Bank of New York v Montana Board of Investments & Anor

This is a case about structured investment vehicles or SIVs. It concerns a Cayman Island incorporated investment vehicle, a United States security trustee and the law of the State of New York. It comes before the English Court for an urgently required decision on the proper construction of one of the underlying agreements. It arises, in essence, because the parties cannot agree on how the security trustee of a defaulting SIV should behave when one group of investors wants to direct a quick sale of the assets, and another group wants to wait for the market to improve.

The Claimant bank (“the Security Trustee”) is the security trustee under an Amended and Restated Security Agreement dated 27 June 2006 (“the Security Agreement”) of the assets held by Orion Finance Corporation (“Orion”). Pursuant to and in accordance with the terms of the Security Agreement, all of Orion’s assets (“the Collateral”) are charged to the Security Trustee for the benefit of Orion’s Secured Obligations.

Orion was incorporated on 1 June 1995 under the laws of the Cayman Islands. Orion, the SIV, invested in a range of asset-backed securities. It funded its investment activities by issuing various classes of debt securities, including:

The First Defendant is a holder of Senior Notes issued by Orion. On 22 May 2008, Norris J made an order pursuant to CPR 19.6(1)(b) that the claim be continued against the Senior Creditor as a representative defendant on behalf of all the holders of the Senior Notes. I will refer to the First Defendant as the Senior Creditors.

The Second and Third Defendants are the only two holders of the Senior Subordinated Notes issued by Orion. Also on 22 May 2008, Norris J made an order pursuant to CPR 39.2(4) that the identities of the Second and Third Defendants are not to be disclosed in these proceedings. This is an approach which has been adopted in a number of case concerning SIVs: see Re Cheyne Finance plc [2007] EWHC 2116 (Ch) at [2] (Briggs J); Re Cheyne Finance plc [2007] EWHC 2402, [2008] BCC 182 at [20] (Briggs J); Re Whistlejacket Capital Ltd [2008] EWHC 463 (Ch) at [2] (Etherton J); Re Whistlejacket Capital Ltd [2008]EWCA Civ 575 (Court of Appeal). Their identity has not been revealed to me as I did not consider it necessary. I will refer to the Second and Third Defendants as the Subordinated Creditors, whilst not forgetting that there are other more junior subordinated creditors, the holders of the Capital Subordinated Notes (whom they do not represent).

The Claim Form seeks the determination of the following questions of construction in relation to the Security Agreement:

The intention of the Claim Form is to decide issues of construction only at this stage. The Claim Form does not raise any logically subsequent questions as to the precise content of any fiduciary duties or the way in which any discretion as to timing of the liquidation of the Collateral should be exercised, which may raise issues of fact.

The Security Trustee, represented by Mr Robin Dicker QC and Mr David Allison, has remained neutral as to the outcome of the dispute, which has been argued out between the Senior Creditors (represented by Mr William Trower QC and Mr Richard Fisher ) and the Subordinated Creditors (represented by Mr Gabriel Moss QC and Mr Barry Isaacs).

The relevant provisions of the Security Agreement are either summarised or set out below. I deal with them in the order in which they appear in the Agreement. Where they are not merely background I set them out in full to avoid doing so in the text which follows.

Article II of the Security Agreement deals with the grant of the security interest and the delivery, maintenance, investment, disposition and preservation of the Collateral.

Article V deals with Enforcement Events, rights of recourse, Acceleration Events, the liquidation and sale of the Collateral and the subordination and other rights of the Secured Parties.

No party attached any weight to anything in the Enforcement Management Guidelines.

Article VI deals with Distribution Priorities. Section 6.2 deals with payment priorities which govern the making of distributions before a Mandatory Acceleration Event. Section 6.3 sets out the priorities following the occurrence of a Mandatory Acceleration Event.

Article VII deals with the appointment of the Security Trustee.

Article IX deals with miscellaneous matters. The following provisions should be noted:

During the course of 2007, serious concerns arose in the financial markets regarding the level of potential defaults by borrowers in the United States sub-prime mortgage market. This, in turn, led to a material decline in the market values of most asset classes held in SIV portfolios. As a result, the rating agencies conducted a review of the SIV sector which led to the downgrading of the ratings of the assets of a large number of SIVs.

On 30 November 2007, Moody’s downgraded the ratings of Orion’s US$ and Euro commercial paper and its US$ and Euro medium-term note programmes. This downgrade constituted an Automatic Enforcement Event under Section 5.1.1(b) and (c) of the Security Agreement.

On 4 December 2007, pursuant to Section 5.1 of the Security Agreement, the Security Trustee sent an Enforcement Notice. This, in turn, caused the occurrence of the Enforcement Date, following which only the Security Trustee has the right to dispose of the Collateral.

On 6 December 2007, pursuant to Section 5.1 of the Security Agreement, the Security Trustee sent a Notice of Exclusive Control to the Custodian. The effect of this notice is that the Security Trustee has exclusive control of the Collateral.

On 14 January 2008, certain Senior Obligations became due and payable and the Deposited Funds available at that date were insufficient to discharge those obligations. In order to raise the funds required to meet these Senior Obligations, it would have been necessary to liquidate a significant amount of the Collateral.

In these circumstances, the Security Trustee’s financial adviser, Henderson Global Investors Ltd (“Henderson”), advised that, given the extreme illiquidity in the credit markets generally at that date, and the structured products markets in particular, the likely realisation values of the Collateral could be insufficient to meet all Senior Obligations.

In light of Henderson’s advice, the Security Trustee did not realise the Collateral and, as a result, Orion could not discharge the Senior Obligations that fell due for payment on 14 January 2008. This failure constituted an Insolvency Event which, in turn, constituted a Mandatory Acceleration Event under the terms of the Security Agreement, the effect of which is that all Senior Notes became immediately due and payable.

Following the occurrence of the Mandatory Acceleration Event, the Security Trustee sought restructuring proposals from third parties in an attempt to avoid a piecemeal sale of the Collateral. The restructuring proposals were rejected by the holders of the Senior Notes and the Senior Subordinated Notes.

In the absence of any acceptable restructuring proposal, the Security Trustee consulted the holders of the Senior Notes and the Senior Subordinated Notes regarding the approach which they considered should be taken in relation to the realisation of the Collateral. The positions of the holders of the Senior Notes and the Senior Subordinated Notes were opposed both in relation to the rights and obligations of the Security Trustee and as to the appropriate course that should be taken.

The holders of the Senior Notes have directed the Security Trustee to commence the liquidation of the Collateral. The Notices require the Security Trustee

“1.

to commence promptly the liquidation of the Collateral through a public Foreclosure Sale, on or prior to the date that is 30 calendar days after the date of this Direction, to be conducted in New York and in a commercially reasonable manner under Section 9-610 of the New York Uniform Commercial Code and in accordance with Clause 5.6.1. of the Security Agreement”

The direction to the Security Trustee also required it to arrange the sale to allow “credit bidding” by the holders of Senior Notes, so as to allow them to use the value of their holdings to acquire assets forming part of the Collateral.

The Subordinated Creditors did not agree. They in turn have directed the Security Trustee to refrain from liquidating any Collateral at the present time.

It is in consequence of this disagreement that the present action arises.

The Agreement states that it is to be governed by and construed, and the obligations, rights and remedies of the parties under it determined, in accordance with the internal laws (without application of its conflicts of laws provisions) of the State of New York.

New York Law may be relevant in two main areas, namely:

The Security Trustee served an expert report from Professor Steve Thel who is the I. Morris Wormser Professor of Law at Fordham University in New York City. His evidence was admitted without cross examination and is uncontroversial. The Senior Creditors called Professor Theodore Eisenberg who is the Henry Allen Mark Professor of Law at Cornell University Law School in Ithaca, New York. The Subordinated Creditors called Professor Steven L. Schwarcz who is the Stanley A Star Professor of Law and Business at Duke University.

The main relevant principles of construction may be summarised as follows:

None of the parties here seeks to rely on any parol evidence to clarify any ambiguity, or suggested that the application of these principles would produce a materially different construction from the one that would be arrived at by applying English rules.

New York has a Uniform Commercial Code (UCC). Article 9-610 provides that

“(a)

Disposition after default After default, a secured party may sell, lease, license or otherwise dispose of all of the collateral ….”

(b)

Commercially reasonable disposition. Every aspect of a disposition of collateral, including the method, manner, time, place and other terms, must be commercially reasonable….

It is not possible to contract out of 9-610(b): see 9-602(g).

The UCC includes notes added by the draftsmen, which are highly persuasive as to how the relevant Article is to be interpreted, but not formally binding. Under “Time of disposition” it is pointed out that

“This Article [i.e. 9-610] does not specify a period within which a secured party must dispose of collateral… It may, for example, be prudent not to dispose of goods when the market has collapsed”.

Article 9-627 is entitled “Determination of Whether Conduct was Commercially Reasonable” and provides:

“(a)

Greater amount obtainable under other circumstances; no preclusion of commercial reasonableness. The fact that a greater amount could have been obtained by a .. disposition…. at a different time or in a different method…. is not of itself sufficient to preclude the secured party from establishing that the … disposition … was made in a commercially reasonable manner.”

Sub-article (b) has a list of dispositions that are commercially reasonable, and includes a disposition “in the usual manner on any recognized market”.

The experts were agreed that under New York law, before default, a security trustee has very limited duties. That is because, prior to default, the debtor is solvent and in charge of the collateral which is under his control. After default New York law imposes on a security trustee an enhanced duty, that is to say to act as prudent men of intelligence and discretion employ in their own affairs. The prudent security trustee would preserve trust assets, not waste them.

Where the experts disagreed is as to the existence and application of the enhanced duty of prudence in the case where there is a conflict of interest between classes of creditor. I do not think this dispute really matters. It is more concerned with how the Trustee is to perform his duties in a particular situation than with any of the questions of construction which I have to answer. What I derive from the general New York law pertaining to security trustees is that they are required to exercise prudence, or to put it another way, judgment in the way in which they deal with trust assets.

The first issue is whether the Security Agreement provides the Senior Creditors with the right to direct the Security Trustee with respect to the time, place and manner of sale of Orion’s assets.

It is important, in my judgment, to keep separate and distinct two matters. The first is the existence of an obligation on the Security Trustee to enforce the security for the benefit of Senior Creditors, so as to secure the payment of Orion’s obligations. The second is the execution of that obligation. If the obligation exists, there is no doubt that the Security Trustee must perform the obligation, but it may not follow that Senior Creditors have the right to dictate the time, place and manner of execution.

There is no provision in the Security Agreement which expressly lays down that the Senior Creditors have the right to direct the Security Trustee with respect to the time, place and manner of sale of Orion’s assets.

The Senior Creditors rely on two matters of background. Firstly they rely on the granting clause, Section 2.1, as showing an underlying purpose which should inform construction, namely that the grant to the Security Trustee is “for the prompt payment and performance when due (whether by acceleration or otherwise) of Secured Obligations… for the security and benefit of the Secured Parties (as their interests may appear)”. It is correct that this clause forms part of the contractual context, but it is no more than that. A general clause of this nature does not under either English or New York Law have as much weight as more specific clauses which follow it.

Secondly the Senior Creditors rely on the extent of subordination of the rights of the subordinated creditors.

The parties were not agreed as to the precise nature and extent of the subordination of the Subordinated Creditors’ rights. It is undoubtedly the case that the Subordinated Creditors rank behind the Senior Creditors in point of payment: see Section 5.9.1. But it seems to me that the subordination in this agreement goes further than that: the rights of the Subordinated Creditors under 5.9.2(a) are limited to delivering a notice to the Security Trustee of the occurrence of an Enforcement Event. Section 5.9.2(c) refers to the Security Trustee being obligated to enforce the Collateral in a manner consistent with “full subordination” of the Subordinated Creditors, and Section 9.1 says that, with the single exception of giving Notice of an Enforcement Event, the Subordinated Creditors have no rights to enforce any obligations of Orion so long as any of the Senior Creditors remain unpaid.

Keeping those matters of background in mind, the argument of the Senior Creditors for the existence of a power to direct the Security Trustee as to the time, place and manner of sale is founded mainly on Section 5.9.2(a). This provision commences with a prohibition on, amongst others, the Security Trustee and the Senior Creditors from “bringing any action or proceeding or otherwise attempting to enforce any remedies”… “with respect to the Collateral”. The prohibition includes, for good measure, a prohibition on the Senior Creditors directing the Trustee to take prohibited action.

The wide prohibition in Section 5.9.2(a) is subject to an exception in the case of the Security Trustee and the Senior Creditors, who shall have the right to “take such action to the extent and in the manner as contemplated by this Agreement and the Transaction documents”.

The Senior Creditors argue that the exception gives them the right to give directions to the Security Trustee to take action with respect to the Collateral. They say that “such action” refers back to and includes the giving of directions to the Security Trustee.

I am unable to see Section 5.9.2(a) as doing anything more than preserving such rights as the Senior Creditors may have to take action, or give directions to the Security Trustee to take action, as may be given to them elsewhere in the Agreement.

It is clear that the prohibition is intended to be wide, covering for example the mere giving of notices, as the exception in favour of the Subordinated Creditors, allowing them to do just that, shows. The exception in favour of the Senior Creditors merely brings back in all the things which the Senior Creditors would otherwise be able to do in pursuance of the Agreement. It is clear, therefore, that if the right to give the direction specified in the first issue is to be found, it must be found elsewhere in the Agreement or the Transaction Documents.

The Senior Creditors submit that the Agreement and the Transaction Documents do contemplate the Senior Creditors giving the Security Trustee directions. The Security Agreement and Transaction Documents contemplate that the Senior Creditors will be able to give directions to the Security Trustee to enforce the security against the Collateral. Thus, Section 11.01 of the U.S. Medium-Term Note program Second Amended and Restated Indenture (the “Indenture Agreement”) envisages that a meeting of the holders of the Notes of one or more Series may be called at any time for various purposes, including:

“(a)

to give any notice to the Company, the Guarantor, the Indenture Trustee or the Security Trustee, to give any directions to the Indenture Trustee or the Security Trustee, to consent to the waiving of any Event of Default hereunder and its consequences, to resolve to direct the Security Trustee after an Enforcement Event has occurred, to enforce the security in accordance with the Security Agreement, to provide any other direction to the Security Trustee in accordance with the provisions of the Security Agreement or to take any other action authorized to be taken by the Holders of the Notes of such Series pursuant to any of the provisions of Article Five”.

The Indenture Agreement is, by Section 3.17, subject to the terms of the Security Agreement.

The Senior Creditors also point to Section 5.2.1 which states that an Enforcement event will occur on

“(v)

any other event which is an Event of Default in respect of any series of MTNs with respect to which a majority of the holders… (represented at a meeting of such holders duly convened) have passed a resolution in accordance with [the relevant indenture] directing the Security Trustee to enforce the security constituted by this Security Agreement”

and to the remainder of Section 5.2.9(a) which prohibits the holders of Junior Obligations from giving directions to the Trustee until the Senior Creditors and the Subordinated Creditors have paid. All this, the Senior Creditors argue, points to an ability in the Senior Creditors to give directions to the Trustee to enforce against the Collateral.

I am unable to see in these provisions and the Security Agreement as a whole anything other than an obligation on the Security Trustee to enforce the Security in accordance with the Security Agreement (an obligation which arises in specified circumstances under the Agreement), and a power in the Senior Creditors to direct that the Security Trustee should do so once that obligation has arisen. I can see nothing whatever in the Agreement that gives the Senior Creditors a power, once the obligation to enforce has arisen, to direct the time, place and manner of a sale of the Collateral.

Firstly, it seems to me that the Agreement expressly leaves it to the Security Trustee to decide how it is to go about enforcing the Security, subject only to the terms of the Agreement. The Security Trustee is given by section 5.6.1 “exclusive control” of the Collateral and the “exclusive right” to exercise rights in relation to it, which may include preserving all or part of it or selling it “at such place or places as the Security Trustee deems best”. It must do it in a “commercially reasonable manner”. These provisions are inconsistent with a power in the Senior Creditors to mandate the time, place and manner of the sale.

Mr Trower endeavoured to reconcile his submissions with the provisions of Section 5.6.1 by saying that that Section only regulated the position in the absence of a direction. Following a direction from the Senior Creditors, it would be the direction of the Senior Creditors that would prevail. I am unable to read the Agreement in this way. I have no doubt that if it had been intended to give the Senior Creditors the power to trump Section 5.6.1, then this would have been spelled out in the Agreement.

Secondly, it has to be remembered that the Security Trustee may be obliged to enforce the security in a wide range of circumstances, in some of which it may be more important to take account of the interests of classes of creditor other than the Senior Creditors than in others. The Collateral is held for the benefit of all the Secured Parties. Against that background it is difficult to see, as a matter of construction of the Agreement, why any one class, even if they are the senior class, should have the right to dictate the time, place and manner of any sale.

Thirdly, both the position of a security trustee generally under New York Law, and a number of other provisions of the Agreement make it clear that the Trustee is not the mere agent of the creditors, but is required to exercise a discretion. It cannot surrender that discretion or any part of it to any individual class of creditor. The language of Section 2.5 “shall have the right”, Section 5.1.1 “shall be entitled”, and Section 7.3 “error of judgment” all contemplate the existence of a discretion.

Fourthly, I think the difficulty with the Senior Creditors’ position is well illustrated by the terms of the direction which they have purported to give to the Security Trustee. The direction purports to lay down the time, place and in some respects the manner of the sale, but also to direct that it take place in a commercially reasonable manner. It is plain from a reading of Articles 9-610 and 9-627, however, that the time, place and manner of sale are themselves aspects of the sale which are required to be commercially reasonable. On receipt of a direction specifying these matters, the Trustee could be prevented from conducting a sale in a commercially reasonable manner. I do not think that the Agreement envisages placing the Security Trustee in this curious position.

So I would answer the first question of construction by saying that the Senior Creditors do not have the power under the Security Agreement to direct the time, place and manner of the sale of Orion’s assets.

None of this is to say that the Security Trustee enjoys anything approaching an unfettered discretion as to how to enforce against the Collateral. Firstly, the Security Trustee must (not may) enforce in a manner consistent with the full subordination of the Subordinated Creditors’ rights in the sense discussed above: see Section 5.9.2(c). Secondly, it must bear in mind the purpose of the security interest which it has been granted, which is to ensure prompt payment of the Notes when due. Thirdly it is to bear in mind that all the Senior Creditors have resolved that it should enforce the security. That is the framework within he must exercise the discretion which he is given by the Security Agreement to decide on the time, place and manner of sale of the Collateral.

The Second Issue does not therefore arise. Moreover, attempting to answer the question posed by section 2 on the basis that I am wrong, and the Agreement does give the Senior Creditors rights which I have held them not to have, would be a particularly artificial task for the court to undertake in this case.

The Third Issue is directed at Section 5.5. It asks whether the Security Agreement mandates any specific timing for the liquidation of Collateral following the occurrence of a Mandatory Acceleration Event when there are insufficient funds available to redeem in full all of the then outstanding Senior Notes.

Section 5.5 has to be read against the background of Section 2.1: the security is there for ensuring prompt payment of obligations when due (including when due by acceleration). It also has to be read against the subordination provisions which I have dealt with above.

Section 5.5 makes all Senior Notes due and payable. If there are insufficient available funds, the Security Trustee must “collect… the proceeds of the Collateral”. It seems to me that these words are apt to include both receiving the income from the Collateral and selling the assets forming the Collateral and collecting the proceeds. Thus, where there is a shortfall in the available funds as compared with the amount required to pay the Senior Creditors in full, the Security Trustee must collect money from the Collateral (either by receiving income or forcing sales) so as to raise money to pay the Senior Notes. If the shortfall is small, the Security Trustee would no doubt be able to comply with his obligations under this Section without selling any Collateral at all.

A literal response to the question posed would, of course, be that Section 5.5 does not lay down any specific timing for the liquidation of Collateral. Indeed it does not necessarily require, depending on the circumstances, the Collateral to be liquidated at all. In my judgment a more helpful, and correct answer would be that Section 5.5 requires the Security Trustee, in complying with Section 5.5 to conduct any liquidation or sale of the collateral in accordance with the requirements of Section 5.6.1. I give my reasons below.

Firstly, I can see no reason to read the guidance in 5.6.1 as to the manner in which sales are to be conducted (for example that they should be in a commercially reasonable manner) as disapplied in the case of a sale for the purposes of Section 5.5. That provision applies following the occurrence of an Enforcement Date, which must be the case where section 5.5 applies. Section 5.6, as I have already held, gives to the Security Trustee a discretion over the timing of any sale.

Secondly, the purpose of Section 5.5 is to accelerate the maturity of the Senior Notes, and, after a redemption request, the collection of assets to redeem the Notes in full. There is no a priori reason why this situation should require any different regime to apply to asset sales.

Thirdly, disapplying the provisions of Section 5.6 would simply beg the question as to what timing should apply to Section 5.5. The Senior Creditors suggested that the Trustee should sell “as soon as reasonably practicable”. I think that it would be wrong to imply such a term into the Agreement. To do so would be to imply an obligation into the Agreement against the Security Trustee, contrary to the terms of Section 7.3.

Fourthly, I think there are difficulties in the way of excluding the requirement for commercial reasonableness required by Article 9-610 of the UCC. The phrase “as soon as reasonably practicable” is not the same thing as “commercially reasonable”. I should be wary of any construction of Section 5.5 which, by implication, amounts to contracting out of the requirement for commercial reasonableness, contrary to Article 9-602(g).

In summary: