This article was published in The Bankruptcy Strategist newsletter (February 2019). Copyright © 2019 ALM Media Properties, LLC. All Rights Reserved. It is republished here with permission.
In June 2017, affiliated holders of the most senior class of notes in a CDO known as Taberna Preferred Funding IV, a CDO that held various issues of trust preferred securities known as TruPS, filed an involuntary petition under the Chapter 11 of the Bankruptcy Code. That noteholders did so on the purported ground that the CDO was in default and in need of immediate reorganization in order to preserve value. That justification, however, was a ruse, put forward by the noteholders in an attempt prematurely to force liquidation of all the CDO’s collateral in order to earn an extraordinary return at the expense of every other class of noteholders. The filing of the petition understandably prompted a group of junior noteholders, the collateral manager and an industry group vigorously to oppose the filing and to seek dismissal of the petition.
After months of discovery, expert reports and an eight-day trial spanning several months, the Bankruptcy Court in the Southern District of New York dismissed the petition with prejudice. See, In re Taberna Preferred Funding IV, Ltd., No. 17-11628 (MKV), 2018 WL 5880918 (Bankr. S.D. N.Y. Nov. 8, 2018). The bankruptcy court held that the noteholders were not eligible to file an involuntary petition under Chapter 11 because they were non-recourse secured creditors under the terms of the CDO’s indenture and such creditors are not eligible under Section 303 of the Bankruptcy Code to file an involuntary petition.
Prompted by a recent ruling of the Court of Appeals for the Second Circuit (In re Murray, 900 F.3d 53 (2d Cir. 2018)), the bankruptcy court invoked a second, independent ground for dismissal, and exercised its discretion to dismiss the proceeding for cause. The court held that no bankruptcy purpose would be served by the filing and that, in fact, it would be “an injustice for the Court to find that the Petitioning Creditors, sophisticated business entities who analyzed and bargained for Taberna’s current liquidation scheme, are prejudiced by the contractual terms and conditions they freely sought out and entered.”
The court added that: “Petitioning Creditors took intricate — choreographed — steps to manufacture eligibility to file an involuntary case” and “[n]ot only is this involuntary petition fundamentally at odds with the purpose of securitization vehicles, but the Court concludes it also violates the spirit and purpose of the Bankruptcy Code.”
The bankruptcy court’s ruling is a seminal decision that meaningfully circumscribes the ability of a secured noteholder under an indenture, particularly for structured debt, to force the debtor (i.e., issuer of the debt) into an involuntary bankruptcy.
In Taberna, even though the CDO had gone into default during the Great Recession, the indenture expressly prohibited the premature liquidation of collateral absent consent of each of the classes of notes — a key bargained-for protection for junior noteholders. From even the time they purchased their notes more than year prior to commencing the involuntary bankruptcy, the senior noteholder’s strategy was to exploit a poorly reasoned and procedurally distinguishable 2011 decision (In re Zais Investment Grade Limited VII, 455 B.R. 839 (Bankr. D. N.J. 2011)) that did not dismiss an involuntary case commenced by a senior secured noteholder. This representation is supported by the fact that the bankruptcy court found that the senior noteholder had purchased its notes for the purpose of commencing an involuntary proceeding, in violation of Bankruptcy Rule 1003, even though its principal had signed an affidavit to the contrary. Moreover, the bankruptcy court explained in detail why the Zais decision should be accorded no weight.
The Taberna senior noteholder insisted that it could file such a petition because eight years earlier the Taberna trustee had declared a default under the indenture when the CDO was no longer able to pay the most junior noteholders (Class E and F noteholders) their interest. Even though the senior notes were at all times receiving both all the interest due and the preferential distribution of principal dictated by the terms of the indenture’s waterfall, the senior noteholder insisted that the default at the lowest levels of the waterfall required a dramatic reorganization of the CDO and the immediate sale of collateral.
Even though Taberna had defaulted years ago, its collateral had been substantially improving over the last few years, and the market value of its notes had accordingly also substantially increased. Nevertheless, the senior noteholder wanted the ability to immediately sell all of the CDO’s collateral, thereby accelerating repayment of the principal due on the senior notes, which would otherwise have been paid off in less than 10 years, and consequently enable the noteholder to earn as high as a 48% internal rate of return on its 2016 investment in the senior notes. Similar to what occurred in Zais, the petitioning creditors in Taberna tried to convince the CDO’s directors not to object to the filing of an involuntary petition. However, after the instant involuntary case was commenced, at the urging of the objecting noteholders, the CDO’s directors ultimately objected and joined the opposition to the involuntary petition.
If the senior noteholder succeeded in its gambit of filing an involuntary petition and liquidating the collateral, the proceeds would have been used exclusively for the noteholders and every other class of noteholders would have been wiped out, notwithstanding the clear prospect of several of classes receiving payment over the remaining life of the indenture. Indeed, it was this obvious and unacceptable act of greed that contributed to the bankruptcy court’s exercise of discretion to dismiss on the alternative ground of cause.
The bankruptcy court’s decision in Taberna has significance that goes far beyond the immediate results of frustrating the ill-advised strategy of the senior noteholder. Most obviously, as many commentators have already written, the decision creates an insuperable obstacle to similar filings against CDOs. That obvious consequence, however, has only a short-lived impact, as many CDOs after the 2011 Zais decision have made it explicit in the indenture that no bankruptcy petition may ever be filed by a noteholder — thus, the holding effectively protects only those CDOs that were created prior to the Zais decision.
More importantly, beyond CDOs, the decision prevents such tactics with respect to any structured bond indenture for which the debtor is in distress or is in default of payment obligations to a junior class. Typically, the rights of any noteholder, including a senior noteholder, under a structured debt indenture is nonrecourse, i.e., its right to be repaid is limited to the assets of the trust and there is no right to seek repayment from the issuer that created the structured debt.
As a result, the Taberna decision essentially eliminates any incentive for an investor to buy the most senior level of notes in order to force a bankruptcy or the immediate liquidation of collateral as a means of enhancing the return on that class of notes at the expense of any other class. In other words, the Taberna decision rips an involuntary bankruptcy out of the arsenal of weapons that the holder of the most senior class of structured debt may have.
Further, even if the noteholder holds recourse claims and could technically file an involuntary petition, the Taberna decision puts any noteholder who seeks to force an involuntary bankruptcy in jeopardy of having the petition dismissed for cause. See, 11 U.S.C. §1112.
The bankruptcy court focused on the fact that an involuntary petition for a structured debt vehicle such as a CDO would not create or preserve some value that would otherwise be lost outside of bankruptcy, and it conducted a comprehensive review of the terms of the indenture. The court’s analysis established that the only purpose of the filing was essentially to enrich the senior noteholder and to override all the terms and protections that were built into the indenture for the benefit of both the senior noteholder as well as the junior creditors.
Such a finding of cause has potentially serious risks for a noteholder who seeks to compel an involuntary bankruptcy proceeding. The Taberna decision contains numerous holdings and findings that easily could have resulted in a finding of bad faith. Such a finding would have exposed the noteholder to the risk of liability for punitive damages as well as liability for the debtor’s attorney’s fees. See, 11 U.S.C. §303(i).
As a result, the decision provides a strong deterrent against a senior noteholder trying to exploit a weakness in a structured debt by filing an involuntary petition. If the ulterior purpose of the petition is to advance the interest of the noteholder to the detriment of other noteholders, there is a serious likelihood that a bankruptcy court will find that the petition was filed in bad faith.
The bankruptcy court’s decision in Taberna has leveled the playing field, and has insured that all noteholders and creditors of a structured debt are treated in accordance with the terms of the structured debt’s indenture. At first blush, the decision can be viewed as being pro-debtor, as the decision protects debtors from non-recourse secured creditors threatening to commence an involuntary bankruptcy. But the decision is equally pro-creditor because it insures that the interests of all creditors are considered and treated fairly as well as in accordance with the terms of the indenture terms and conditions that all noteholders readily accepted when acquiring the notes. By reaching an outcome that is both pro-debtor and pro-creditor, the Taberna decision promotes the “spirit and purpose of the Bankruptcy Code.”
Peter Haveles, Jr. is a partner in the New York office of Pepper Hamilton and Eric Winstonis a partner in the Los Angeles office of Quinn Emanuel Urquhart & Sullivan, LLP. The authors both served as co-counsel for one of the junior noteholders, Hildene Opportunities Master Fund II, Ltd, in the Taberna case.
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.