On November 8, 2018, the United States Bankruptcy Court for the Southern District of New York (the "Bankruptcy Court") issued a decision dismissing an involuntary chapter 11 case filed against Taberna Preferred Funding IV, Ltd. ("Taberna"), a CDO, by holders of non-recourse notes (the "Petitioning Creditors"). The Bankruptcy Court held that the Petitioning Creditors' non-recourse claims against Taberna's collateral (as opposed to claims against Taberna itself) were not claims against the debtor for purposes of eligibility to commence an involuntary case pursuant to the Bankruptcy Code. In the alternative, the Bankruptcy Court concluded that, even if there were a proper basis for the commencement of the involuntary chapter 11 case, it would exercise its discretion under section 1112 of the Bankruptcy Code to dismiss the case for cause, finding that no bankruptcy purpose was served by the involuntary filing. In doing so, the Bankruptcy Court cautioned that rewarding the Petitioning Creditors' tactics with an order for relief would create significant uncertainty across capital markets, as CDOs are designed to avoid bankruptcy.
Background
In 2005, Taberna issued eleven classes of notes pursuant to an indenture. In August of 2009, an event of default occurred under the indenture due to Taberna's payment default with respect to the Class B notes, which notes were accelerated the following month. Over six years later, the Petitioning Creditors purchased the most senior and second-most senior classes of notes (the "A-1 Notes" and the "A-2 Notes," respectively). At all times, Taberna remained current on its payments to Class A noteholders.
Prior to filing the involuntary petition, the Petitioning Creditors took a number of steps in a failed effort to liquidate the collateral securing the notes (which collateral consisted mostly of long-term securities issued by REITs and other real estate entities). Thereafter, they immediately purchased the remaining A-1 Notes that they did not own, and two months later filed an involuntary petition against Taberna. The Petitioning Creditors simultaneously filed a "partial waiver," waiving their rights to benefit from security interests in any asset of Taberna solely on account of their ownership interests in the Class A-2 Notes, in an amount not to exceed $5,259.00.1 The day after filing the involuntary petition, the Petitioning Creditors moved to terminate Taberna's exclusivity period in order to pursue their proposed plan, which plan permitted an auction of the collateral at the option of a majority of the holders of the A-2 notes.2
Taberna, its collateral manager, and five holders of the junior classes of notes moved to dismiss the involuntary petition, seeking a judgment that the Petitioning Creditors failed to establish that they hold a claim against the target of the petition as required by the Bankruptcy Code.3 These parties argued that the Petitioning Creditors' claims are only against the collateral securing the notes, and not against Taberna itself.4 At the close of discovery, the Petitioning Creditors moved for partial summary judgment seeking a ruling that, having filed the partial waiver, they now held unsecured claims against Taberna. The collateral manager and several junior noteholders opposed the summary judgment motion, arguing that the Petitioning Creditors' note claims are both oversecured and nonrecourse.
Summary judgment was denied and a bench trial ensued concerning the eligibility of the Petitioning Creditors to maintain the case. The issues before the Bankruptcy Court were whether the note claims are nonrecourse, and, if so, whether the Petitioning Creditors nonetheless meet the eligibility requirement of section 303(b) of the Bankruptcy Code. The Petitioning Creditors argued, among other things, that section 1111(b) of the Bankruptcy Code, which governs how undersecured nonrecourse claims are to be treated under a chapter 11 plan for allowance and distribution purposes, treats nonrecourse claims as recourse under all circumstances. As a result, the Petitioning Creditors argued, nonrecourse creditors must be treated as holding recourse claims when determining eligibility to commence an involuntary case. The objecting parties, on the other hand, took the position that section 1111(b) takes effect only after a bankruptcy case has been filed, and does not operate to render a party eligible to commence an involuntary case.
At the close of trial, the objecting parties sought a determination that the Petitioning Creditors' note claims are nonrecourse and, as holders of nonrecourse claims, the Petitioning Creditors are ineligible under section 303(b) of the Bankruptcy Code to file an involuntary petition. While this motion was pending, the Second Circuit Court of Appeals issued a decision affirming that a bankruptcy court has the authority to dismiss sua sponte an involuntary chapter 7 bankruptcy case for cause.5 In light of the decision of the Court of Appeals, the Bankruptcy Court issued an order directing the parties to show cause as to whether the case should be dismissed for cause pursuant to section 1112(b) of the Bankruptcy Code.
Decision
First, the Bankruptcy Court found that the indenture unambiguously provides that the notes are nonrecourse obligations. The indenture explicitly provides, for example, that "[t]he obligations of the Co-Issuers under the Notes and this Indenture are nonrecourse obligations of the Co-Issuers payable solely from the Collateral...."6 Moreover, the Bankruptcy Court stated that nonrecourse provisions are enforceable under New York state law. Therefore, the Bankruptcy Court held that the notes are nonrecourse obligations for which Taberna has no liability.
With respect to the second inquiry, the Bankruptcy Court found that the plain language of section 1111(b) of the Bankruptcy Code provides that the recourse transformation is for distribution purposes only; it does not change the nature or terms of a creditor's security interest.7 The Bankruptcy Court also noted that "the purpose and legislative history of section 1111(b) make clear that [it] was enacted to protect undersecured lenders in cases where debtors seek to retain the collateral, through a judicial valuation of the collateral, in the context of cramdown... [it] was not enacted to give nonrecourse lenders... a right to commence an involuntary bankruptcy case against their borrower." Therefore, the Bankruptcy Court concluded that section 1111(b) is not applicable when considering a party's eligibility to commence an involuntary bankruptcy case.
The Petitioning Creditors also argued that section 102(2) of the Bankruptcy Code, which provides that a claim against a debtor includes a claim against the property of the debtor, eliminates the distinction between recourse and nonrecourse claims in bankruptcy. As a result, the Petitioning Creditors argued, they "hold a claim against such person" (i.e., Taberna) as required by section 303(b) of the Bankruptcy Code, because a claim against Taberna includes a claim against the property of Taberna (i.e., the collateral). The Bankruptcy Court disagreed, reasoning that had Congress intended to allow commencement of an involuntary case by a creditor holding a claim against a person's property, as opposed to a claim against the person (which term does not include a person's property), it could have easily used the phrase "claim against the debtor," which includes a claim against such person's property. As a result, because the claims are against the collateral, and not against Taberna, the Petitioning Creditors failed to meet the eligibility requirement under section 303(b) of the Bankruptcy Code.
Finally, the Bankruptcy Court held that, in the alternative, the case should be dismissed for cause.8 The Bankruptcy Court found that no bankruptcy purpose was served by the filing, and that the Petitioning Creditors would not suffer any prejudice if the case was dismissed. Moreover, the Bankruptcy Court found that Petitioning Creditors took intricate, choreographed steps to manufacture an involuntary case.9 The Bankruptcy Court then listed a litany of facts supporting its conclusion that dismissal of the case for cause was warranted.10
The Bankruptcy Court found that Petitioning Creditors were trying to pattern their behavior after what they "believed led to the positive result" in the Zais case, in which the bankruptcy court declined to dismiss an involuntary chapter 11 case commenced against a CDO by holders of non-recourse notes. 11 Although the Petitioning Creditors, citing Zais, argued that their actions were taken in good faith and consistent with the purpose of chapter 11, the Bankruptcy Court disagreed. The Bankruptcy Court found Zais distinguishable because in that case, the debtor did not oppose the involuntary filing; instead, the noteholders moved to dismiss on grounds unrelated to eligibility after the court had entered an order for relief (as opposed to the facts of Taberna, where the putative debtor sought dismissal of the involuntary petition for cause). Moreover, the Zais court found that the case was brought in good faith because the petitioning creditors sought to maximize value for themselves without negatively impacting junior creditors who had no prospect of recovery; in contrast, here, the Petitioning Creditors' involuntary case would increase their own recovery at the expense of Taberna's junior noteholders, who were not necessarily out of the money outside of bankruptcy. The Bankruptcy Court focused on the Petitioning Creditors' "very methodical and deliberate process, set out to force an accelerated liquidation of Taberna."
In conclusion, the Bankruptcy Court stated: "It is clear from the totality of circumstances that this is not the type of case for which Congress enacted Chapter 11 of the Bankruptcy Code. There is no genuine attempt to reorganize the putative debtor... [r]ather, this case is a last-ditch effort by a senior sophisticated noteholder to further its personal, tactical and pecuniary aims and to coerce a redemption of its notes to the detriment of junior creditors..." Therefore, the Bankruptcy Court held that the interests of the (putative) estate and all creditors are best served by dismissal of the case.
Discussion
The Bankruptcy Court noted that a bankruptcy petition must seek to create or preserve some value that otherwise would be lost—not merely distributed to a different stakeholder—outside of bankruptcy. The court went on to state that it is pivotal to recognize the potential for a creditor to abuse its ability to bring a debtor into bankruptcy, and rejected what it called the Petitioning Creditors' "bootstrapping attempt" to invoke section 1111—a provision dealing with the allowance of claims in a chapter 11 case—to support an argument regarding their eligibility to commence an involuntary chapter 11. The Bankruptcy Court also pointed out that allowing the case to continue "would encourage other parties...to disregard bargained-for contractual remedies in an indenture and pursue bankruptcy as a way to redefine the terms of the contracts they freely entered"—a result not in keeping with Congress's intent in enacting chapter 11 of the Bankruptcy Code.
As mentioned earlier, the Bankruptcy Court cautioned that if the Petitioning Creditors' tactics were permitted and rewarded with an order for relief, it would create significant uncertainly across the capital markets, as CDOs are designed to avoid bankruptcy. Moreover, the facts made clear that as a result of being a CDO in run-off, the alleged debtor had no business to rehabilitate or which necessitated a fresh start in chapter 11. The Bankruptcy Court stated, in summary, that the Petitioning Creditors focused on selective Bankruptcy Code provisions in the hope that it would enable them to effectuate an accelerated liquidation of an already self-liquidating securitization vehicle, for their own benefit at the expense of the larger creditor community.
Footnotes
1 This amount was chosen so that the Petitioning Creditors could collectively meet the requirement under section 303 of the Bankruptcy Code that the entities commencing the involuntary case hold claims aggregating at least $15,775.
2 At the time the Petitioning Creditors filed the involuntary petition, they held 100% of the A-1 Notes and approximately 34% of the A-2 Notes. Prior to commencing the case, the Petitioning Creditors coordinated with the company that owned 50% of the A-2 Notes to effectuate the proposed plan, which the company agreed to support "as long as they were not on the front lines."
3 Section 303 of the Bankruptcy Code, which governs involuntary bankruptcy cases, requires (among other things) that an involuntary petition be brought by at least three qualifying creditors and that each creditor holds a claim against the target of the involuntary petition.
4 The term "nonrecourse" describes a type of debt that involves an obligation that can be satisfied only out of the collateral securing the obligation, and not out of the debtor's other assets.
5 Wilk Auslander LLP v. Murray (In re Murray), 900 F.3d 53 (2d Cir. 2018).
6 The Petitioning Creditors argued that the notes do not become nonrecourse until the collateral is liquidated; the Bankruptcy Court, however, found that such interpretation "is not supported by the plain meaning of the provision, any other provision in the Indenture, or common sense."
7 The Bankruptcy Court noted that section 1111(b) does not unequivocally treat all nonrecourse claims as recourse under all circumstances; instead, for allowance purposes, it permits an undersecured nonrecourse claim to be allowed as a recourse claim only if certain requirements are met.
8 Section 1112 authorizes dismissal of a case for cause when it is in the best interest of the creditors and the estate to do so. Section 1112(b) contains a non-exhaustive list of circumstances that constitute cause to dismiss a case, and grants a bankruptcy court broad equitable discretion to grant relief based upon the facts and circumstances of a particular case.
9 These actions included knowingly purchasing a controlling stake of Class A notes after previous failed attempts to liquidate the collateral; drafting a liquidating plan for the exclusive benefit of Class A noteholders; filing the involuntary petition under chapter 11 (rather than chapter 7) to invoke the benefits of section 1111(b); and waiving their right to benefit from any security interest up to the statutory eligibility filing requirement.
10 Additional facts included, for example: the alleged debtor is not an operating business and does nothing other than hold securities that generate cash flow to pay noteholders pursuant to the terms of the indenture; the alleged debtor does not need, or want, a discharge; the Petitioning Creditors are being paid pursuant to the indenture; and one day after filing the involuntary petition, the Petitioning Creditors moved to terminate the putative debtor's exclusivity period to file a plan, thereby seeking authorization to file their own plan, having circulated pre-filing, but failing to obtain other creditors consent to, a proposed plan that would liquidate the collateral.
11 In re Zais Investment Grade Limitd VII, 455 B.R. 839, 849 (Bankr. D.N.J. 2011).
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