U.S. Bank National Association v. Triaxx Prime CDO 2006-1, Ltd. (S.D.N.Y. June 23, 2016) provides a useful lesson on the limits of the ability of indenture fiduciaries to exercise discretion in the face of facially mandatory provisions of an indenture requiring remedial action. It also illustrates the limited role that equities will play where the debt documents create priorities among different classes of noteholders and the demands of the senior tranches conflict with the interests of the noteholders lower down in the food chain. While not of direct applicability outside the complex mortgage securities structures of the past decade, the principles of the case speak to broader issues of indenture interpretation.
U.S. Bank served as trustee for Triaxx Prime CDO 2006-1, Ltd., a special-purpose Cayman Islands investment company that issued a $2.667 billion principal amount of CDOs, in a series of tranches in descending order of payment priority. The proceeds of the issuance were used by Triaxx to purchase residential mortgage backed securities (RMBS). U.S. Bank instituted an interpleader action after the collateral manager for Triaxx received conflicting directions from holders of the notes in different tranches.
Under the terms of the indenture and the collateral management agreement applicable to the Triaxx notes, upon the direction of the collateral manager to Triaxx and the trustee, Triaxx was required to sell any RMBS within three years after the RMBS first went into default. The sale was to be effected by soliciting bona fide bids from at least three approved dealers, five business days before the sale, and then selling the defaulted securities to the highest bidder. Not surprisingly, following the collapse of the RMBS market in the middle of the 2000s, Triaxx experienced what appears to be a not insignificant number of defaults in its RMBS portfolio, all of which were duly scheduled by the collateral manager as required by the governing documentation.
South Tyron LLC was the beneficial holder of $136,264,000 of Class A-1 Notes, the highest tier of notes in the Triaxx hierarchy, and was also the controlling certificate holder in a resecuritization trust that owned approximately 82.6% of the Class A-1 Notes. (A resecuritization trust is a so-called CDO-squared that owns interests in tranches of CDOs rather than in the RMBS themselves.). South Tryon demanded that the trustee sell the aged defaulted RMBS, in accordance with the terms of the indenture. Its demand was opposed by the collateral manager and by Goldman Sachs & Co., BlackRock Financial Management, Inc. and GoldenTree Asset Management, each of which owned notes that were more junior in the Triaxx waterfall. In justifying the decision not to sell the aged defaulted RMBS, the collateral manager asserted that its ongoing litigation on behalf of Triaxx “has and will recover tens of millions of dollars for its investors.” Also, it noted that the defaulted securities “continue[d] to receive contractual payments of some principal and interests, which are paid to noteholders.”
Faced with the competing demands of the noteholders, the trustee filed an interpleader action in federal court, in which South Tryon moved for summary judgment. It sought an order declaring that certain securities became defaulted securities more than three years prior, directing Triaxx, through the collateral manager, to effect the sale of these securities and directing the collateral manager to sell all future three-year defaulted securities in accordance with the terms of the indenture.
In opposing the motion, the collateral manager, and the other noteholders, relied on provisions of the collateral management agreement that directed it to act in a reasonable manner and not in a way that would prejudice the rights of noteholders:
[The collateral manager shall] exercise reasonable care, using a degree of skill and attention no less than the Collateral Manager exercises with respect to comparable assets that it manages for itself and in a commercially reasonable manner consistent with practices and procedures followed by institutional managers of national standing in connection with the management of assets of the nature and the character of [the collateral RMBS].
[The collateral manager] shall use commercially reasonable efforts to ensure that no action is taken by it, and shall not intentionally or with reckless disregard take any action, which would . . . adversely affect the interests of the Trustee [or] the Noteholders in any material respect (other than the effect of such actions expressly permitted here under or under the Indenture).
(emphasis supplied) The collateral manager and the other noteholders argued that the requirement to sell the three-year defaulted RMBS was qualified by commercial reasonableness, and whether the collateral manager was acting in a commercially reasonable manner in determining not to sell the securities was a triable issue of fact. The opinion does not expressly address the economic motivation of the noteholders opposing the sale of the aged defaulted securities. It would appear, however, that, being lower down in the payment hierarchy, they would not benefit from a current sale of the securities, and would have better prospects for recovery were Triaxx to continue to retain ownership of the securities and maintain its standing in litigation against the securities’ originators and promoters.
The court agreed with South Tryon. On the court’s reading of the indenture, the collateral manager did not have unfettered discretion to refrain from selling the aged defaulted securities. (Under the terms of the indenture, the collateral manager could decline to sell the securities only if it failed to receive a bid for the securities after following the sales procedures prescribed by the indenture.) Applying common rules of contractual construction, the court held that the reasonableness standard of conduct applicable to the collateral manager was a general provision overridden by the specific terms of the indenture directing the sale of the three-year defaulted securities. Although the more junior noteholders may be disadvantaged by the sale, that would not justify departing from the mandatory prescription of the indenture to dispose of the defaulted securities.
In August 2016, the Second Circuit declined to stay the district court’s order to sell the defaulted RMBS. Oral argument in Triaxx’s appeal of the district court’s decision, which if successful would be relevant to RMBS in the Triaxx portfolio that had not yet passed the three-year default mark, was heard in early November. Based on the questioning of the appellate panel, Triaxx would appear to have an uphill battle.
The high default rate on RMBS that underlie the complex CDOs of the 2000s, coupled with the hierarchy of recoveries, left even the upper tranches of the junior notes with dim prospects for meaningful recovery. It is unsurprising that holders in these tranches would prefer to pursue possible litigation recoveries rather than accept the leftovers from the disposition of collateral whose proceeds would go largely to the most senior notes. The Triaxx decision is yet another reminder, however, that courts will enforce unambiguous debt documentation as written, on the theory that the documentary text is the best evidence of the bargain struck by the parties. It also illustrates the limitation on the ability of trustees and other fiduciaries to exercise discretion, even for what they perceive as the greater good of security holders, in the face of seemingly mandatory indenture provisions. (See the companion article in this issue of Debt Dialogue for further discussion of the exercise of discretion by indenture trustees.)