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CDOs Are Less Bankruptcy Remote than You Thought
The recent decision of the United States Bankruptcy Court for the District of New Jersey in In re Zais Investment Grade Limited VII, No. 11-20243 (RTL), 2011 WL 3795169, *3 (Bankr. D. N.J. 2011) took many holders of collateral debt obligations (“CDOs”) by surprise. In Zais, the court denied a group of junior noteholders' motion to dismiss an involuntary bankruptcy case commenced by a group of senior noteholders for the admitted purpose of circumventing provisions of the underlying indenture that prohibited liquidation without junior noteholder consent. The decision flies against market assumptions that CDOs are structured to be bankruptcy remote and that the terms of the indenture, rather than the issuer's plan of reorganization, will determine the disposition of the collateral in the event of default.
Despite the initial shock occasioned by the result, the Zais decision is not surprising on its facts. Upon close examination, the decision is primarily the result of two features of the underlying indenture. First, the indenture did not prohibit senior noteholders from filing an involuntary bankruptcy petition. Second, the indenture did not require the issuer to oppose an involuntary petition. What is more surprising than the decision in Zais is that these features are common to CDO indentures. In the wake of Zais, this article proposes drafting solutions designed to protect junior noteholders in future transactions.
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