United States: Bankruptcy Court Rejects Involuntary Chapter 11 For CDO

A bankruptcy case is usually commenced by the debtor, but the Bankruptcy Code permits creditors to seek to place a debtor into bankruptcy involuntarily, where certain statutory conditions are met. Recently, the bankruptcy court for the Southern District of New York rejected an attempt by certain creditors (the "Petitioning Creditors") to place a financing vehicle known as a collateralized debt obligation, or CDO, into involuntary chapter 11 bankruptcy. See Taberna Preferred Funding IV, Ltd. v. Opportunities Fund II Ltd., et al. (In re Taberna Preferred Funding IV, Ltd.), No. 17-11628 (MKV), 2018 WL 5880918 (Bankr. S.D.N.Y. Nov. 8, 2018).

The Petitioning Creditors held senior notes issued by Taberna, which the court found were nonrecourse (i.e., the Petitioning Creditors had agreed to look solely to the collateral securing their notes). Taberna and certain junior noteholders sought dismissal of the petition on a number of grounds. The court addressed one of these grounds, that the Petitioning Creditors, as nonrecourse claimants, did not hold claims against Taberna as required under Section 303 of the Bankruptcy Code. Additionally, pursuant to Wilk Auslander LLP v. Murray (In re Murray), 900 F.3d 53 (2d Cir. 2018), the bankruptcy court issued an order to show cause on whether it should dismiss the Taberna petition for cause under Section 1112(b) of the Bankruptcy Code. The court ruled against the Petitioning Creditors on both grounds.

First, the court concluded that the Petitioning Creditors, as nonrecourse claimants, were not eligible to file the involuntary petition, because Section 303(b)(1) of the Bankruptcy Code permits an involuntary petition to be filed against a person by a "holder of a claim against such person." The court concluded that the notes held by Petitioning Creditors were nonrecourse, and Taberna had no personal liability for the notes.

The Petitioning Creditors relied on two provisions of the Bankruptcy Code to argue that the recourse/nonrecourse distinction was irrelevant for purposes of Section 303. First, Section 102(2) of the Bankruptcy Code provides that the phrase "claim against the debtor" in the Bankruptcy Code includes a claim against property of the debtor. Second, Section 1111(b) of the Bankruptcy Code provides that a secured claim is generally allowed or disallowed in chapter 11 as if the holder had recourse to the debtor. The court concluded that neither section applied. Section 303(b) uses the phrase "claim against such person," so Section 101(2)'s guidance on the meaning of the phrase "claim against the debtor" was inapplicable. The issues arising from Section 1111 regarding allowance and secured status of a claim inhere in the chapter 11 process itself, and do not apply to the question of whether a company should be placed into chapter 11 in the first place.

Second, the court ruled that even if the Petitioning Creditors were eligible under Section 303(b), the case should be dismissed for cause pursuant to Section 1112. The court concluded that "cause" is a fact-specific inquiry that can consider whether the filing is an appropriate use of the Bankruptcy Code. Thus, a petition that seeks to benefit all creditors by creating or preserving value and ensuring equal distribution to creditors is consistent with the objectives of chapter 11. Here, in contrast, the court concluded that the purpose of the filing was to liquidate the collateral solely for the benefit of the Petitioning Creditors, in contravention of the indenture and at the expense of other noteholders. Taberna was a financing vehicle that held securities for the purpose of generating cash flow to pay noteholders in accordance with the indenture. It did not have any operating business to rehabilitate in chapter 11. The filing of the petition followed extensive efforts by the Petitioning Creditors to liquidate their collateral, which were unsuccessful outside of bankruptcy because of bargained-for limitations in the indenture (which set forth a process for management and liquidation of the remaining portfolio and distribution of losses among the noteholders).

Far from a legitimate attempt to rehabilitate the debtor, the court concluded, the case was "nothing more than a last-ditch effort by a senior sophisticated noteholder to further its personal, tactical and pecuniary aims and to coerce redemption of its notes to the detriment of junior creditors." Taberna, 2018 WL 5880918 at *22 (emphasis in original). If these "tactics were permitted and rewarded with an entry of an order for relief, this would create significant uncertainty across the capital markets." Id. at *23.

While the Section 303 statutory analysis in Taberna is interesting, the greater impact of the decision is likely to be the analysis and ruling on Section 1112. As noted by the court, a CDO is a "bankruptcy remote" structure, in which the creditors of the entity - the noteholders - negotiate their respective rights and remedies. It is not an operating business with numerous, diverse creditor groups. In this context, permitting one group of noteholders to employ chapter 11 to rewrite their contract to the detriment of other noteholders is problematic, and the Taberna decision sends a clear signal that such tactics are not likely to prevail. The decision may therefore find application in other structured finance situations where all the creditors have contractually agreed on a process for liquidation and distribution.

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