In re Zais Investment Grade Ltd. VII1 is the latest in a recent line of bankruptcy cases challenging bedrock assumptions regarding securitization special purpose entities (SPEs) and bankruptcy considerations in securitization transactions.2 Zais establishes precedent allowing a senior noteholder of a collateralized debt obligation (CDO) to place the CDO issuer in an involuntary chapter 11 bankruptcy in order to advance an asset management plan that would otherwise require supermajority approval of all noteholders (including all junior classes) under the related indenture. Investors should be aware of the implications of this decision for existing and future investments in CDOs and other asset-backed debt issued by SPE issuers. Particular attention must be paid to the non-petition provisions in operative deal documents.

Background

Zais Investment Grade Limited VII (ZING VII) is a cash flow CDO issuer formed in the Cayman Islands in 2005. In March 2009, a covenant default (for failure to maintain a certain debt coverage ratio) occurred under the related indenture, which in turn triggered an event of default and resulted in the declaration of the notes to be due and payable. Following such an event of default and acceleration of the notes, the indenture requires that the indenture trustee hold the CDO’s assets passively to maturity. Any deviation from this, including disposition of any of the CDO’s assets, is not permitted under the indenture except upon the direction of at least 66 2/3% of all noteholders.

According to publicly available investor communications regarding Zais, various subsidiaries of Anchorage Capital Group, LLC (Anchorage) purchased a majority of the class A-1 notes in October 2009 (i.e., after the covenant default). Anchorage has since advocated a plan of active management or orderly liquidation of the assets designed to accelerate payment of the class A-1 notes. It submitted its plan to a vote of the class A-1 noteholders and received two-thirds approval. However, as noted above, such a plan would require two-thirds approval of all noteholders. Deeming such approval unlikely, Anchorage asked ZING VII’s directors to submit its plan via a voluntary chapter 11 petition. The directors declined to do so, and Anchorage filed an involuntary petition in April 2011.