Collateral Manager Cannot Enforce Trustee’s Promise To Indemnify For Expenses In Excess Of Indenture Waterfall

April 26, 2017

By: Alan Kolod and David Rabinowitz

A collateral manager for a CDO issuer cannot enforce a promise, allegedly made by the indenture trustee with respect to the CDOs, to pay administrative expenses from collateral proceeds, where the payment would exceed the cap for such expenses provided in the waterfall provision of the indenture.  In a recent unreported decision, the Commercial Division of New York State Supreme Court dismissed the claim of Commonwealth Advisors, Inc. as collateral manager, claiming that it had relied on such a promise by the indenture trustee in performing its duty to liquidate the collateral for the CDOs. 

Commonwealth Advisors was the collateral manager for Collybus CDO I Ltd., an issuer of CDOs secured by residential mortgage-backed securities.  The waterfall provision in the indenture limited Commonwealth Advisors’ reimbursement of administrative expenses on any principal Distribution Date to $75,000 unless the CDO holders received complete repayment of principal. According to the complaint, which the Court accepted as true on the trustee’s motion to dismiss, Commonwealth had incurred over $3 million of legal fees defending itself for its actions in connection with the issuer and Wells Fargo, the indenture trustee, had promised Commonwealth that, if it liquidated the collateral for the CDOs, it would receive additional reimbursement beyond the $75,000 cap in the indenture waterfall.   Commonwealth Advisors claimed that it was entitled to enforce this promise, on which it had relied, despite its deviation from the waterfall provision.

The Commercial Division dismissed the claims based on the indenture trustee’s alleged promise. The Court held that Commonwealth Advisors had a fiduciary duty to liquidate the collateral, if that was in the best interests of the issuer, and could not condition its obligation to do so by demanding payments in excess of what the Indenture provided.  It further held that the indenture trustee could not promise to disburse collateral proceeds in excess of what the waterfall specified.  Thus, as a matter of law Commonwealth Advisors could not reasonably rely on any such promise.  The Court held that:

If Commonwealth believed, as it professes, that the liquidation of the CDO's collateral was the right thing to do for the CDO, it had no right to condition such liquidation on Wells Fargo's promise to provide Administrative Expenses reimbursement in excess of that permitted by the Indenture…

Simply put, Wells Fargo had no right to violate the Indenture [by promising payments in excess of the cap], nor did Commonwealth have the right, as a sophisticated party, to rely on an erroneous interpretation of the Indenture or a promise it should have known would contravene the Indenture. The Indenture serves to protect the rights of the CDO [collateralized debt obligation] and its noteholders.  Commonwealth cannot insist that the Indenture be violated by virtue of the Trustee's or Commonwealth's prior erroneous understanding of its waterfall provisions.

The Court also rejected Commonwealth Advisor’s claim that a different distribution in excess of $75,000 made on a prior date, other than the distribution made on the final Distribution Date in question, established a course of conduct by the indenture trustee that justified deviation from the indenture terms.   A payment made between Distribution Dates was not governed by the principal payment waterfall at issue in this case, and, therefore, was “not a valid predicate for a course of conduct argument.”

Commonwealth Advisors, Inc. v. Wells Fargo Bank, NA (Sup. Ct. N.Y. Co. 3/31/17)

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