VII, No. 11-20243 (RTL), 2011 WL 3795169, *3 (Bankr. D. N.J. 2011) took many holders of collateral debt obligations (“CDOs”) by surprise. In Zais, the court denied a group of junior noteholders' motion to dismiss an involuntary bankruptcy case commenced by a group of senior noteholders for the admitted purpose of circumventing provisions of the underlying indenture that prohibited liquidation without junior noteholder consent. The decision flies against market assumptions that CDOs are structured to be bankruptcy remote and that the terms of the indenture, rather than the issuer's plan of reorganization, will determine the disposition of the collateral in the event of default.

Despite the initial shock occasioned by the result, the Zais decision is not surprising on its facts. Upon close examination, the decision is primarily the result of two features of the underlying indenture. First, the indenture did not prohibit senior noteholders from filing an involuntary bankruptcy petition. Second, the indenture did not require the issuer to oppose an involuntary petition. What is more surprising than the decision in Zais is that these features are common to CDO indentures. In the wake of Zais, this article proposes drafting solutions designed to protect junior noteholders in future transactions.

Background

Zais Investment Grade Limited VII (“ZING VII”) is a special-purpose entity formed under Cayman Islands law. As with other CDOs, ZING VII issued multiple “tranches” of notes secured by a pool of securities on a non-recourse basis. The ZING VII transaction is governed by U.S. law and its terms are memorialized in an indenture using a form that is common to U.S. law-governed CDO transactions.

After an event of default, senior noteholders accelerated amounts due under their notes. Pursuant to ' 13.1 of the Indenture, following acceleration, all proceeds of the collateral must be distributed to the Class A-1 Notes (the most senior notes), before any proceeds are applied to principal or interest on more junior notes. Under ' 5.5 of the indenture, the Trustee is required to hold the collateral securities intact and collect and distribute their proceeds unless 66.67% of all noteholders direct the Trustee to liquidate the collateral.

Various funds managed by Anchorage Capital Group (collectively, “Anchorage”) filed an involuntary Chapter 11 bankruptcy petition against ZING VII. Anchorage also filed a plan of reorganization calling for all of the collateral securities to be transferred to Anchorage for management and orderly liquidation with all proceeds distributed to Class A-1 noteholders. Anchorage had acquired Class A-1 Notes after the event of default and sought to liquidate the collateral, asserting that liquidation would produce a better return than leaving the collateral intact and distributing collections. The issuer did not oppose Anchorage's involuntary bankruptcy petition and the court entered an order for relief by default under 11 U.S.C. ' 303(h).

The Motion to Dismiss

Junior noteholder Hildene Capital Management, LLC (“Hildene”) filed a motion to dismiss the involuntary bankruptcy case or abstain under ” 305 and 1112 of the Bankruptcy Code. Hildene raised four principal arguments. First, it argued that, as a Cayman-organized entity, ZING VII was not eligible to be a debtor under 11 U.SC. ' 109(a), which requires that a debtor reside or have a domicile, place of business, or property in the United States. The court dismissed this argument, finding that the collateral manager, collateral administrator and trustee services, “the major portion of the Debtor's operations,” were all performed in the United States and that ZING VII's collateral securities and cash were held or registered in the United States, thereby satisfying ' 109(a). Id. at * 4-5.

Second, Hildene argued that the Anchorage entities were not eligible to be petitioning creditors under 11 U.SC. ' 303(b)(1) because their claims were non-recourse. Section 303(b)(1) permits three or more entities holding claims aggregating at least $14,425 more than the value of any collateral securing such claims to file an involuntary petition. Hildene asserted that because the notes were non-recourse, the Anchorage claims could never be greater than the value of the collateral, and thus, the petitioning creditors were secured, but not unsecured, creditors. The court rejected this argument on procedural grounds, finding that “[o]nly the alleged debtor may contest an involuntary petition, including challenging the qualifications of the petitioning creditors.” Id. at *5. Thus, the failure of the issuer to object to the involuntary petition was outcome determinative on this issue.

Third, Hildene argued that the court should abstain and dismiss the case under 11 U.SC. ' 305(a)(1) for bad faith because the petition was filed in order to circumvent the indenture's restrictions on liquidation. The court determined that Hildene's contentions did not constitute a prima facie case of bad faith, and that the issue should be resolved at confirmation. The court observed that bankruptcy traditionally allows for liquidation for the benefit of all creditors. It noted Anchorage's contention that, even if managed well, the collateral would never yield enough to satisfy the Class A-1 Notes in full and, thus, the junior noteholders were entirely out of the money. Thus, receiving nothing under the plan of reorganization would be no worse than getting nothing from a runoff of the collateral securities.

Fourth, Hildene argued that the indenture provision requiring the trustee to hold the collateral securities intact following default absent the consent of a supermajority of all noteholders was a subordination agreement for their benefit and must be enforced pursuant to 11 U.SC. ' 510(a). Id. at *8. The court found this argument unpersuasive, observing that ' 1129(b)(1) of the Bankruptcy Code permits confirmation of a plan “notwithstanding section 510(a).” Id. Further, even if ' 510(a) required enforcement of the indenture as an intercreditor subordination agreement, the terms of the indenture did not prohibit senior noteholders from filing an involuntary bankruptcy
petition. Id.

CDO Indentures Commonly Do Not Prohibit Senior Noteholders from Filing an Involuntary Bankruptcy Petition Against the Issuer

The result in Zais is largely the result of two key features of the indenture. First, the indenture did not require the issuer to contest an involuntary bankruptcy petition. Because the issuer did not oppose the petition, the court never addressed whether the Anchorage entities were eligible to be petitioning creditors under Bankruptcy Code ' 303(b)(1). Instead, the argument was dismissed for lack of standing. Had ZING VII contested the involuntary petition, its objection might have prevailed because holders of strictly non-recourse debt cannot meet the plain language of Section 303(b)(1) requiring that at least three petitioning creditors hold claims aggregating at least $14,425 more than the value of their collateral.

Second, the indenture did not contain any express prohibition on the most senior class commencing an involuntary bankruptcy case. Rather, as the Zais court observed, the non-petition provisions in the ZING VII indenture limit only the ability of the trustee and the junior noteholders to file an involuntary petition. As in many CDOs, the non-petition provisions in the ZING VII indenture were set forth in ” 5.4 and 13.1. Section 5.4 of the ZING VII indenture provides in relevant part that the “Trustee may not, prior to the date which is one year and one day (or if longer, any applicable preference period) after the payment in full of all Senior Notes, institute against, or join any other Person in instituting against the Issuer any bankruptcy, reorganization arrangement, insolvency, moratorium or liquidation Proceedings, or other Proceedings under federal or State bankruptcy or similar laws.” Similarly, ' 13.1 of the ZING VII indenture provides in relevant part that “Holders of each Junior Class agree, for the benefit of the Holders of the Notes of each Priority Class in respect of such Junior Class, not to cause the filing of a petition in bankruptcy against the Issuer for failure to pay to them amounts due to such Junior Class or hereunder until the payment in full of such Priority Classes and not before one year and a day, or if longer, the applicable preference period then in effect, has elapsed since such payment.” Thus, while the trustee and junior noteholders were prohibited from filing a bankruptcy petition, there was no such restriction on senior noteholders.

The form of non-petition provisions in ZING VII is common in the CDO market. In connection with the drafting of this article, the authors reviewed the non-petition provisions of 48 separate CDOs. Only 11 of these contained a limitation on senior noteholders' right to file an involuntary bankruptcy petition. The other 37 indentures contained provisions nearly identical to those found in ZING VII. This suggests that the Zais decision is not an outlier but, rather, symptomatic of a common feature in the structuring of CDOs.

Opportunity/Wake-up Call

The absence of non-petition provisions binding senior noteholders may be an opportunity for senior noteholders to use the Bankruptcy Code to circumvent contractual restrictions on remediation rights. In a bankruptcy case, the collateral could be sold or otherwise disposed through a bankruptcy sale authorized by ' 363 of the Bankruptcy Code or pursuant to a plan of reorganization, notwithstanding the failure to meet the voting thresholds in the indenture.

For junior noteholders, Zais is a wake-up call that their remediation consent rights are suspect without stronger non-petition protections.

For issuers, more robust non-petition provisions may be required to support the marketability of CDOs, which commonly offer remediation control rights designed to induce junior noteholders to invest.

Toward Better Protection For Junior Noteholders

We recommend several changes to protect junior noteholders' remediation rights under the standard CDO form. First, the provisions in ' 5.4 should be expanded to prohibit all secured parties (and not just the trustee) from commencing a bankruptcy case against the issuer until a year and a day after all notes are paid in full. Such a provision would strengthen both the bad faith and the ' 510(a) arguments rejected by the Zais court.

Second, the issuer should have a non-discretionary obligation to oppose any involuntary bankruptcy petition. In light of the static nature of most CDO issuers, this requirement could be effectuated via an irrevocable power of attorney granted to the trustee, with the trustee obligated to oppose the petition on behalf of the issuer and to give notice to noteholders. The issuer would have standing to object that noteholders holding strictly non-recourse rights are ineligible to be petitioning creditors under ' 303(b)(1).

Third, a provision should be added prohibiting noteholders from seeking recourse treatment of their debt in an issuer bankruptcy case. Under ' 1111(b) of the Bankruptcy Code, holders of non-recourse debt have the option to have their debt treated as recourse in exchange for giving up their claim to the collateral. Thus, had the Zais court not rejected Hildene's ' 303(b)(1) argument on standing grounds, Anchorage might nevertheless have prevailed by electing recourse treatment of its claims under ' 1111(b), thereby manufacturing the requisite unsecured claim of at least $14,425. To avoid this device, the indenture should require that, in the event of an issuer bankruptcy, each noteholder must elect non-recourse treatment under ' 1111(b)(2).

Finally, we recommend that a provision be included in the agreement deeming cancelled any notes held by a noteholder that files an involuntary bankruptcy petition in breach of the indenture. Absent such a penalty provision, senior noteholders might determine that the risk of a breach of contract claim is outweighed by the benefit of enhanced remediation rights in bankruptcy. Moreover, a breach of contract claim is a far from ideal remedy since damages from breach would likely be difficult to establish with requisite certainty and any judgment would be subject to the credit risk of the breaching party. Forfeiture of the notes of the breaching noteholder(s) would be a strong disincentive and frustrate the petitioning creditors' ability to improperly influence the terms of any bankruptcy sale or plan of reorganization.

Todd L. Padnos, a member of this newsletter's Board of Editors, is a partner in the Silicon Valley office of Dewey & LeBoeuf LLP, and Paul Jasper is an associate in the firm's San Francisco office. They may be reached at [email protected] and [email protected], respectively. The authors gratefully acknowledge the assistance of contributing authors Danielle Kennedy and Benjamin Heuer, associates in the Silicon Valley and San Francisco offices, respectively.

The recent decision of the United States Bankruptcy Court for the District of New Jersey in In re Zais Investment Grade Limited VII, No. 11-20243 (RTL), 2011 WL 3795169, *3 (Bankr. D. N.J. 2011) took many holders of collateral debt obligations (“CDOs”) by surprise. In Zais, the court denied a group of junior noteholders' motion to dismiss an involuntary bankruptcy case commenced by a group of senior noteholders for the admitted purpose of circumventing provisions of the underlying indenture that prohibited liquidation without junior noteholder consent. The decision flies against market assumptions that CDOs are structured to be bankruptcy remote and that the terms of the indenture, rather than the issuer's plan of reorganization, will determine the disposition of the collateral in the event of default.

Despite the initial shock occasioned by the result, the Zais decision is not surprising on its facts. Upon close examination, the decision is primarily the result of two features of the underlying indenture. First, the indenture did not prohibit senior noteholders from filing an involuntary bankruptcy petition. Second, the indenture did not require the issuer to oppose an involuntary petition. What is more surprising than the decision in Zais is that these features are common to CDO indentures. In the wake of Zais, this article proposes drafting solutions designed to protect junior noteholders in future transactions.

Background

Zais Investment Grade Limited VII (“ZING VII”) is a special-purpose entity formed under Cayman Islands law. As with other CDOs, ZING VII issued multiple “tranches” of notes secured by a pool of securities on a non-recourse basis. The ZING VII transaction is governed by U.S. law and its terms are memorialized in an indenture using a form that is common to U.S. law-governed CDO transactions.

After an event of default, senior noteholders accelerated amounts due under their notes. Pursuant to ' 13.1 of the Indenture, following acceleration, all proceeds of the collateral must be distributed to the Class A-1 Notes (the most senior notes), before any proceeds are applied to principal or interest on more junior notes. Under ' 5.5 of the indenture, the Trustee is required to hold the collateral securities intact and collect and distribute their proceeds unless 66.67% of all noteholders direct the Trustee to liquidate the collateral.

Various funds managed by Anchorage Capital Group (collectively, “Anchorage”) filed an involuntary Chapter 11 bankruptcy petition against ZING VII. Anchorage also filed a plan of reorganization calling for all of the collateral securities to be transferred to Anchorage for management and orderly liquidation with all proceeds distributed to Class A-1 noteholders. Anchorage had acquired Class A-1 Notes after the event of default and sought to liquidate the collateral, asserting that liquidation would produce a better return than leaving the collateral intact and distributing collections. The issuer did not oppose Anchorage's involuntary bankruptcy petition and the court entered an order for relief by default under 11 U.S.C. ' 303(h).

The Motion to Dismiss

Junior noteholder Hildene Capital Management, LLC (“Hildene”) filed a motion to dismiss the involuntary bankruptcy case or abstain under ” 305 and 1112 of the Bankruptcy Code. Hildene raised four principal arguments. First, it argued that, as a Cayman-organized entity, ZING VII was not eligible to be a debtor under 11 U.SC. ' 109(a), which requires that a debtor reside or have a domicile, place of business, or property in the United States. The court dismissed this argument, finding that the collateral manager, collateral administrator and trustee services, “the major portion of the Debtor's operations,” were all performed in the United States and that ZING VII's collateral securities and cash were held or registered in the United States, thereby satisfying ' 109(a). Id. at * 4-5.

Second, Hildene argued that the Anchorage entities were not eligible to be petitioning creditors under 11 U.SC. ' 303(b)(1) because their claims were non-recourse. Section 303(b)(1) permits three or more entities holding claims aggregating at least $14,425 more than the value of any collateral securing such claims to file an involuntary petition. Hildene asserted that because the notes were non-recourse, the Anchorage claims could never be greater than the value of the collateral, and thus, the petitioning creditors were secured, but not unsecured, creditors. The court rejected this argument on procedural grounds, finding that “[o]nly the alleged debtor may contest an involuntary petition, including challenging the qualifications of the petitioning creditors.” Id. at *5. Thus, the failure of the issuer to object to the involuntary petition was outcome determinative on this issue.

Third, Hildene argued that the court should abstain and dismiss the case under 11 U.SC. ' 305(a)(1) for bad faith because the petition was filed in order to circumvent the indenture's restrictions on liquidation. The court determined that Hildene's contentions did not constitute a prima facie case of bad faith, and that the issue should be resolved at confirmation. The court observed that bankruptcy traditionally allows for liquidation for the benefit of all creditors. It noted Anchorage's contention that, even if managed well, the collateral would never yield enough to satisfy the Class A-1 Notes in full and, thus, the junior noteholders were entirely out of the money. Thus, receiving nothing under the plan of reorganization would be no worse than getting nothing from a runoff of the collateral securities.

Fourth, Hildene argued that the indenture provision requiring the trustee to hold the collateral securities intact following default absent the consent of a supermajority of all noteholders was a subordination agreement for their benefit and must be enforced pursuant to 11 U.SC. ' 510(a). Id. at *8. The court found this argument unpersuasive, observing that ' 1129(b)(1) of the Bankruptcy Code permits confirmation of a plan “notwithstanding section 510(a).” Id. Further, even if ' 510(a) required enforcement of the indenture as an intercreditor subordination agreement, the terms of the indenture did not prohibit senior noteholders from filing an involuntary bankruptcy
petition. Id.

CDO Indentures Commonly Do Not Prohibit Senior Noteholders from Filing an Involuntary Bankruptcy Petition Against the Issuer

The result in Zais is largely the result of two key features of the indenture. First, the indenture did not require the issuer to contest an involuntary bankruptcy petition. Because the issuer did not oppose the petition, the court never addressed whether the Anchorage entities were eligible to be petitioning creditors under Bankruptcy Code ' 303(b)(1). Instead, the argument was dismissed for lack of standing. Had ZING VII contested the involuntary petition, its objection might have prevailed because holders of strictly non-recourse debt cannot meet the plain language of Section 303(b)(1) requiring that at least three petitioning creditors hold claims aggregating at least $14,425 more than the value of their collateral.

Second, the indenture did not contain any express prohibition on the most senior class commencing an involuntary bankruptcy case. Rather, as the Zais court observed, the non-petition provisions in the ZING VII indenture limit only the ability of the trustee and the junior noteholders to file an involuntary petition. As in many CDOs, the non-petition provisions in the ZING VII indenture were set forth in ” 5.4 and 13.1. Section 5.4 of the ZING VII indenture provides in relevant part that the “Trustee may not, prior to the date which is one year and one day (or if longer, any applicable preference period) after the payment in full of all Senior Notes, institute against, or join any other Person in instituting against the Issuer any bankruptcy, reorganization arrangement, insolvency, moratorium or liquidation Proceedings, or other Proceedings under federal or State bankruptcy or similar laws.” Similarly, ' 13.1 of the ZING VII indenture provides in relevant part that “Holders of each Junior Class agree, for the benefit of the Holders of the Notes of each Priority Class in respect of such Junior Class, not to cause the filing of a petition in bankruptcy against the Issuer for failure to pay to them amounts due to such Junior Class or hereunder until the payment in full of such Priority Classes and not before one year and a day, or if longer, the applicable preference period then in effect, has elapsed since such payment.” Thus, while the trustee and junior noteholders were prohibited from filing a bankruptcy petition, there was no such restriction on senior noteholders.

The form of non-petition provisions in ZING VII is common in the CDO market. In connection with the drafting of this article, the authors reviewed the non-petition provisions of 48 separate CDOs. Only 11 of these contained a limitation on senior noteholders' right to file an involuntary bankruptcy petition. The other 37 indentures contained provisions nearly identical to those found in ZING VII. This suggests that the Zais decision is not an outlier but, rather, symptomatic of a common feature in the structuring of CDOs.

Opportunity/Wake-up Call

The absence of non-petition provisions binding senior noteholders may be an opportunity for senior noteholders to use the Bankruptcy Code to circumvent contractual restrictions on remediation rights. In a bankruptcy case, the collateral could be sold or otherwise disposed through a bankruptcy sale authorized by ' 363 of the Bankruptcy Code or pursuant to a plan of reorganization, notwithstanding the failure to meet the voting thresholds in the indenture.

For junior noteholders, Zais is a wake-up call that their remediation consent rights are suspect without stronger non-petition protections.

For issuers, more robust non-petition provisions may be required to support the marketability of CDOs, which commonly offer remediation control rights designed to induce junior noteholders to invest.

Toward Better Protection For Junior Noteholders

We recommend several changes to protect junior noteholders' remediation rights under the standard CDO form. First, the provisions in ' 5.4 should be expanded to prohibit all secured parties (and not just the trustee) from commencing a bankruptcy case against the issuer until a year and a day after all notes are paid in full. Such a provision would strengthen both the bad faith and the ' 510(a) arguments rejected by the Zais court.

Second, the issuer should have a non-discretionary obligation to oppose any involuntary bankruptcy petition. In light of the static nature of most CDO issuers, this requirement could be effectuated via an irrevocable power of attorney granted to the trustee, with the trustee obligated to oppose the petition on behalf of the issuer and to give notice to noteholders. The issuer would have standing to object that noteholders holding strictly non-recourse rights are ineligible to be petitioning creditors under ' 303(b)(1).

Third, a provision should be added prohibiting noteholders from seeking recourse treatment of their debt in an issuer bankruptcy case. Under ' 1111(b) of the Bankruptcy Code, holders of non-recourse debt have the option to have their debt treated as recourse in exchange for giving up their claim to the collateral. Thus, had the Zais court not rejected Hildene's ' 303(b)(1) argument on standing grounds, Anchorage might nevertheless have prevailed by electing recourse treatment of its claims under ' 1111(b), thereby manufacturing the requisite unsecured claim of at least $14,425. To avoid this device, the indenture should require that, in the event of an issuer bankruptcy, each noteholder must elect non-recourse treatment under ' 1111(b)(2).

Finally, we recommend that a provision be included in the agreement deeming cancelled any notes held by a noteholder that files an involuntary bankruptcy petition in breach of the indenture. Absent such a penalty provision, senior noteholders might determine that the risk of a breach of contract claim is outweighed by the benefit of enhanced remediation rights in bankruptcy. Moreover, a breach of contract claim is a far from ideal remedy since damages from breach would likely be difficult to establish with requisite certainty and any judgment would be subject to the credit risk of the breaching party. Forfeiture of the notes of the breaching noteholder(s) would be a strong disincentive and frustrate the petitioning creditors' ability to improperly influence the terms of any bankruptcy sale or plan of reorganization.

Todd L. Padnos, a member of this newsletter's Board of Editors, is a partner in the Silicon Valley office of Dewey & LeBoeuf LLP, and Paul Jasper is an associate in the firm's San Francisco office. They may be reached at [email protected] and [email protected], respectively. The authors gratefully acknowledge the assistance of contributing authors Danielle Kennedy and Benjamin Heuer, associates in the Silicon Valley and San Francisco offices, respectively.