Court Tells Junior Investors in CDO “You Gotta Have Faith” – Good Faith and Fair Dealing, That Is

Cases analyzing rights under indentures – and the transactions holders and issuers contemplate (or not) under indentures – continue to gain attention in the restructuring world.  Some of those cases involve section 316(b) of the Trust Indenture Act (see our own blog’s recent posts) and payment rights under indentures.  Others, such as Wells Fargo Bank, N.A. v. Wrights Mill Holdings, LLC, examine the limits on the exercise of rights under an indenture—in that case, finding that certain junior stakeholders’ exercise of sale-approval authority was subject to an implied duty of good faith and fair dealing.  The case is a reminder of how notions of good faith and fairness might constrain a decision maker’s exercise of discretion in a particular transaction.  
Wells Fargo brought an interpleader action in the U.S. District Court for the Southern District of New York asking whether, as trustee for assets held in a collateralized debt obligation (“CDO”), it was obliged, under the governing indenture’s terms, to sell certain collateral.
The CDO in question, Tropic IV CDO, issued by Tropic IV CDO Ltd. in November 2004, had offered for sale to investors series of six classes of notes with an aggregate principal balance of $318.5 million, secured by a portfolio of fixed income assets.  Wells Fargo, as trustee, held a first priority security interest in the portfolio collateral and related assets.  The waterfall in the indenture provided the senior tranches of notes (Class A Notes) with the highest priority to receive principal and interest on the portfolio collateral and the proceeds of sales of portfolio collateral, as well as the greatest protections against losses.
The issuer also issued preferred shares, which were at the bottom of the waterfall and therefore would be the first to bear losses if the collateral failed to perform.  And that is exactly what happened – the CDO’s underlying assets, in Wells Fargo’s words, failed to perform “catastrophically.”  Therefore, the value of the assets in the CDO was insufficient to reach past the first tranche of noteholders, and the preferred shareholders were almost certain to never receive payouts.  A single entity held 67.22% of the preferred shares.
As is typically the case in a CDO structure, the most junior tranche of investors had certain control rights, and the indenture provided that two-thirds of the preferred holders could direct the Trustee to sell an item of portfolio collateral if two offers were made for that asset, and the Preferred Shareholders certified that the second offer was equal to or greater than the first offer.  Thus, even though the preferred holders had no realistic economic stake in the price at which CDO assets were sold, they had the authority under those circumstances to direct the sale of that collateral.
Two successive offers were made for the same collateral.  First, Wells Fargo received an offer from Brogno LLC on July 25, 2014 to purchase $5 million of trust preferred securities for a purchase price of $500,000, plus a “consent payment” of up to $250,000 for those preferred shareholders that directed the trustee to accept the offer.  Two holders of Class A notes objected to the sale.  The offer expired on October 23, 2014, without acceptance.
Before the expiration of that offer, though, the majority holder of the preferred shares sent Wells Fargo a letter directing it to sell the trust preferred securities to “Moishe Gubin or his designee” for $800,000, on the basis that Gubin’s offer constituted a second offer.  The Class A noteholders again objected to the new offer and threatened to sue if it were accepted.  Gubin also threatened to sue if the sale did not go through.  Therefore, Wells Fargo filed the interpleader action for judicial guidance on whether it was obligated and/or permitted to sell the securities to Gubin over the Class A noteholders’ objection.
The district court held that the “initial offer [from Brogno LLC] was on its face not a valid offer within the meaning of [the indenture], containing as it did an overt side payment to the Preferred Shareholders to induce these shareholders to approve of a sale of CDO collateral.  That offer by nature invited and induced the Preferred Shareholders to disregard their duties of good faith and fair dealing.”
To reach its decision, the court parsed the definition of “Offer” under the indenture.  The indenture defined an “Offer” as “any offer by . . . any . . . person made to all holders of such class of security to purchase or otherwise acquire all such securities.”  Because of the somewhat circular definition, the court had to look to the plain meaning of “offer.”  It concluded that “the term ‘offer’ necessarily implies something that is capable of being accepted.”  So, the question was whether Brogno’s offer was capable of acceptance.  The court concluded that it was not capable of acceptance – the preferred shareholders “could not approve Brogno’s offer because accepting a side payment to exercise their authority to decide whether to approve a sale would blatantly breach their implied duty of good faith and fair dealing, owed to the stakeholders in the CDO.”  That is, the preferred shareholders had an obligation to exercise their decision-making power in good faith, and if they accepted $250,000 in exchange for approving a low-ball offer for particular collateral, then they would not be upholding their duty to other stakeholders to make a good faith decision.  This was particularly so where their status as lowest priority on the waterfall ironically should have incentivized them to insist on a fair sales price for the collateral, but, in light of the CDO’s performance, left them without any skin in the game.
Accordingly, the court ruled that the preferred shareholders’ direction to sell the collateral was invalid, and Wells Fargo lacked authority to accept Gubin’s offer.
The court also offered pragmatic reasons for rejecting Gubin’s interpretation of the indenture.  Construing Gubin’s offer with the consent fee as triggering the indenture’s successive-offer provision would have compelled the senior tranche to take a hit on its collateral, with the out of the money junior holders getting a recovery through the consent fee; this, the court noted, would have been “a commercially unreasonable interpretation.”  As the court observed, no rational investor would have purchased the CDO’s notes if they understood that the indenture provision at issue allowed the junior equity holders to enrich themselves at the higher priority noteholders’ expense.  Although this transaction arose outside of a bankruptcy case, it bears similarities to attempts by parties in a bankruptcy case to change the bankruptcy “waterfall” established by the absolute priority rule.
The court limited its decision to the idiosyncratic facts presented by the offers at issue, but indicated to Wells Fargo that if it determined the indenture did not provide a workable mechanism for selling portfolio collateral, it could seek to amend or reform the indenture or it could seek judicial guidance through a trust instruction proceeding.
Debora Hoehne is an Associate at Weil Gotshal & Manges, LLP in New York.