A typical collateralized debt financing involves a variety of service providers that owe fiduciary duties to investors. In a recent decision handed down in New York State Supreme Court, Commonwealth Advisors, Inc. v. Wells Fargo Bank, N.A. (N.Y. Sup. Ct. March 31, 2017), the court dismissed the claim of a collateral manager for expenses, where the collateral manager argued that it would not have foreclosed on the collateral had it known that its expenses would not be covered. The court held that the collateral manager was bound by its fiduciary duty to act in the best interest of investors and could not condition its performance on receiving extra-contractual compensation.1

The Facts

The case concerns a collateral manager, Commonwealth Advisors Inc., seeking to recover its expenses from a CDO that it had organized, Collybus CDO I Ltd. The trustee for the CDO, Wells Fargo Bank, was refusing to make payment of the substantial portion of the requested expense reimbursement, claiming that, by the terms of the relevant indenture and the related collateral management agreement, the expenses of the collateral manager were capped at $75,000. The case was before the court on a motion to dismiss.

Commonwealth was not exactly a poster child for integrity and ethical dealings by financial advisers and organizers. The adviser and its principal were being sued by the SEC for fraud in connection with the management of several hedge funds. Quoting from a federal district court in Louisiana, the court explained that the hedge funds organized by Commonwealth had invested heavily in residential mortgage-backed securities (RMBS). When the RMBS investments began to sour during the financial crisis of 2007-2008, Commonwealth was said to engage in an “elaborate, multifaceted, and fraudulent scheme to hide losses and conceal the truth of those losses from investors.” The alleged scheme involved transferring distressed RMBS bonds to a CDO at inflated prices thereby concealing their decline in value; transferring overvalued CDO interests to a Commonwealth-managed fund; engaging in cross-trading, whereby securities from one Commonwealth-managed fund would be sold to another at fraudulent prices to artificially create gains; and purchasing more of the troubled CDO for the hedged funds managed by Commonwealth and inflating its value to offset losses.

The New York Supreme Court case, however, involved none of this. Rather, it was an action with Commonwealth as plaintiff seeking to exercise its reimbursement rights. Commonwealth’s rights to reimbursement were addressed in the indenture and the collateral management agreement for Collybus, whose provisions the court painstakingly reviewed. In brief, based on its reading of the plain meaning of these documents, the court concluded that Commonwealth was limited to reimbursement of no more than $75,000 until the principal amount of the notes issued by Collybus was paid in full.

Apparently, Collybus defaulted on the notes that it had issued to investors, and pursuant to the provisions of the relevant documentation, Commonwealth foreclosed upon and sold the RMBS assets of the CDO, which were pledged as collateral for the Collybus notes. The sale proceeds amounted to some $45 million, which fell short of the amount required to make complete repayment of principal. The proceeds were distributed by Wells Fargo to noteholders, with the exception of $5.5 million, which was being held back in escrow pending resolution of the dispute with Commonwealth. Commonwealth claimed that it was entitled to recover more than the $75,000 capped amount because Wells Fargo supposedly provided assurances that Commonwealth would receive further reimbursement if it liquidated the Collybus collateral.

The Court’s Analysis

Commonwealth’s causes of action included promissory estoppel — a doctrine that renders a promise enforceable when the promisee relies on the promise to its detriment — negligent misrepresentation and equitable estoppel. The court held that, even if it were true that Wells Fargo had made the alleged promise to make reimbursement to Commonwealth above the $75,000 cap, Commonwealth could not recover, because as a matter of law its reliance on the promise would have been unreasonable. (The court secondarily observed that a party could not maintain a promissory estoppel claim where its rights and obligations were governed by contract, here the collateral management agreement.)

As collateral manager, Commonwealth owed “contractual and fiduciary duties of care to [Collybus] ... that generally required the collateral manager to put the interest of [Collybus] ahead of its own.” In support of this dictum, the court quoted the collateral management agreement: “The Collateral Manager shall cause any purchase or sale of any [collateral] to be conducted on arm’s length terms in accordance with reasonable and customary business practices and in compliance with applicable laws. ...” Although perhaps not compelled, the court extracted from the quoted language a duty on the part of the collateral manager “to sell the collateral if it was in the best interest of [Collybus].”

Accordingly, the court said, if Commonwealth believed (as it professed) that liquidating the collateral was in the best interest of Collybus, it had no right to condition its actions on the trustee’s promise to provide administrative expense reimbursement in excess of what was allowed under in the indenture. Indeed, Wells Fargo would have had no right to promise Commonwealth reimbursement in excess of what was provided for in the indenture, because the trustee itself was obligated to carry out its duties in accordance with the indenture. Wells Fargo’s promise to Commonwealth could not have reasonably informed its decision to liquidate the collateral, because neither the collateral manager nor the trustee had the right to violate the indenture.2

Observations

Commonwealth was hardly a sympathetic plaintiff, and it is difficult to know whether Commonwealth’s alleged misdeeds colored the court’s conclusions.3 Missing from the court’s discussion, however, was consideration of whether the fiduciary and contractual duties on which the court focused implied an obligation on the part of the collateral manager to expend its own funds without prospect for new reimbursement. The court appears to accept that, at least in this case, the fiduciary responsibilities of the collateral agent did obligate it to go out of pocket if required to fulfill its duties. Otherwise, it may have been legitimate for Commonwealth to decline to liquidate collateral without an assurance of expense reimbursement.

Typically, indentures declare that a trustee is not obligated to expend its own funds, and provide the trustee with a charging lien ensuring that its expenses will come ahead of debt holder recovery. In this case, the court may have read into the indenture’s waterfall provisions an affirmative obligation upon the collateral manager to act even if as a consequence it would suffer financial loss. Read in this manner, the case leaves for another day the default rule of whether an indenture fiduciary is required to go out of pocket to fulfill its duties.

While the waterfall provisions of the Collybus indenture may well be uncommon, the case does afford a takeaway for fiduciaries under debt documentation concerned with financial exposure for out-of-pocket expenses. Not just the trustee but all service providers acting as fiduciaries of a trust estate should be alert to this exposure. They would be wise to insist on express provision in the debt documentation conditioning their obligation to perform on adequate reimbursement of their out-of-pocket expenditures.