The Bottom Line:

The New Jersey case of In re Zais Investment Grade Ltd. VII, No. 11-20243, 2011 WL 3795169 (Bankr. D.N.J. Aug. 26, 2011), (“ZING VII”) lays claim to an interesting first – it sets precedent as being the first time a collateralized debt obligation (“CDO”) issuer has been a debtor in bankruptcy.  CDO issuers are generally designed to be “bankruptcy-remote” special purpose entities.  The organizational documents of these entities impose limited purpose and corporate separateness covenants, and restrictions on filing for bankruptcy.  Similarly, the CDO’s indenture, the primary transaction document that governs a CDO, often contains a non-petition provision that will establish a period of time during which certain noteholders cannot place the issuer into bankruptcy.  A common non-petition indenture provision – and the one at issue here – provides that the junior noteholder cannot place the issuer into bankruptcy from the closing date to a date that is one year and one day after the senior noteholder has been paid in full.  While some transactions may have no such restriction on the rights of the senior noteholder to file an involuntary bankruptcy petition, there may be a provision that requires all noteholders to vote to liquidate the underlying collateral securities.  In Zais, the senior noteholder did not undertake to obtain any vote otherwise required by the indenture; instead, it filed an involuntary petition.

In a case where a senior noteholder is successful in placing the CDO issuer into an involuntary bankruptcy, such as in this case, junior noteholders are at a significant risk of losing the rights that were negotiated in the indenture. Further, under the Bankruptcy Code, only the CDO issuer, as debtor, can challenge the propriety of an involuntary filing by any of its noteholders.  Since CDO issuers are typically shell entities with no real business purpose other than to hold notes for the benefit of investors, an issuer may not step in and oppose the involuntary filing.  In addition, with a CDO, unlike with other types of securitization transactions, there is no sponsor company to consider the broader implications of the bankruptcy filing. Accordingly, the above factors generated a “perfect storm” in which certain ZING VII junior noteholders found themselves without standing to object to the senior noteholder’s attempt to circumvent the voting requirement of the indenture.  Should other courts follow the precedent set by the Bankruptcy Court for the District of New Jersey here, other CDO junior noteholders could suffer a similar fate. 

What Happened:

In Wall Street parlance, ZING VII is what is known as a “CDO Squared.”  That is, Zing VII, a Cayman Islands special purpose entity, issued certain notes pursuant to an indenture, and then used the proceeds of those notes to acquire securities issued by other CDOs.  ZING VII then pledged those CDO securities as collateral (the “Collateral Securities”) for its obligations to the noteholders.  The Bank of New York Mellon Trust Company served as trustee under the indenture and held the Collateral Securities in trust in the United States for the benefit of the noteholders.  The notes were issued in classes, or “tranches,” entitled to payments pursuant to an order of priority set forth in the indenture. 

In March, 2009, the ZING VII CDO suffered an event of default under its indenture.  As was their right under the indenture, the holder of the Class A-1 (i.e. first priority) notes then demanded the acceleration of the notes.  Per the indenture, the Trustee proceeded to hold the Collateral Securities intact and distribute the funds collected to the Class A-1 noteholder until its claims were satisfied in full.  The Class A-1 noteholder, however, felt that the Collateral Securities could yield a better return if they were managed or liquidated in an orderly fashion, rather than simply held by the Trustee.  But in order to deviate from the terms of the indenture and institute an orderly liquidation of the Collateral Securities, the Class A-1 noteholder would have to obtain the consent of 66.67% of all of the noteholders.  In order to avoid this requirement, on April 1, 2011, the Class A-1 noteholder filed an involuntary petition on behalf of ZING VII pursuant to section 303(c) of the Bankruptcy Code.  No other creditor joined the petition and ZING VII did not file an answer or otherwise object to the relief sought.  On April 26, 2011, the Bankruptcy Court for the District of New Jersey entered an order for relief by default.  The Class A-1 noteholder also filed a plan of reorganization that called for all of the Collateral Securities to be transferred to the Class A-1 noteholder for management and orderly liquidation with the proceeds distributed solely to the Class A-1 noteholder until paid in full. 

The Class A-2 (i.e. second priority) noteholder who felt the Collateral Securities were (or could, over time, be) worth more than the amount needed to satisfy the Class A-1 notes, then filed a motion to dismiss the involuntary bankruptcy proceeding under section 1102 of the Bankruptcy Code.  The Class A-2 noteholder argued that there were two issues that warranted dismissal: first, that ZING VII was not eligible to be a debtor under section 109 of the Bankruptcy Code; and second, that the Class A-1 noteholder did not qualify as a petitioning creditor.  In response to the Class A-2 noteholder’s first argument, the Court noted that even though ZING VII is a Cayman Islands corporation with no residence or domicile in the United States, each of its important functions, including investing, collecting, disbursing, record keeping and communicating with noteholders, is performed in the U.S. through the collateral manager and the Trustee.  The Court found that those factors were sufficient to meet the requirement of “place of business” under section 109(a), as without these functions, ZING VII would not be able to operate.  In addition, the Court found that since ZING VII’s property (the Collateral Securities) was held by the Trustee in New York, ZING VII further qualified to be a debtor under section 109 of the Bankruptcy Code.  With respect to the Class A-2 noteholder’s second argument, that the Class A-1 noteholder did not qualify as a petitioning creditor, the Court found that under section 303(d) of the Bankruptcy Code, only the debtor may contest an involuntary petition, including challenging the qualifications of the petitioning creditors. 

The Class A-2 noteholder also asked the Court to abstain from hearing the case under section 305 of the Bankruptcy Code.  After considering the relevant factors that a court should consider when determining whether to abstain, including, among others, the economy and efficiency of administration, whether another forum is available, and whether the debtor and creditors can do an out-of-court work out, the Court found that there was no alternate forum available to the Class A-1 noteholder.  Accordingly, the Court found no basis to abstain.  The Court noted that in declining to dismiss or abstain from hearing the case, the Court in no way was confirming the Class A-1 noteholder’s proposed plan.  The Court said that the Class A-2 noteholder continues to have a right to object to confirmation of that plan and if the Court finds that the Class A-1 noteholder’s valuation of the Collateral Securities is incorrect, and that there are, in fact, funds available to pay junior tranches, then the Class A-1 noteholder’s plan cannot be confirmed.  But if the Class A-1 noteholder is correct that no noteholders other than the Class A-1 notes will ever receive payment under either a plan of reorganization or simply from amortization through payouts of the Collateral Securities, then the Class A-2 noteholder is not disadvantaged by the bankruptcy filing.  Importantly, these are traditional valuation issues in a contested plan confirmation process – the result that the Class A-2 noteholder hoped to avoid by having the case dismissed.

Lastly, the Class A-2 noteholder argued that the indenture was a subordination agreement that must be enforced under section 510(a) of the Bankruptcy Code.  The Court, however, noted that section 1129(b)(1) of the Bankruptcy Code allowed for confirmation of a plan “notwithstanding section 510(a).”  The Court went on to note that section 365(a) of the Bankruptcy Code specifically permits the rejection of an executory contract in bankruptcy.  While not specifically finding the indenture to be an executory contract subject to rejection, the Court did use that concept as justification for the notion that in certain circumstances, it is appropriate to override burdensome contracts.  To conclude, the Court found that the Class A-2 noteholder did not demonstrate that it was in the best interest of the creditors or the debtor to abstain or dismiss the petition.  Moreover, the Court said that in attempting to maximize the value of the debtor’s assets by actively managing them, the Class A-1 noteholder did demonstrate a good faith basis for filing the petition. 

Why the Case is Interesting:

In allowing the involuntary bankruptcy of ZING VII, the Court allowed the Class A-1 noteholder to use the Bankruptcy Code to seek to obtain rights over the collateral not expressly permitted by the indenture.  This, in turn, allowed the senior noteholder to avoid the liquidation voting requirement contained in the indenture – that, absent bankruptcy – was bargained for to protect the interest of all affected noteholders.  The bankruptcy court focused less on the motive of the petitioning (senior noteholder) creditor and more on the use of the bankruptcy process to maximize estate value.  While such a focus is appropriate for a bankruptcy court, the suggestion that agreements such as indentures could be seen as executory contracts subject to rejection in bankruptcy raises future issues for securitization industry participants. 

This case is the latest in a recent line of bankruptcy cases that has challenged the basic assumptions, principals and structures underlying all securitization transactions.  Investors in such securitizations must be aware of the implications of this decision.  Consideration should be given to whether indenture documents should be modified to prevent all noteholders (and not just junior noteholders) from putting the CDO issuer into an involuntary bankruptcy proceeding.  Such an expansion of the non-petition clause would clarify that senior noteholders would be subject to the same limitations as junior noteholders and, for these purposes, avoid placing a CDO issuer into bankruptcy.