Issuers of collateralized debt obligations, whose assets consist of investments in debt and debt-like instruments, often must contend with potential application of the Investment Company Act of 1940. In order to steer clear of the Act, these issuers typically look to Section 3(c)(7), which exempts an issuer if all of its investors are so-called qualified purchasers. In Lansuppe Feeder, LLC v. Wells Fargo Bank (SDNY Sept. 29, 2016), holders of junior debt tried to upend the priority of the senior debt by claiming a failure to comply with Section 3(c)(7). Their efforts were rebuffed when the court found no private right of action under the Investment Company Act and equities that weighted heavily against the junior creditors.
Soloso CDO 2005-1, a trust, was the issuer under an indenture of collateralized debt obligations secured by investments in trust preferred securities. The debt obligations of the trust were issued in the form of several tranches of notes. The plaintiff in the Lansuppe case was the holder of Class A-1 notes, which had the highest ranking, while the intervenors were holders of notes in more junior classes. The holders of the junior notes purchased their interests from the initial purchasers of the notes or in the secondary market, but not from the issuer. The trust itself was a nominal defendant in the proceeding, with the real action being a contest between the plaintiff and the intervenors.
When the trust went into a payment default in April 2013, the plaintiff exercised its right to accelerate its notes. Moreover, as the holder of more than two-thirds of the Class A-1 notes, the plaintiff also demanded the liquidation of the trust and distribution of its assets, as authorized in these circumstances by the indenture. It was undisputed that upon such a liquidation, the trust would not have sufficient assets to make any payment on the junior notes held by the intervenors. The juniors attempted to end-run the waterfall of the indenture by claiming a violation of the Investment Company Act that entitled them to share in the liquidation proceeds.
The Investment Company Act and Section 3(c)(7)
The Investment Company Act defines an investment company broadly to include not only companies that hold themselves out as investment companies, but also entities that hold more than 40% of their assets in the form of “investment securities,” subject to various complex limitations and exceptions. “Investment securities” are themselves defined broadly, to encompass both instruments traditionally thought of as securities and instruments that in other realms of the securities laws are not so regarded. The Act imposes numerous requirements and restrictions on entities that are subject to its jurisdiction and that would be extremely burdensome to issuers that are in fact not intending to operate as true investment companies. Entities that might otherwise fall within the expansive definition of investment companies under the Act — so-called inadvertent investment companies — seek out exemptions to escape the breadth of its reach.
One such exemption is Section 3(c)(7). That section exempts “[a]ny issuer, the outstanding securities of which are owned exclusively by persons, who, at the time of acquisition of such securities are qualified purchasers, and which is not making and does not at the time propose to make a public offering of such securities.” A “qualified purchaser” is essentially defined as a natural person (and certain related entities) who owns not less than $5,000,000 in investments or any other person, acting for his or her own account or the accounts of other qualified purchasers, who in the aggregate owns and invests on a discretionary basis not less than $25,000,000 in investments.
Also of relevance is Section 47(b)(1) of the Investment Company Act, which provides:
A contract that is made, or whose performance involves, a violation of [the Act], or of any rule, regulation, or order thereunder, is unenforceable by either party ... unless a court finds that under the circumstances enforcement would produce a more equitable result than nonenforcement and would not be inconsistent with the purposes of [the Act].
The Intervenors’ Argument and the Court’s Reponses
The intervenor junior creditors of the trust represented to the court that at least some of them were not qualified purchasers. That being the case, they argued, the exemption of Section 3(c)(7) should be unavailable to the trust, which would thus be required to qualify under the Investment Company Act. Since admittedly it was not so qualified, the indenture should be determined to be a contract in violation of the Act and therefore unenforceable, particularly with respect to the waterfall of creditor recovery. The juniors, on this theory, would be entitled to share with the senior creditors in the proceeds of liquidation.
Not surprisingly, the court was wholly unsympathetic to this argument. Since the posture of the decision was summary judgment, the court did not have to decide whether some of the intervenors were not in fact qualified purchasers as claimed, although the court was skeptical of the assertion. Regardless, the court disposed of the intervenors’ claims to jump the line in liquidation on several grounds.
First, basing itself on Second Circuit jurisprudence, the court held that there was no private right of action under Section 47(b). According to the court, only the SEC would have the right to take action to invalidate the indenture.
Second, as quoted above, the statute authorizes a court to permit enforcement of a contract in violation of the Act, where enforcement would be more equitable than nonenforcement and would not be inconsistent with the purposes of the Act. In finding that the equities favored enforcement of the indenture, the court observed that neither the trust nor the holder of the Class A-1 notes had sold the junior notes to the intervenors. If anyone were culpable, it would be the nonqualified holders of the junior notes (and their sellers), whose transactions in the notes triggered the alleged violation of the Investment Company Act. Invalidating the indenture to the detriment of the innocent holder of the Class A-1 notes would, in the words of the court, be a “misplaced remedy.”
Third, the purpose of the Investment Company Act, the court said, was to benefit investors by preventing abusive practices in the management of investment companies. In Lansuppe there were no allegations of management abuse, and enforcing the indenture to distribute the liquidation proceeds in accordance with the waterfall was consistent with the Act and the protection of the rights of investors.
It is common to limit investors in securitizations and similar investment vehicles to qualified purchasers to avoid application of the Investment Company Act. The indentures governing the issuance of securities by these issuers typically provide that the securities may not be transferred to persons who are not qualified purchasers, and require that various 3c-7 tags be affixed to the securities by DTC and the financial reporting services, such as Bloomberg and Reuters, to assure compliance with provisions of this sort. The Lansuppe case is a useful view from the other end — what to expect if, notwithstanding all the customary protections, some of the securities migrate to persons who are not qualified purchasers. While Lansuppe offers no guidance on the possible reaction of the SEC in such circumstances, the case offers the sensible reassurance that junior creditors will not be able to take advantage of lapses in Section 3(c)(7) compliance to jump the line on recovery against innocent senior noteholders.