New York Judge Dismisses an Involuntary Petition Against a CDO

Holders of nonrecourse notes issued by a “static pool investment vehicle” do not have claims against the issuer and therefore are not eligible to be involuntary petitioners under Section 303(b), according to Bankruptcy Judge Mary Kay Vyskocil of New York City.

Even if they were eligible petitioners, Judge Vyskocil said she would dismiss the involuntary chapter 11 petition for “cause” under Section 1112 because the senior noteholders were attempting to “increase their recovery at the expense of junior noteholders.”

As described by Judge Vyskocil, the case involved a conventional “structured finance entity known as a collateralized debt obligation,” or CDO. The debtor issued 11 classes of 30-year notes, in descending order or priority, scheduled to mature in 2036.

With funds from issuance of the notes, the debtor mostly purchased long-term securities issued by real estate investment trusts. The indenture trustee held a lien on the securities as collateral for the noteholders. Income from the REITs was intended to pay debt service on the notes.

In 2009, four years after issuance, the debtor defaulted on notes junior to the senior-most notes held by the petitioning noteholders. In 2016, six years later, the petitioning senior noteholders purchased the remainder of the senior notes they did not already own. Later, they filed an involuntary chapter 11 petition and submitted a proposed liquidating plan alongside a motion to terminate the debtor’s exclusivity.

After Judge Vyskocil denied the petitioner’s motion for summary judgment, she held a trial on the involuntary petition. The debtor and junior noteholders urged dismissal, contending that the senior noteholders, by virtue of holding nonrecourse debt, did not qualify as petitioning creditors because they held no claims against the debtor.

Under Rule 52, made applicable by Bankruptcy Rule 7052, Judge Vyskocil ruled that the petitioners had failed at trial to make out a prima facie case. Having held a trial, the judge said she was not required to take the evidence in the light most favorable to the petitioners, nor was she obliged to take inferences in the petitioners’ favor.

Opposing dismissal, the petitioners advanced several theories to show they held claims against the debtor. Judge Vyskocil rejected them all.

Judge Vyskocil focused on Section 303(b)(1), which requires that the three involuntary petitioners must each hold “a claim against such person . . . .” She interpreted the section to mean that each petitioner must hold “a claim against the target of the involuntary petition.” [Emphasis in original.]

The petitioners argued that they held recourse claims against the debtor. Judge Vyskocil rejected the contention, found no ambiguity in the indenture, and quoted numerous provisions in the indenture saying that the obligations were nonrecourse, that the notes were payable solely from the collateral, and that the debtor has no personal liability to the noteholders. Furthermore, the indenture says the noteholders cannot look to the debtor for a deficiency if the collateral is exhausted.

Under the terms of the indenture, Judge Vyskocil therefore held that senior noteholders were not qualified to be involuntary petitioners because they held only nonrecourse claims that were not claims against the debtor, only claims against the collateral.

Next, Judge Vyskocil rejected the petitioner’s contention that Sections 1111(b)(1) and 102(2) eliminate the distinction between recourse and nonrecourse debt in specifying who may be an involuntary petitioner.

Judge Vyskocil ruled that the “clear and unambiguous” statutory language makes Section 1111(b) applicable only to the allowance and distribution of claims. Furthermore, she said, the purpose of the statute was to protect secured creditors when the debtor elects to retain the collateral, not “to give nonrecourse lenders . . . a right to commence an involuntary bankruptcy case against the borrower.”

The petitioner’s argument under Section 102(2) likewise failed. The section provides that the term “‘claim against the debtor’ includes claim against property of the debtor.”

Judge Vyskocil noted that Section 303(b) does not employ the phrase “claim against the debtor.” Rather, it says that a petitioner must have an unsecured claim “against such person.” She therefore held that Section 102(2) does not authorize a nonrecourse creditor to be an involuntary petitioner.

Even if the senior noteholders qualified as involuntary petitioners, Judge Vyskocil held that she would nonetheless dismiss the petition sua sponte under Section 1112, citing the Second Circuit’s decision this year in Wilk Auslander LLP v. Murray, 900 F.3d 53 (2d Cir. Aug. 14, 2018). To read ABI’s discussion of Wilk Auslander, click here.

Making 15 findings of fact from the trial record, Judge Vyskocil found “cause” for dismissal under Section 1112 because “no bankruptcy purpose is served by this filing.” She said the petitioners “will not suffer any prejudice if the case is dismissed.”

Among other things, Judge Vyskocil said the petitioners “are seeking to liquidate the collateral solely for their benefit, and at the expense of other noteholders.” The debtor, she said, is not operating a business and neither needs nor wants a discharge. No assets are being lost or dissipated; the petitioners are “fully secured,” and the petitioning creditors are being paid.

The petitioners were making “no genuine attempt to reorganize . . . . Rather, this case is a last-ditch effort by a senior sophisticated noteholder to further its personal, tactical and pecuniary aims . . . to the detriment of junior creditors.” [Emphasis in original.]

Citing an amicus brief by an industry group, Judge Vyskocil dismissed petition for “cause” under Section 1112 because validating the petitioners’ tactics “would create significant uncertainty across the capital markets.”

Observation

Before filing, the three petitioners had waived their security interests in the amount of $5,259 each, so they could claim to be unsecured creditors with the required $15,775 in unsecured claims. The waiver of their secured claims gave the petitioners a facially persuasive argument.

Judge Vyskocil said the petitioners took “intricate — choreographed — steps to manufacture eligibility to file an involuntary case.” Although she specifically declined to find that they filed in bad faith, she evidently found “cause” to dismiss under Section 1112 even if they held the required $15,775 in unsecured claims.

Beyond Section 1112, the unsecured claims still might not qualify the petitioners for at least two reasons: (1) By waiving their security interests, the senior noteholders arguably held no claims at all against the debtor; and (2) even if they held unsecured claims, the claims may be subject to bona fide dispute, disqualifying them under Section 303(b)(1).