Bankruptcy Court Overrides CDO Indenture Provision Requiring Noteholder Consent to Liquidation After Accelerating Default

October 31, 2011


In declining to dismiss a CDO issuer’s involuntary chapter 11 case in In re Zais Investment Grade Limited VII, a Bankruptcy Court for the District of New Jersey recently held that it had authority to override express contractual provisions setting out intercreditor rights.[1] The court also found that it had jurisdiction over an offshore CDO, an investment entity that is traditionally viewed to be beyond the reach of bankruptcy courts in the United States.[2] This novel and questionable decision, which is now on appeal, could encourage senior noteholders to force offshore CDOs or other special purpose entities into involuntary bankruptcy in the U.S., notwithstanding express indenture terms about collateral disposition.


Zais Investment Grade Limited VII (the “Debtor”) is a Cayman Islands corporation and a “CDO squared”—a CDO that issued notes secured by the debt of other CDOs—formed in 2005 and managed by Zais Group, LLC.[3] The Debtor CDO issued senior secured notes in the face amount of $365.5 million that were listed on the Irish Stock Exchange (the “Secured Notes”).[4] The most senior tranche of Secured Notes was A-1, followed by A-2.[5] The Bank of New York Mellon Trust Company, N.A. (the “Trustee”) was trustee under the indenture (the “Indenture”) for the benefit of the holders of the Secured Notes.[6] The Debtor also issued approximately $40 million of unsecured notes junior to the Secured Notes.[7]

In October of 2009, the holders of the Secured Notes accelerated the notes after the Debtor defaulted on a covenant in the Indenture. Acceleration triggered an Indenture provision prohibiting the Trustee from disposing of any assets without the consent of at least 66.66% of the holders of the Secured Notes.[8] From and after acceleration, the Trustee held the assets and collected as well as distributed significant amounts to reduce the principal balances of the A-1 Notes, in accordance with the provisions of the Indenture.[9] Shortly after default, four funds, all managed by Anchorage Capital Group, L.L.C. (“Anchorage”), purchased A-1 Notes.[10] Unlike many CDO indentures that prohibit any noteholder from commencing an involuntary bankruptcy proceeding prior to one year and one day after all of the CDO issued debt has been repaid in full, the Indenture here contained no such express prohibition as to the holders of A-1 Notes.[11] Anchorage filed an involuntary bankruptcy petition against the Debtor on April 1, 2011, asserting that the collateral could yield a better return if it were managed or liquidated in an orderly fashion rather than left to run off by collecting amounts due under the loans securing the Secured Notes.[12]

The Debtor did not respond to the involuntary petition, and on April 26, 2011, the court entered an order for relief by default.[13] Anchorage filed a plan of reorganization that called for transfer of the securities to Anchorage for management and liquidation with all proceeds going to the holders of the A-1 Notes.[14] Hildene Capital Management, L.L.C. and Hildene Opportunities Master Fund, LTD (together, “Hildene”), which purchased A-2 Notes also after default, filed a motion seeking to dismiss the bankruptcy case.[15] Hildene believed that collections on the Secured Notes—if allowed to run off in accordance with the terms of the Indenture—would be sufficient to provide for a distribution to holders of the A-2 Notes.[16] In its motion to dismiss, Hildene argued, among other things, that (i) the Debtor was not eligible to be a Debtor under chapter 11 because it was not located in the U.S.; (ii) the court should abstain and dismiss the case because Anchorage was using bankruptcy to avoid the limitations of the Indenture, requiring 66.66% of all holders of Secured Notes to consent to the collateral’s liquidation; and (iii) the court should dismiss the case for lack of good faith because Anchorage was attempting to gain an unfair extra-contractual advantage not available in the Indenture at the expense of other noteholders.[17]


Eligibility to be a Debtor: Debtor’s Location and Property

The court found that the Debtor was eligible to be a chapter 11 debtor because it was a “letterbox company” that had a Cayman Islands address only to maintain registration there.[18] As is common in the CDO industry, the Debtor conducted most of its business in the U.S. as its operations consisted of services provided by the collateral manager, collateral administrator, and Indenture Trustee in the U.S., without which “the Debtor would not be able to operate.”[19] The court found that these activities were (i) sufficient to meet Section 109(a)’s “place of business” requirement; and (ii) satisfied the Section 109(a) bankruptcy eligibility requirements because virtually all of the Debtor’s property was located in the U.S.[20]

Involuntary Bankruptcy Petition: Only Non-Debtor May Object

The court held that only an alleged debtor may contest an involuntary petition, including challenging the qualifications of petitioning creditors.[21] Therefore, non-debtor Hildene could not move to dismiss Anchorage’s involuntary bankruptcy petition. But Hildene was free to raise objections at the plan confirmation hearing.[22]

Filing for Bankruptcy to Avoid Indenture Provisions: Not Bad Faith

The court declined to abstain from exercising jurisdiction over the Debtor’s bankruptcy case, finding that there was no other realistically available forum to grant relief.[23] The court rejected Hildene’s argument that the petitioning noteholders were acting in bad faith by improperly using bankruptcy to avoid the Indenture’s restrictions on collateral disposition.[24] The court also refused to abstain because Hildene failed to prove that abstention was in the best interest of creditors and the Debtor, which here took no position.[25] The court considered this to be an intercreditor dispute. The court added that the Bankruptcy Code authorizes reorganization plans to wipe out classes of unsecured creditors and equity interests.[26] Therefore, prejudice to junior creditors is not grounds for dismissal.

The court rejected Hildene’s argument that Anchorage did not act in good faith by filing for bankruptcy to circumvent the Indenture’s limitations on liquidating securities.[27] The court reasoned that under Sections 365(a) and 1123(b)(2), which permit rejecting executory contracts, it could override “burdensome” contractual terms.[28] The court did not explain which contract terms were “burdensome” or in what way they were so.[29] The court also pointed to Section 1123(b)(1) as authority to disregard the Indenture’s express language because that provision allows a plan to impair claims or interests.[30]

Finally, the court rejected Hildene’s contention that the Indenture is a subordination agreement that must be enforced under Section 510(a) of the Bankruptcy Code, reasoning that Section 1129(b)(1) permits confirmation of a plan that is inconsistent with a subordination agreement.[31] The court noted that while the Indenture prohibited the Trustee or junior noteholders from filing an involuntary petition, the non-petition clause did not so restrict the holders of the A-1 Notes and appeared to be intended solely for their benefit as its restrictions were to expire a year and a day after payment in full of the A-1 Notes.[32]


The Zais decision may have two significant implications for the structured finance area.

First, Zais raises the possibility that a bankruptcy court could disregard provisions setting out creditors’ rights—such as an indenture’s post-default collateral management provision. The court’s reference to rejecting burdensome executory contracts seems questionable at best because there is nothing in the decision to suggest that the Indenture was burdensome (or how it was so) to the debtor’s estate or that it was an executory contract (though it arguably was because there were ongoing obligations under the Indenture). It is therefore far from certain that Sections 365(a) and 1123(b)(2) authorize overriding express contractual terms under the circumstances in Zais. While Hildene has filed a notice of appeal to the United States District Court for the District of New Jersey, senior noteholders could try to apply Zais to disregard the provisions of virtually any intercreditor agreement. Indeed, Zais could be read broadly to override any contract. Read more narrowly, however, this decision’s impact could be limited to transactions involving indentures that do not prohibit all noteholders—as opposed to just more junior holders—from commencing an involuntary bankruptcy proceeding before repayment in full of all issued debt of the CDO.

Second, Zais suggests that an offshore CDO could be eligible to be a debtor in the U.S. That result is noteworthy because many offshore CDOs are structured with a view to minimizing risk of a bankruptcy filing in the U.S. But under Zais, performing essential managerial or administrative functions and holding pledged collateral in the U.S. creates a basis for such entities to qualify as debtors under the Bankruptcy Code.

While senior noteholders could use Zais to liquidate their collateral through involuntary bankruptcy, junior noteholders could protect themselves by insisting on careful drafting. Specifically, junior noteholders of an offshore CDO could require indenture terms that (i) prohibit senior noteholders from commencing an insolvency proceeding against the debtor and (ii) provide that no insolvency proceeding may be commenced in the U.S.

[1] 2011 WL 3795169 (Bankr. D.N.J. Aug. 26, 2011) at *7-8.
[2] Id. at *5.
[3] Id. at *1.
[4] Id.
[5] Id.
[6] Id.
[7] Id.
[8] Id. at *2; see also Motion of Hildene Capital Management and Hildene Opportunities Master Fund, LTD to Dismiss Chapter 11 Case Pursuant to 11 U.S.C. §§ 305 and 1112 or, in the Alternative, Abstain Pursuant to 11 U.S.C. §305, No. 11-20243 (Docket No. 46) (“Hildene Motion”), at 8.
[9] Id.
[10] Id.
[11] Id. at *8.
[12] Id. at *2.
[13] Id.
[14] Id.
[15] Id. at *3.
[16] Id. at *3, 7.
[17] Id. at *3, 5, 7; Hildene Motion at 11.
[18] Id. at *5.
[19] Id. at *3.
[20] Id. at *3-5.
[21] Id. at *5.
[22] Id. at *5-6.
[23] Id. at *6.
[24] Id.
[25] Id.
[26] Id.
[27] Id. at *7-8.
[28] Id. at *7.
[29] Id.
[30] Id.
[31] Id. at *8.
[32] Id.