On November 22, 2015, Patriarch Partners XV, LLC (the “Petitioning Creditor”), an investor in Zohar CDO 2003-1, Limited (“Zohar I”), a collateralized loan obligation (“CLO”) vehicle managed by an affiliate of the Petitioning Creditor, filed involuntary chapter 11 petitions in the United States Bankruptcy Court for the Southern District of New York against Zohar I, Zohar CDO 2003-1, Corp. and Zohar CDO 2003-1, LLC (collectively, the “Debtors”). The petitions were filed in an effort to protect the Petitioning Creditor and Zohar I from alleged fraudulent activities by MBIA, Inc. and MBIA Insurance Corporation (collectively, “MBIA”), holders of investment positions senior to that of the Petitioning Creditor in the Zohar I capital structure.
Background
Broadly speaking, a CLO is a special purpose vehicle that issues notes to investors, and uses the note proceeds to invest in loans and other collateral, the cash flows from which are distributed to pay interest and principal on the CLO notes pursuant to an agreed-upon payment “waterfall” over a fixed period of time. The Petitioning Creditor is the holder of approximately $286.5 million in notes issued by Zohar I, making it Zohar I’s largest creditor. Notably, affiliates of the Petitioning Creditor own significant equity stakes in the borrowers under the loans held by Zohar I.
Under a CLO insurance policy, MBIA guaranteed the payments of interest and principal to senior CLO noteholders in the event of a payment default by Zohar I. The senior notes came due, and according to press reports, MBIA stepped in to make the payments and became the controlling party-and thus the party with the exclusive right to control the disposition of the Zohar I assets-under the relevant Zohar I documents. The Petitioning Creditor alleges that MBIA fraudulently induced it to spend over $103 million to purchase a position in the Zohar I capital structure in order to facilitate a restructuring that would, among other things, extend the November 20, 2015 maturity date of the Zohar I notes (that dispute is the subject matter of a state court action filed on November 2, 2015).
MBIA allegedly reneged on its agreement to extend the Zohar I maturity date in order to foreclose on and liquidate Zohar I’s assets, presumably at fire sale prices. By filing the involuntary petition, the Petitioning Creditor is seeking to regain control of the process and prevent such a sale. The Petitioning Creditor has stated in its Bankruptcy Court filing that it has developed a restructuring plan for Zohar I that will pay MBIA’s senior notes in full, while maximizing value for the Petitioning Creditor.
Petitioning Creditor’s Motion to Terminate the Debtors’ Plan Exclusivity Period
Simultaneously with the filing of the involuntary petition, the Petitioning Creditor filed a motion to terminate the Debtors’ plan exclusivity period. Pursuant to section 1121(b) of title 11 of the United States Code (the “Bankruptcy Code”), the debtor has the exclusive right to file a plan of reorganization for 120 days. Pursuant to section 1121(d) of the Bankruptcy Code, this exclusive period may be terminated for cause. The Petitioning Creditor argues that Zohar I itself has no meaningful interest in the proceedings, as its common shares do not entitle its holders to any material value, there are no officers of Zohar I, and prior to the filing of the involuntary petition, it was a Patriarch entity that supplied personnel to monitor its assets. Moreover, the Petitioning Creditor argues that MBIA, as the controlling party under the Zohar I documents, should not be allowed to control the process because of its previous fraudulent conduct. The Petitioning Creditor argues that since MBIA is over-secured and has no incentive to generate value for the Petitioning Creditor, and Zohar I has no authority to protect such value, exclusivity must be terminated and Patriarch’s restructuring plan must proceed immediately.
Non-Petition Clauses in CLO Structures
CLO structures often have standard “non-petition clauses” which prevent the CLO’s creditors from filing involuntary bankruptcy petitions against the CLO itself. While the filing of the involuntary petition by the Petitioning Creditor is a surprising development in the CLO world, it is not unprecedented. In In re Zais Inv. Grade Ltd. VII, 455 B.R. 839 (Bankr. D.N.J. 2011), junior noteholders moved to dismiss an involuntary petition brought by senior noteholders in a collateralized debt obligation (“CDO”) structure to force an immediate liquidation. The Bankruptcy Court for the District of New Jersey denied the motion and held that the specific non-petition clause in that CDO structure prohibited only the trustee and junior noteholders from filing an involuntary petition against the debtor, whereas the senior noteholders were not mentioned in the provision. Since these limitations expired only after the senior noteholders were paid in full, the Court reasoned that such limitations existed to benefit the senior noteholders, not to limit their ability to file a petition. Id. at 849.
The Zais decision did not comment on the enforceability of non-petition clauses generally, since such clause did not extend to the relevant petitioning creditors. The applicability of the Zais precedent to Zohar I and the other Debtors is likewise not readily apparent. Indeed, the papers currently on file with the Bankruptcy Court in the Debtors’ cases reference neither the existence nor scope of any non-petition clause.
Implications
Through its involuntary petition and motion to terminate exclusivity, the Petitioning Creditor is essentially attempting to flip chapter 11 on its head by permitting the creditor to propose a plan of reorganization during a period where the debtor would typically have exclusive ability to file and attempt to confirm a plan. It is not clear if this surprise tactic will succeed. The Petitioning Creditor can point to the harm that immediate liquidation of the collateral by an MBIA-sponsored plan will have on the junior noteholders. On the other hand, the subordination and other contractual provisions embedded in the CLO structure (including the existence and scope of any non-petition provisions) may well lead the Bankruptcy Court to dismiss the Petitioning Creditor’s attempt to escape from the bargain it made.
While the Petitioning Creditor’s arguments are largely driven by the unique facts and circumstances of Zohar I, there is one valuable takeaway for CLO investors: careful attention must be paid to the scope of CLO “non-petition clauses” to ensure that they properly reflect the intent of the parties.
If you have any questions concerning this Client Alert, please feel free to contact Greg Cioffi (212-574-1439) or Ronald L. Cohen (212-574-1515).
