Richard Ruffer, svp at Walkers Management Services in the Cayman Islands, suggests two indenture provisions that could safeguard against future CDO involuntary bankruptcies

The recent US Bankruptcy Court decision in In re Zais Investment Grade Limited VII, No. 11-20243 (Bank. D. N.J. August 26, 2011) raises troubling concerns for investors in CDOs. The decision rejected a motion to dismiss an involuntary bankruptcy order entered against a Cayman Islands CDO.

As a result, the case opens the door for struggling Cayman CDOs to be pushed into involuntary bankruptcy in the US, despite having "bankruptcy-remote" structures. The case, however, also provides guidance on how CDO directors can help preserve the structural integrity of bankruptcy-remote transactions if they choose to act.

ZING structure and performance
Zais Investment Grade Limited VII CDO (ZING) closed in October 2005. ZING is a Cayman Islands exempted company with three Cayman-based independent directors. ZING's ordinary shares are held on trust for charitable purposes by a Cayman-based trust company.

ZING issued various classes of non-recourse, secured notes (with original ratings ranging from Aaa/AAA to A3/NR by Moody's and S&P) and a class of unsecured, unrated income notes that has rights similar to preferred equity. Zais Group acts as collateral manager for ZING with The Bank of New York Mellon Trust Company serving as indenture trustee.

As a CDO-squared, ZING's collateral portfolio consists primarily of securities issued by, or swaps referencing, other CDOs. By mid-2008, ZING's portfolio had deteriorated sufficiently to trigger ratings downgrades on all of its rated notes.

ZING suffered a covenant default on its notes in March 2009 and the senior note holders elected acceleration in June 2009. Under the transaction documents, the acceleration caused Zais to lose its ability to actively manage the collateral portfolio. Also at that point, the trustee became obligated to hold ZING's portfolio intact unless either the trustee could sell the portfolio and pay all notes in full or the holders of two-thirds of each class of notes consented to the sale - two highly unlikely events.

Bankruptcy petition, directors' failure to answer and motion to dismiss
On 1 April 2011, a related group of funds holding a large portion of the most senior class of notes filed an involuntary chapter 11 bankruptcy petition against ZING in the Bankruptcy Court for the District of New Jersey. The petitioners reasoned that the portfolio could not fully repay the most senior notes but that the portfolio, if actively managed, could yield more than if left to run off.

The reorganisation plan proposed by the petitioners called for the transfer of ZING's portfolio to an affiliate of the petitioners for management and orderly liquidation, with the proceeds distributed to the most senior class of notes. No other noteholders joined the petition.

The directors did not file an answer to the petition, so the Bankruptcy Court entered a default judgment against ZING on 26 April 2011. Afterwards, a junior noteholder filed a motion to dismiss the bankruptcy case. Another holder of the most senior class of notes and Zais joined in the motion.

Court's decision on motion to dismiss
The Court rejected the motion to dismiss after working through the movant's various arguments. The decision is noteworthy not only for the Court's analysis of the arguments, but also for what arguments the Court summarily rejected and why.

The Court rejected out of hand probably the strongest argument for dismissal: non-recourse. As non-recourse debt holders, the petitioners' claims are limited to the value of the collateral; thus, the petitioners can never be unsecured. In order to file a petition, the petitioners must be, at least partly, unsecured.

Non-recourse forms the backbone of bankruptcy remoteness and the Court's rejection of the argument at first appears shocking. The Court, however, rejected the argument not on its merits but on the basis that only the debtor can make the argument, and ZING missed its chance when the directors failed to contest the petition and allowed a default judgment.

The movant also argued that ZING does not qualify as a debtor under US bankruptcy laws because, as a Cayman company, it does not have a place of business or have property in the US. The Court disagreed. It concluded that a major and critical portion of ZING's operations are actually performed by Zais and the trustee, each from their offices in the US.

To meet the threshold, the Court noted that ZING only needs "a" place of business in the US, not its "principal" place of business. It found the activities of Zais and the trustee sufficient to constitute a place of business for ZING.

The Court went on to conclude that ZING's accounts and securities held by the trustee in New York City qualify as property in the US. Thus, the Court held ZING has both a place of business and property in the US, either of which qualifies ZING as a US debtor. Importantly, this analysis results in virtually every CDO with a US-based collateral manager or trustee qualifying as a US debtor, as could many Cayman hedge and private equity funds.

Finally, the movant argued that the Court should abstain from exercising bankruptcy jurisdiction for a number of reasons that are essentially fairness or equitable arguments. The reasons included that the petitioner was trying to gain an unfair advantage over other creditors, that bankruptcy is an end run around the indenture and that the petitioner's plan does not reorganise ZING. All of these arguments the Court systematically rejected.

Lessons learned
The case confirms that in order to ensure structured finance investors receive the deal they bargained for in the transaction documents, the entity must stay out of bankruptcy. The Court's willingness to entertain a reorganisation plan that overrides the indenture shows all deals are off once in bankruptcy. The case further shows that any CDO with a US collateral manager or trustee, or potentially just a US custodian, can end up in bankruptcy in the US.

The case also makes it clear that the directors of a CDO control the non-recourse argument, which had the best chance of keeping ZING out of bankruptcy if put forward by the directors. It is not clear why the directors failed to contest the petition. A letter from Zais to the ZING investors states that the directors had counsel and consciously chose not to oppose the petition.

Similarly, the Court stated in its opinion that ZING "has no stake and takes no position on the motion. It views this matter as an inter-creditor dispute to be resolved in an appropriate forum."

It is troubling to think the directors could believe that the company over which they have oversight would have no stake in whether or not it is declared bankrupt, particularly when the non-recourse nature of the debt means it should be solvent. Maybe instead the directors decided the deal was now a bad one for the senior noteholders and were willing to let the noteholders rewrite the deal in bankruptcy.

In any event, by deciding to do nothing, the directors guaranteed that a bankruptcy reorganisation plan would replace the deal the investors bargained for in the transaction documents. This will surely work to some investors' benefit and to others' detriment, but the fundamental premise of structured finance is that the structure is set at the start and followed through to the end, all in accordance with the transaction documents. Here, the directors proved themselves to be the weak link in ZING's bankruptcy remoteness chain.

Potential safeguards
ZING points out the importance of engaging the right independent directors - ones who will strive to have the CDO meet investors' expectations as set out in the transaction documents. In order further to reduce bankruptcy risk on future transactions, however, two provisions added to the note indenture could help.

First, the non-petition covenant in ZING did not apply to senior noteholders, only to junior noteholders. Having all noteholders bound by a non-petition covenant, particularly one phrased as a mutual covenant among the holders, may give noteholders a better footing from which to contest a petition.

Second, adding a covenant that the CDO will contest any involuntary bankruptcy petition - provided sums are available to pay for counsel - may provide an additional reason for directors to act. Failure to contest a bankruptcy typically constitutes an event of default in CDOs, but if an event of default has already occurred, the potential for a second event may not alone push the directors to act. A continuing covenant, in contrast, may compel the directors to act to support the integrity of the structure in all events.