Many investors in CDOs and similar products were taken by surprise when a U.S. bankruptcy court declined to dismiss an involuntary chapter 11 case filed against CDO-squared issuer Zais Investment Grade Ltd. VII (a.k.a. ZING VII). A test of the so-called bankruptcy-remoteness of offshore issuers was perhaps inevitable given the volume of distressed CDO securities in the market today. From a pure bankruptcy law perspective, the court's decision is not revolutionary; it simply confirms the reality that entities can still wind up in bankruptcy even if they were structured to avoid it. But for investors in the lower tranches of distressed CDOs hoping to see values rebound over time, the ZING VII bankruptcy makes the prospect of future "tranche warfare" in chapter 11 seem inevitable. It remains to be seen whether the dismissal will be affirmed on appeal, whether ZING VII's senior noteholders will succeed in confirming their chapter 11 plan, and most importantly, whether ZING VII is merely the first of many CDO bankruptcy cases to come. Regardless of ZING VII's ultimate outcome, the bankruptcy court's analysis in denying the motion to dismiss should be considered carefully as market participants structure, sell or buy into future CDOs.
ZING VII, a 2005-vintage, special-purpose entity formed under Cayman Islands law, issued multiple tranches of debt secured by a portfolio of RMBS, CMBS, ABS and CDO securities. A collateral manager located in New Jersey managed the collateral portfolio, and a New York bank served as indenture trustee.
A covenant default (but not a payment default) under the governing indenture occurred in March 2009. The indenture provided that after an event of default, the trustee was required to hold the collateral securities intact and could only dispose of collateral under either of two conditions:
(i) upon a determination by the trustee, with the consent of the controlling class of notes, that the collateral had sufficient value to pay all tranches of notes in full or (ii) upon a direction by the holders of two thirds of the outstanding amount of each tranche.
In April 2011, a group of funds that had purchased super-senior (Class A-1) notes filed an involuntary chapter 11 petition against the Cayman issuer. The issuer did not contest the petition, and it consented to the termination of its exclusive periods under the Bankruptcy Code for filing and soliciting a plan of reorganization. The petitioning A-1 noteholders filed a chapter 11 plan providing for an orderly liquidation of the collateral and distribution of proceeds to the holders of A-1 notes and certain other priority creditors.
Apparently concerned by the potential precedential impact of this involuntary filing, another fund purchased junior notes and moved for dismissal of the chapter 11 case. The junior noteholder argued that: (i) ZING VII was not eligible to be a debtor under the Bankruptcy Code because it had no place of business or property in the United States, (ii) the petitioning noteholders were not qualified petitioning creditors because their debt was non-recourse and (iii) the interests of creditors would be better served if the bankruptcy court would abstain from exercising jurisdiction and dismiss the case.
The bankruptcy court rejected all of these arguments and denied the motion to dismiss. In holding that ZING VII was eligible to be a debtor under the Bankruptcy Code, the court found that ZING VII conducted most of its business in the U.S. through the New Jersey-based collateral manager and New York-based indenture trustee. That business conduct was enough to establish a place of business in the U.S. for purposes of ZING VII's eligibility to be a debtor under the Bankruptcy Code. The court also found ZING VII was eligible for the separate reason that collateral securing the notes (certificated collateral securities physically located in New York and cash collateral accounts with the New York indenture trustee) was located in the United States.
The bankruptcy court declined to consider whether the "non-recourse" petitioning noteholders were qualified to file an involuntary petition under the Bankruptcy Code. Since only an alleged debtor can contest an involuntary petition (which ZING VII did not do), the bankruptcy court found that the petitioners' qualifications could not be challenged.
The bankruptcy court denied the junior noteholder's request that the court abstain from exercising jurisdiction over the bankruptcy case, finding it was "not realistic" to suggest another forum might be available to grant relief. The court found there was nothing improper about the petitioners' purpose in filing the case (i.e., to avoid the indenture's limitations on collateral liquidation) or the fact that the proposed plan would not "reorganize" ZING VII. The court observed that in bankruptcy, circumstances sometimes justify overriding a burdensome contract, which is why the Bankruptcy Code permits the rejection of executory contracts.
The bankruptcy court also found no evidence of bad faith on the petitioning noteholders' part, specifically rejecting the idea that the bankruptcy was being used to gain an unfair advantage over junior noteholders.
The bankruptcy court rejected the junior noteholder's assertion that the indenture was a subordination agreement that must be enforced pursuant to section 510(a) of the Bankruptcy Code, which gives effect to contractual subordination agreements. In doing so, the court noted that plans can be confirmed notwithstanding subordination provisions. The court also noted that the non-petition clause in the indenture (which prohibited junior noteholders, but not senior noteholders, from filing an involuntary petition) was for the benefit of the senior noteholders and did not limit their right to file a petition.
Based on all of these findings, the court held that the petitioning noteholders had shown good faith in their desire to realize the greatest present value of the collateral securities for the super senior tranche without negatively impacting out-of-the money junior creditors. The court left for another day the question of whether those junior creditors really were out of the money.
The junior noteholder subsequently appealed the bankruptcy court's decision to the U.S. District Court. In the meantime, a confirmation battle is well under way in the bankruptcy court.
Implications for Other CDOs and Similar Investments
CDOs and similar investment vehicles are designed to limit their exposure to U.S. bankruptcy proceedings, but they are not immune from bankruptcy risk.
Perhaps most significantly, in ruling that ZING VII was eligible to be a debtor in an involuntary chapter 11 proceeding, the court relied on certain facts and circumstances that are common among many offshore CDOs and similar vehicles managed by U.S.-based managers. Even though ZING VII indisputably did not have a domicile or residence in the United States, the court emphasized that because the investing, collecting, disbursing, recordkeeping and communicating with noteholders was primarily done in the U.S. (through the indenture trustee and collateral manager), ZING VII had a place of business in the United States. Applying the same logic, any offshore CDO issuer or similar vehicle that has a collateral manager, administrator or indenture trustee performing customary services in the United States could be eligible for chapter 11.
Furthermore, the court's finding that the CDO issuer's property interests in the United States were an independent basis for ZING VII's eligibility makes it clear that pledged collateral held in the United States (whether in a bank account, in a vault or registered through the DTC) could render an offshore CDO or similar entity susceptible to a voluntary or involuntary chapter 11 proceeding.
It is significant that the court found nothing improper about a senior CDO noteholder's efforts to avoid limitations in an indenture designed to protect junior tranches from being wiped out in a liquidation. The court equated such restrictions to burdensome executory contracts that can be rejected in bankruptcy, noting that "[a]ny knowledgeable attorney opining on the enforceability of a contract will disclaim the effects of bankruptcy law." It remains to be seen whether other courts will apply the court's reasoning in the context of other indentures, which often include similar restrictions.
The court's observations with respect to the indenture's non-petition clause are also significant. Although the junior noteholders under the ZING VII indenture were explicitly prohibited from instituting an insolvency proceeding against ZING VII before senior noteholders were paid in full, there was no analogous restriction on the most senior noteholders. The court construed that as an indication that the non-petition clause existed for the senior noteholders' benefit and was not a limitation on their right to file an involuntary petition. Some commentators have suggested that CDO indentures that impose non-petition obligations on senior noteholders could prevent an involuntary filing. However, the court's likening of indentures to burdensome executory contracts, together with the court's analysis of ZING VII's eligibility under the Bankruptcy Code, raise questions as to whether a bankruptcy court would ultimately enforce such a non-petition clause to dismiss an otherwise eligible chapter 11 case. Moreover, while the issuer did not contest the involuntary petition, it is far from clear that the issuer could have succeeded in challenging the petitioners' qualifications or the issuer's eligibility for chapter 11. Thus, an indenture that obligates the issuer to contest the petition will not necessarily keep the issuer out of bankruptcy.
At the very least, the ZING VII decision currently stands as support for the filing of involuntary chapter 11 proceedings against offshore CDO issuers under some circumstances. Senior noteholders of defaulted or otherwise insolvent issuers may look to the case as a roadmap for an alternative strategy to realize accelerated returns through liquidation of CDO collateral. Holders of junior notes or interests (as well as any party structuring a new deal) should consider how an involuntary bankruptcy could impact their positions and whether measures can be taken to avoid or reduce those risks.