Bankruptcy Court Turns Down Attempt to Circumvent CDO Liquidation Procedure
In a recent decision that will be of interest to capital and structured finance market participants,1 a bankruptcy court in the Southern District of New York found that nonrecourse noteholders of a structured finance vehicle were not eligible petitioners under § 303(b) of the Bankruptcy Code and therefore could not commence an involuntary bankruptcy case. In fact, the court dismissed the petition sua sponte, pursuant to a recent decision of the Second Circuit holding that bankruptcy courts may dismiss involuntary cases if they constitute inappropriate uses of the Code. The decision is noteworthy for its invocation of a bankruptcy court’s authority to act as gatekeeper for involuntary bankruptcy petitions that threaten to undermine bargained-for liquidation procedures.
In August 2009, an event of default occurred on the Taberna Preferred Funding IV CDO (Taberna) following a payment default on Taberna’s Class B Notes. Over six years later, in March 2016, three funds managed by HH Holdco purchased over $150 million of the two most senior classes of Notes (Classes A-1 and A-2).
Because Taberna’s indenture required the consent of 66.66% of each class of Notes to liquidate the collateral, the HH funds tried to “break open the CDO,” including by requesting the indenture trustee to solicit consents for liquidation and making two offers to purchase Notes so that it could direct an auction. Id. at *3. When those efforts failed, the HH funds purchased the rest of the Class A-1 Notes and filed an involuntary Chapter 11 bankruptcy petition against the Taberna CDO.
The Bankruptcy Court’s Decision
Taberna, pursuant to the instruction of junior noteholders, moved to dismiss the petition, and the court did so. It found that the Notes are nonrecourse2 and that the creditors’ claims are therefore limited to the collateral. See id. at *7 (“The obligations of the Co-Issuers under the Notes and this Indenture are non-recourse obligations of the Co-Issuers payable solely from the Collateral,” and “no judgment in the nature of a deficiency judgment or seeking personal liability shall be asked for or (if obtained) enforced.”).
As holders of nonrecourse claims, the petitioning creditors did not hold “claims against” the debtor (i.e., Taberna), as required by section 303(b) of the Code. The petitioning creditors argued that section 1111(b) of the Code “eliminates any distinction in Chapter 11 between recourse and nonrecourse debt” so that nonrecourse holders are treated as recourse holders for purposes of section 303(b). The court disagreed, limiting section 1111(b) to claim allowance and distributions. According to the decision, the language and legislative purpose behind section 1111(b) does not permit nonrecourse holders to “bootstrap” their claims into recourse claims for purposes of filing or maintaining an involuntary petition.
The petitioning creditors similarly argued that under section 102(2)—which states that a “claim against the debtor includes [a] claim against property of the debtor”—they held a “claim against” Taberna because they held a claim against its property (i.e., the collateral). Section 303(b) of the Code, however, requires that a petitioning creditor hold a “claim against such person.” As the court further clarified, the Code’s “definition of a ‘person,’ does not, however, include such person’s property.” 2018 WL 5880918, at *13. Because the petitioning creditors held claims only against the collateral (the “property”) and not against Taberna (the “person”), they failed to meet section 303(b)’s eligibility requirements.
Further, relying on the Second Circuit’s decision in Wilk Auslander LLP v. Murray (In re Murray), 900 F.3d 53 (2d Cir. 2018), the court found that, even if the petitioning creditors were eligible under section 303(b), dismissal was still appropriate because “[n]ot only is th[e] involuntary petition fundamentally at odds with the purpose of securitization vehicles, but  it also violates the spirit and purpose of the Bankruptcy Code.” Taberna, 2018 WL 5880918, at *24.
The court distinguished another recent bankruptcy petition that was allowed to proceed against a CDO. See In re Zais Inv. Grade Ltd. VII, 455 B.R. 839 (Bank. D.N.J. 2011). First, no one in Zais had objected to the petition, whereas both Taberna’s junior noteholders and the collateral manager had done so. More importantly, the court in Zais determined that the petition was made in good faith and for a proper purpose because the involuntary bankruptcy would maximize present value for petitioning creditors without negatively affecting junior noteholders, who had no prospect of recovery under either the CDO’s contractual liquidation scheme or bankruptcy. In Taberna,by contrast, the petitioning creditors themselves admitted that the junior noteholders could receive money under the indenture. The court found that the bankruptcy filing was an effort to evade that contractual procedure.
The importance of not permitting nonrecourse creditors to circumvent the liquidation procedures that they freely contracted for appeared particularly acute here because the petitioning creditors had (i) purchased their Class A Notes more than six years after Taberna had defaulted on its junior notes, (ii) retained bankruptcy counsel before attempting to liquidate the collateral, (iii) threatened other creditors that they had sufficient holdings to push through a liquidation plan and (iv) admitted to modeling their tactics on Zais.
The Big Picture
Taberna establishes that bankruptcy is not an escape hatch from contractual liquidation methods for structured vehicles, and it limits Zais to cases in which bankruptcy merely supplements, but does not contradict, the indenture. That will comfort investors and other parties who rely on indenture terms, but it may be a source of frustration for investors who are stymied by consent requirements for liquidation or other actions. The petitioning creditors’ largest investor, Howard Hughes Medical Institute, had “prepared a detailed internal memorandum recommending the investment” in the Taberna Notes, which concluded that “the optimal means to maximize profits was to force a premature liquidation of the Collateral within one to two years, which realistically could be accomplished only through an involuntary bankruptcy.” In re Taberna Preferred Funding IV, Ltd., ECF No. 101 ¶ 16.
While liquidation may have allowed a quick payment on the senior notes, avoiding ongoing leakage of administrative fees and uncertain timing of an eventual recovery, it also would have permanently shut off any chance of recovery on the junior notes. The senior holders had to resort to bankruptcy only because the indenture required the junior holders’ consent to liquidation under the contract. The outcome in Taberna should provide greater certainty and predictability both as to liquidation procedures specifically and to bankruptcy-remoteness of structured vehicles generally.
1Taberna Preferred Funding IV, Ltd. v. Opportunities II Ltd. (In re Taberna Preferred Funding IV, Ltd.), No. 17-11628 (MKV), 2018 WL 5880918 (Bankr. S.D.N.Y. Nov. 8, 2018)
2The court found the related indenture “unambiguous” in this regard. Mayer Brown was drafting counsel in this transaction and prepared this indenture.