A May 14 decision by the Delaware Court of Chancery may have significant implications for senior noteholders in structured credit transactions, specifically CDOs, according to a recent special report from Moody’s Investor Service.
Concord Real Estate CDO 2006-1, a commercial real estate (CRE) CDO backed by a pool of loans, CMBS, and other CRE related interests, issued approximately $414 million of notes divided into tranches from Class A to Class H.
There were also $51 million of preferred shares that were separately issued.
The deal’s credit profile had declined so drastically by the end of 2009 that the CDO sponsor became concerned about failing the par coverage test. This failure would have resulted in payments being diverted from the subordinate tranches of the capital structure to the senior noteholders, according to Moody's.
To circumvent failure of the test, an affiliate of the CDO sponsor delivered approximately $67 million of notes from Class C through Class H that it owned to the CDO co-issuers with the intention of having them cancelled without consideration.
The co-issuers directed the indenture trustee to cancel the subject notes, but the trustee refused to do so, stating that the CDO indenture did not permit this type of cancellation.
The Delaware court rejected the trustee’s challenge and argued that, without the incorporation of a provision in the indenture explicitly barring note cancellations, noteholders are entitled to surrender their notes for cancellation. After the cancellation occurs, the notes would no longer be considered outstanding, including for par value coverage test purposes.
The court's decision in this instance sets the precedent to allow CDO sponsors to potentially avoid par value tests that trigger the diversion of principal and interest proceeds to senior noteholders. One of the primary arguments made against cancellation was that it could undermine the contractual expectations of the senior noteholders by depriving them of proceeds that would have been diverted in the event of test failure.
The ruling would allow losses to increase at the top of the capital structure and decrease at the bottom, Moody’s said.
The credit rating agency expects the decision to lead to further junior note cancellations in other structured credit transactions, an outcome that would prevent senior noteholders from benefiting from the diversion of cash flows as the underlying asset portfolio deteriorates, leading to greater potential losses due to their extended life.
Junior noteholders, Moody’s said, are likely to accrue fewer losses because they will receive cash flows that would otherwise have transferred to the senior notes.
The court’s decision is currently being appealed.
