On July 10, 2008, a decision in London Chancery Court, applying New York law, found that the senior class of note holders of a structured investment vehicle (the “SIV”) did not, under the terms of the SIV documents in question, have the right to direct the trustee as to the time, manner and place of the sale of the SIV’s assets following a default by the SIV on its outstanding obligations. The planned sale was intended to repay certain of the SIV’s obligations, including the senior notes.

In Bank of New York v. Montana Board of Investments, [2008] EWHC 1584 (Ch.), the London Chancery Court also found that the security agreement gave the trustee “exclusive” discretion as to when to sell the assets of the SIV, which consisted of residential mortgage asset-backed securities. The senior note holders had directed that the sale occur “as soon as reasonably practicable” because the proceeds from the sale would be sufficient to pay their notes in full. However, due to the current market for certain asset-backed securities, the proceeds likely would not have been enough to satisfy the junior note holders. The court found that while the senior note holders were entitled to direct the trustee to enforce the security agreement in the collateral, they did not have the power to direct the trustee to conduct an immediate sale, and that the trustee could exercise its discretion to wait to sell the assets, as long as it was acting in a commercially reasonable manner in delaying the sale.

Foreclosure under New York law has long been considered a remedy available to the senior secured creditor at its discretion, and junior secured creditors usually have had no practical means to prevent such a sale, absent buying out the senior position. The importance of this decision is that it could be used by junior note holders in an attempt to delay a sale of assets following a default, even when a prompt sale is supported by the senior note holders. In the current economic environment, the decision could also be cited in an attempt to delay a sale of assets until the market for the particular assets hopefully improves. However, the potential impact of the decision is limited by several factual and legal issues, which are discussed in the last section of this memorandum.

Structure of the SIV and its Default Under the Security Agreement

The SIV at issue was Orion Finance Corporation (“Orion”), incorporated in the Cayman Islands. The SIV invested in asset-backed securities and funded its investment by issuing different classes of debt securities including senior notes, senior subordinated notes and capital subordinated notes. Pursuant to the security agreement, Orion granted the trustee, The Bank of New York (the “Trustee”), a security interest over the SIV’s assets “for the security and benefit” of the secured parties, which included all the note holders.

On November 30, 2007, Moody’s downgraded the rating of the SIV’s medium term notes. The effect of the downgrade was an “Automatic Enforcement Event,” which gave the Trustee the exclusive control over the SIV’s assets and the “exclusive right” to dispose of the assets (the “Collateral”). On January 14, 2008, certain debts of the SIV became due; however the SIV did not have sufficient funds to pay its obligations. The financial advisor to the Trustee advised that given the “extreme illiquidity in the market,” even if all of the Collateral was sold, it was “likely” that the proceeds from the sale would not be enough to meet its obligations.

As a result of this advice, the Trustee did not immediately sell the Collateral. Under the security agreement, the failure to sell Collateral to meet the current obligations resulted in a default under the security agreement. As a result, all the senior notes became due and payable.

The Trustee next sought to restructure the SIV in order to avoid the sale of the Collateral. However, the restructuring proposal was rejected by both the holders of the senior notes, which included the Montana Board of Investments (the “Senior Note Holders”), and the two holders of the senior subordinated notes (the “Subordinated Note Holders”).

The Senior Note Holders then sent a notice that directed the Trustee to conduct a public foreclosure sale of the Collateral in New York within thirty days “in a commercially reasonable manner under section 9-610 of the New York Uniform Commercial Code [the “U.C.C.”] and in accordance with . . . the Security Agreement.” [2008] EWHC 1584 ¶ 25. The Subordinated Note Holders opposed the public foreclosure sale and instructed the Trustee not to liquidate any of the Collateral.

As a result of the dispute over the liquidation of the Collateral, the Trustee filed a claim in the Chancery Division for a declaratory judgment against the Senior Note Holders and the Subordinated Note Holders. Although the suit was brought in England, the court applied New York law as the security agreement is subject to the laws of the State of New York.

The court examined two issues. First, whether the security agreement gave the Senior Note Holders the right to direct the Trustee as to the time, place and manner of the sale of the Collateral.1 Id. ¶ 6(1). Second, whether the security agreement “mandat[ed] any specific timing for the liquidation” of the Collateral. Id. ¶ 6(3).

Ability of the Senior Note Holders to Direct the Time, Place and Manner of the Sale of the Collateral

As to the first issue, the court found that there were two separate inquiries. First, whether the Trustee had an obligation to enforce the security agreement for the “benefit” of the Senior Note Holders in order to pay the SIV’s obligations. Second, whether, the Senior Note Holders as part of their right to direct the trustee to enforce the security interest against the collateral, had the right to direct the time, place and manner of the sale of the Collateral. The court noted that even if the Trustee had the obligation to act for the benefit of the Senior Note Holders, the Senior Note Holders may still not have the right to direct the time, place and manner of the sale of the Collateral.

Although the security agreement gave the Senior Note Holders certain rights, the court acknowledged that the Trustee still was obligated to act in accordance with the U.C.C. Under section 9-610(b) “[e]very aspect of the disposition of collateral, including the method, manner, time, place, and other terms, must be commercially reasonable.” N.Y. U.C.C. § 9-610(b) (McKinney 2002 & Supp. 2008). The court also found that under New York law, security trustees “are required to exercise prudence, or . . . judgment in the way in which they deal with trust assets.” Bank of New York, [2008] EWHC 1584 ¶ 40. The court noted that both parties’ experts agreed that “[t]he prudent security trustee would preserve trust assets.” Id. ¶ 39. The Senior Note Holders claimed that they had the right to direct the time, place and manner of the sale of the Collateral because the Subordinated Note Holders and other junior classes had agreed to be “fully subordinated to payment in full and retirement of all Unsubordinated Obligations; such Subordinated Party shall not be entitled to any payment by or on behalf of the Company or any Company Subsidiary or from the Collateral or any proceeds thereof . . . until such payment in full of all Unsubordinated Obligations.” Id. ¶¶ 11(xi), 46. The security agreement also required the Trustee to “enforce the Collateral in a manner consistent with ‘full subordination’ of the [Subordinated Notes Holders].” Id. ¶ 46.

The court concluded that none of the terms of the agreement expressly gave the Senior Note Holders the right to direct the Trustee as to the time, place and manner of the sale of the Collateral. As such, the court held that the Senior Note Holders could not direct the Trustee as to the time, place and manner of the sale of the Collateral.

In so holding, the court reasoned that the security agreement made clear that the Trustee was to have exclusive control over the Collateral after default and had the “exclusive right” to exercise control over it including “preserving all or part of it or selling it ‘at such place or places as the Security Trustee deems best.’” Id. ¶ 56. The Senior Note Holders’ position that it could direct the Trustee as to time, place and manner of sale was therefore found to be contradictory to this right.

Second, the security agreement required the Trustee to hold the Collateral for the benefit of all the classes of note holders. Therefore, the court found that although the other classes were subordinated to the Senior Note Holders, the Trustee had to act for the interests of the other classes, not just the Senior Note Holders. The court stated it was “difficult to see, as a matter of construction of the [security agreement], why any one class, even if they are the senior class, should have the right to dictate the time, place and manner of any sale.” Id. ¶ 58.

Under both New York law and the security agreement, the court also found that the Trustee was allowed to and required to act with discretion and not as a “mere agent of the creditors.” Id. ¶ 59. Therefore, the Senior Note Holders’ direction conflicted with the security agreement and New York law as it was not allowing the Trustee to act with discretion.

Lastly, because the Senior Note Holders were directing the Trustee as to the time, place and manner of the sale, the court found that it was possible the direction would conflict with the Trustee’s duties to conduct the sale in a commercially reasonable manner. The court pointed out that time, place and manner are components of whether a sale will be found to be commercially reasonable under sections 9-610 and 9-627. Thus, if the Trustee followed the Senior Note Holders’ direction, it would be possible that the Trustee would not act in a commercially reasonable manner.

Timing of the Sale of the Collateral

The second issue examined by the court was whether the security agreement required the Collateral to be sold within a certain time period. As a result of the default of the SIV, all the senior notes became due and payable and thus the Senior Note Holders suggested that the Trustee sell the Collateral “as soon as reasonably practicable.” Bank of New York, [2008] EWHC 1584 ¶ 70.

Although the security agreement stated that the Trustee was required to collect money, either from income of the Collateral or selling the Collateral when there are not enough funds in the SIV to fully pay the Senior Note Holders, the court found that the agreement did not provide any specific timing as to when the Trustee had to pay the Senior Note Holders. Moreover, the court found that “it does not necessarily require, depending on the circumstances, the Collateral be liquidated at all.” Id. ¶ 67.

The court further concluded that the Trustee had discretion whether to conduct a liquidation of the Collateral. In so holding, the court relied on language from the security agreement which gave the Trustee the exclusive right to exercise control over the Collateral. The court further reasoned that if the Trustee was to follow the Senior Note Holders’ direction to sell the Collateral “as soon as reasonably practicable,” it could conflict with section 9-610 of the U.C.C. Specifically, “as soon as reasonably practicable” may not be synonymous with “commercially reasonable” and to allow the Senior Note Holders to make this direction would mean that the parties contracted out of the commercial reasonableness requirement, which is specifically prohibited by section 9-602(g) of the U.C.C. Id. ¶ 71.

Thus, the Trustee had a difficult choice: it could sell the Collateral and pay the Senior Note Holders or hold the Collateral in the hope that the market would improve in order to pay both the Senior Note Holders and Subordinated Note Holders. Although the court clearly held that the Trustee was to act for the benefit of both classes, in the former scenario, the Trustee appears to be acting for the benefit of the Senior Note Holders, while in the later scenario, the Trustee appears to be acting for the benefit of both classes. However, there is a distinct risk in the case of the later scenario, that the Senior Note Holders would be paid less if the value of the Collateral continued to drop.

Without addressing this specific issue, the court held that as long as the Trustee exercised prudence and acted in a commercially reasonable manner, the Trustee had discretion as to when to sell the Collateral. However, the court made clear that the Trustee did not have “anything approaching an unfettered discretion as to how to enforce against the Collateral.” Id. ¶ 62. Indeed, the court stated that the Trustee “must (not may) enforce in a manner consistent with the full subordination of the Subordinated [Note Holders],” that the Trustee had been granted exclusive control over the Collateral in order to “to ensure the prompt payment of the Notes when due,” and the Trustee should take into account that the Senior Note Holders determined that the Collateral should be sold. Id. Therefore, the court recognized that the Trustee, while holding the Collateral for the benefit of all of the note holders, had to keep in mind in exercising its discretion that its purpose was to ensure at least some of the notes were paid and that the junior classes expressly agreed to be subordinated as to payment. Accordingly, it seems the Trustee must weigh such factors, along with others, in determining when to sell the Collateral.

Impact of the Court’s Ruling

The decision on its face appears troubling in that junior note holders may seek to employ it in an attempt to halt the sale of assets that threatens to extinguish their interests. This is especially important in today’s market due to the increasing number of foreclosure sales being conducted by senior creditors pursuant to the U.C.C.

In the current economic environment, the decision could be cited to support an argument that a foreclosure sale in a highly distressed market is commercially unreasonable and that a trustee should await an upturn in the market for the specific assets. In its decision, the court in Bank of New York cited a comment to section 9-610 that states “[i]t may, for example, be prudent not to dispose of goods when the market has collapsed.” N.Y. U.C.C. § 9-610 cmt. 3.

However, there are several limitations on the decision that diminish its value or importance as precedent. Of significant importance, the security agreement at issue in Bank of New York gave “exclusive right[s]” to the Trustee, and did not expressly provide the Senior Note Holders with the right to direct the time, place and manner of proceedings such as the sale of the Collateral.2 Second, while the court was interpreting New York law, this English decision failed to address important New York precedent, and is not binding upon any courts in the United States. Indeed, one can speculate whether a different result could have been reached had the issue been litigated on a fuller record in London Commercial Court.

Moreover, whether or not a party had the power to direct or conduct a sale, commercial reasonableness is a fact-intensive inquiry. As the court in Bank of New York noted several times, in order for a sale to be commercially reasonable, section 9-610(b) of the U.C.C. requires that every aspect of the sale be commercially reasonable “including the method, manner, time, place, and other terms.” N.Y. U.C.C. § 9-610(b). Whether or not a sale of assets like the Collateral at issue will be found to be commercially reasonable depends on all of the specific facts surrounding the sale, not just the current market for the assets.

The Trustee, in such circumstances, would have to make an independent judgment that the sale is commercially reasonable. Under the applicable law this was always the Trustee’s burden; this case merely underscored the existence of that duty, even if the Chancery Court Judge misinterpreted the extent of the duty.

Notwithstanding the possible implication of comment 3 of section 9-610, the Trustee would have to consider that courts in New York have found foreclosure sales of assets to be commercially reasonable even when conducted in a declining or distressed market. See Sumner v. Extebank, 88 A.D.2d 887, 888 (1st Dep’t 1982) (with “their collateral rapidly deteriorating, [the creditor] was under no obligation to imperil its position even further”), aff’d as modified, 58 N.Y.2d 1087 (1983); Chemical Bank v. Haseotes, No. 93 Civ. 2846, 1994 WL 30476, at *4 (S.D.N.Y. Feb. 1, 1994) (in holding that a secured creditor had no obligation to delay the sale, the court stated that there was “no duty to risk throwing good money after bad in the hope that a previously volatile market would rebound to the benefit of [the debtor]”); SNCB Corp. Fin. Ltd. v. Schuster, 877 F. Supp. 820, 828 (S.D.N.Y. 1994) (“A secured creditor is under no obligation to delay the sale of collateral, especially collateral that is declining in value, in the hope of obtaining a higher price unless the timing of the sale renders it commercially unreasonable”), aff’d, 71 F.3d 406 (2d Cir. 1995).

The New York State Court of Appeals has found that a sale of bonds was commercially reasonable when the secured lender disposed of the bonds promptly in the face of a downturn in the market. Bankers Trust Co. v. J. V. Dowler & Co., 47 N.Y.2d 128, 136 (1979). Further, section 9-627(a) of U.C.C. specifically states that a sale is not commercially unreasonable even if it is shown that a greater amount could have been obtained “at a different time or in a different method.” N.Y. U.C.C. § 9-627(a). Indeed, section 9-611(d) of the U.C.C. specifically contemplates that a secured party may proceed rapidly to a foreclosure sale even without notice if the collateral threatened to “decline speedily in value.” N.Y. U.C.C. § 9-611(d). The London Chancery Court judge apparently failed to consider these New York judicial and statutory authorities.

The parties in Bank of New York did not argue issues of fact, including whether a foreclosure sale consisting of asset-based securities would be commercially reasonable in the current market. The Senior Note Holders could have argued that the immediate sale of the Collateral by the Trustee was commercially reasonable and any delay was commercially unreasonable. See Mack Fin. Corp. v. Scott, 606 P.2d 993, 997 (Idaho 1980) (holding that the sale of assets, following an unexcused two-year delay, during which the assets depreciated in value, was commercially unreasonable). Assuming the Trustee decided to proceed with the sale, the Subordinated Note Holders also could have sought an injunction to stop the sale by arguing that the sale was commercially unreasonable. Section 9-625 of the U.C.C. allows a court to restrain or modify the terms of a disposition when it is established that party “is not proceeding in accordance with [Article] 9.” N.Y. U.C.C. § 9-625(a). Such an injunction proceeding would have required a fact-based inquiry as to commercial reasonableness.

In such a proceeding, it is unlikely that the Subordinated Note Holders would have been able to successfully enjoin the disposition. Despite section 9-625, courts and commentators have noted that there are few cases where a debtor even sought an injunction to prevent a disposition. See Hartford-Carlisle Sav. Bank v. Shivers, 566 N.W.2d 877, 880 (Iowa 1997); see also Robert M. Lloyd, The Absolute Bar Rule in U.C.C. Foreclosure Sales: A Prescription for Waste, 40 U.C.L.A. L. Rev. 695, 698 & n.22 (1993). At least one court refused to grant a preliminary injunction because even if the sale was later found to be commercially unreasonable, the court “fail[ed] to see why a judgment for money damages would not make the [complainant] whole.” Overmyer Co. v. First Nat’l Bank of Boston, No. 80-1280-MC, 1980 U.S. Dist. LEXIS 15821, at *8 (D. Mass. Dec. 22, 1980). Thus, had the Trustee proceeded with the sale, it is unlikely that the Subordinated Note Holders would have been able to prevent the sale from occurring. Moreover, a damages claim by the junior note holders after the auction also should fail under the New York cases previously cited that upheld as commercially reasonable auction sales conducted in distressed markets that yielded proceeds far below the claimed ultimate realizable value.

In conclusion, although this decision on its face appears troubling for senior note holders, there are several factors that limit its impact. Whether or not a senior note holder has the power to direct a foreclosure sale is dependent on the specific rights granted to the parties in the agreements at issue. Although the commercial reasonableness of any foreclosure sale of these types of assets in today’s market may someday be litigated and decided in court, there are several legal principles that a secured party seeking to conduct a foreclosure sale can rely upon to proceed with a prompt sale under the U.C.C.