Zohar CDO 2003-1, Ltd. v. Patriarch Partners, LLC

Decision Date29 December 2017
Docket Number17cv307
Citation286 F.Supp.3d 634
Parties ZOHAR CDO 2003–1, LTD., et al., Plaintiffs, v. PATRIARCH PARTNERS, LLC, et al., Defendants.
CourtU.S. District Court — Southern District of New York

Blair Alexander Adams, Ellison Sylvina Ward Merkel, Quinn Emanuel Urquhart & Sullivan, LLP, Michael Barry Carlinsky, Jonathan Pickhardt, New York, NY, for Plaintiffs.

Akiva Shapiro, Lawrence Jay Zweifach, Mark Adam Kirsch, Mary Beth Maloney, Randy M. Mastro, Gibson, Dunn & Crutcher, LLP (NY), New York, NY, for Defendants.

OPINION & ORDER

WILLIAM H. PAULEY III, United States District Judge:

Defendants Patriarch Partners, LLC, Patriarch Partners VIII, LLC, Patriarch Partners XIV, LLC, Patriarch Partners XV, LLC (together, "Patriarch"), Octaluna LLC, Octaluna II LLC, Octaluna III LLC (together, "Octaluna"), Ark II CLO 2001–1, LLC, Ark Investment Partners II, L.P. (together, "Ark"), and Lynn Tilton ("Tilton") move to dismiss Plaintiffs Zohar CDO 2003–1, Ltd. ("Zohar I"), Zohar II 2005–1 Ltd. ("Zohar II"), and Zohar III, Ltd.'s ("Zohar III") (together, "Zohar") complaint.

Zohar asserts a dozen claims against Defendants predicated on a massive racketeering conspiracy involving the investment and management of Zohar's assets. The remedies that Zohar seeks through its common law claims include compensatory damages, declaratory relief, an accounting, and restitution. But all such relief is eclipsed by Zohar's request for treble damages under the Racketeering Influenced and Corrupt Organizations ("RICO") Act, 18 U.S.C. § 1964(c). Defendants seek dismissal of this action in its entirety, both for failure to state a claim under Rule 12(b)(6) and lack of subject matter jurisdiction under Rule 12(b)(1). For the reasons that follow, Defendants' motion to dismiss is granted.

BACKGROUND

This civil RICO action arises from an alleged fraudulent investment scheme orchestrated by Tilton and her firms. At bottom, Zohar alleges that Defendants engaged in a wide-ranging conspiracy to enrich themselves by pillaging Zohar's funds and impairing its assets, ultimately rendering it unable to repay investors. Over the course of five years, Defendants created three special purpose vehicles—Zohar I, Zohar II, and Zohar III—that raised and invested more than $2.5 billion dollars in an assortment of distressed companies. Imbued with the authority to act on Zohar's behalf, Defendants made virtually every investment decision—they chose the companies to whom Zohar would lend, monitored the collateral underlying the loans, and provided the companies with consulting and management services. But instead of acting in Zohar's interest—to maximize repayment to noteholders—Defendants exploited their fiduciary status to expropriate Zohar's equity in its portfolio companies, pay themselves dividends, and deceive Zohar and its investors into paying exorbitant fees by misreporting the value of Zohar's collateral.

Because Zohar's complaint (the "Complaint") focuses on the predicate acts alleged in support of its civil RICO claim, the threshold issue in Defendants' motion to dismiss is whether the alleged scheme is actionable as fraud in the purchase or sale of securities. Indeed, if any one of the predicate acts involves the purchase or sale of securities, the entire claim is foreclosed by the securities fraud bar codified in the RICO statute. Resolving this question requires a more detailed recitation of the Complaint's allegations, which are presumed true on a motion to dismiss.

I. Zohar's Creation and Purpose

Zohar—three special purpose vehicles created by Tilton—raised over $2.5 billion dollars1 from the sale of collateralized loan obligations ("CLOs"), which are essentially investment notes backed by a pool of loans. Zohar used the offering proceeds to make loans to dozens of distressed companies with the aim of rehabilitating their businesses and maximizing profits. (Complaint ("Compl."), ECF No. 1, ¶¶ 40–41.) Zohar loaned money under various arrangements. Some involved standard repayment of principal and interest while others included equity investments in portfolio companies. The latter arrangement—obtaining equity in exchange for a loan—was of paramount importance to Zohar because it offset losses arising from a defaulted loan and offered enormous upside if a portfolio company turned profitable. (Compl. ¶ 41.)

II. Defendants' Roles

Tilton's role in the CLO transactions extended well beyond creating Zohar. She and her investment companies—namely, Patriarch—assumed a panoply of roles in overseeing Zohar's investments. Patriarch's chief task was to manage Zohar's collateral. (Compl. ¶¶ 30–31.) As collateral manager, Patriarch selected loans and other investments making up the collateral pool. (Compl. ¶ 28.) Patriarch also assigned some of its affiliates to oversee Zohar's assets—Patriarch Partners Agency Services collected and processed loan payments, and Patriarch Partners Management Group provided management and consulting services to the portfolio companies. (Compl. ¶ 37.)

Tilton's other entities played pivotal roles in perpetrating the fraudulent scheme. Ark assumed debt or equity positions in portfolio companies alongside Zohar, and Octaluna held preference share rights or interests in Zohar's assets. (Compl. ¶ 38.) As the conspiracy unfolded, Ark and Octaluna were instrumental in expropriating and obscuring Zohar's ownership interests in portfolio companies.

Despite the amalgam of entities involved, Tilton exercised unchecked authority and control over all of them as sole director or managing member. As a practical matter, Tilton made virtually every single investment decision for Zohar. (Compl. ¶¶ 12–20, 37–38.)

III. Collateral Management

As with most secured transactions, the parties' activities were governed by a key set of operative documents: the (i) Indenture governed the rights and obligations of the Zohar Fund vis-à-vis the noteholders, credit enhancer, and controlling party; and (ii) the Collateral Administration Agreement memorialized an agreement between Zohar, Patriarch, and a national bank, as collateral administrator, to provide administrative services concerning the collateral. (See Compl. ¶ 31; see, e.g., Declaration of Akiva Shapiro in Support of Motion to Dismiss ("Shapiro Decl."), ECF No. 55, Exs. 1, 3.)

A third document—the Collateral Management Agreement—enumerated Patriarch's duties, responsibilities, and privileges as collateral manager. (Compl. ¶¶ 31–33.) Chief among Patriarch's duties was the covenant "not [to] take any action which [it] knows or should be reasonably expected to know in accordance with prevailing market practices [that] would ... adversely affect the interests" of the noteholders. (Compl. ¶ 33 (internal citation omitted).) And like all investment advisors, Patriarch owed a number of implied fiduciary duties to Zohar, including the duties of care and loyalty. (Compl. ¶ 34.)

One of Patriarch's most important duties as collateral manager was to report Zohar's financial condition and performance through monthly reports and quarterly note valuation reports ("Monthly Reports") to stakeholders, including rating agencies and Zohar's noteholders. (Compl. ¶ 36.) The purpose of these communications, prepared by the collateral administrator, was to apprise noteholders about the condition of the collateral underlying the CLOs. (Compl. ¶¶ 36, 56.)

To ascertain this information, Patriarch performed an Overcollateralization Test ("OC Test"), which was designed to calculate the ratio between the outstanding amounts due on the loans in Zohar's portfolio and the principal balances on the senior notes. (Compl. ¶ 56.) The OC Test results were a barometer of Zohar's ability to collect sufficient amounts on outstanding loans to meet its obligations to senior noteholders. (Compl. ¶ 56.) Thus, a passing OC Test signaled that the value of the underlying collateral exceeded the balance of the outstanding senior notes, and could be used to satisfy those notes if one of Zohar's loans defaulted. Conversely, a failing OC Test triggered a number of consequences designed to conserve funds, such as suspending payments to certain classes of noteholders and reducing the collateral management fee. (Compl. ¶¶ 56–57.) The OC Test results constituted a key component of the Monthly Reports.

As a collateral manager, Patriarch charged a fee to select and monitor the collateral, and replace any deficient assets. Under the operative Indenture agreements, Patriarch charged a senior management fee and a subordinated management fee, each calculated as 1% of the outstanding principal amount of assets held by Zohar. (Compl. ¶ 57.) Thus, Patriarch received a 2% management fee, which could be halved if the OC Test produced failing results. (Compl. ¶ 57.) A severe failure of the OC Test, which the Indenture categorized as an "Event of Default," resulted in even more devastating consequences to Patriarch—the controlling parties2 were entitled to terminate Patriarch and step in to control Zohar's assets, thus jeopardizing Patriarch's lucrative position to collect "hundreds of millions of dollars in management fees and preference share distributions." (Compl. ¶¶ 57, 65–66.)

Beginning in 2009, Zohar alleges that the OC Test should have produced failing results in view of the "significant deterioration" of the loans in its portfolio. (Compl. ¶ 58.) Rather than reporting those dismal results, Patriarch and Tilton manipulated the OC Test to yield passing results in the Monthly Reports. (Compl. ¶ 58.) Patriarch inflated the value of the collateral in two ways. First, based on Tilton's subjective and biased judgment, Patriarch routinely misclassified certain portfolio companies as posing a low credit risk when, in reality, many were on the verge of default. (Compl. ¶¶ 59–60.)

Second, Patriarch fraudulently valued Zohar's debt at par even though Zohar had previously purchased the debt at a significant discount. (Compl. ¶ 63.) For example, Zohar once purchased a portfolio company's debt originally...

To continue reading

Request your trial
21 cases
  • Cyganowski v. Beechwood Re Ltd. (In re Platinum-Beechwood Litig.)
    • United States
    • U.S. District Court — Southern District of New York
    • 7 de outubro de 2019
    ...lacks standing or is otherwise precluded from asserting a valid claim under the securities laws." Zohar CDO 2003-1, Ltd. v. Patriarch Partners, LLC, 286 F. Supp. 3d 634, 643 (S.D.N.Y. 2017) (emphasis in original); see also MLSMK Inv. Co. v. JP Morgan Chase & Co., 651 F.3d 268, 277 (2d Cir. ......
  • Monterey Bay Military Hous., LLC v. Ambac Assurance Corp.
    • United States
    • U.S. District Court — Southern District of New York
    • 30 de março de 2021
    ...2008) (applying RICO Amendment where "the predicate acts ... may be prosecuted by the SEC")); cf. Zohar CDO 2003-1, Ltd. v. Patriarch Partners, LLC, 286 F. Supp. 3d 634, 646 (S.D.N.Y. 2017) ("[A] civil RICO claim derived from the same allegations as an SEC enforcement action is vulnerable t......
  • Digitalb, SH.A v. Setplex, LLC
    • United States
    • U.S. District Court — Southern District of New York
    • 11 de janeiro de 2018
    ...in the pleading stage and no significant judicial resources have been invested. See Zohar CDO 2003–1, Ltd. v. Patriarch Partners, LLC, 286 F.Supp.3d 634, 652–53, 2017 WL 6628609, at *13 (S.D.N.Y. 2017). While discovery is ostensibly underway, it appears far from complete. (See Reply Memoran......
  • Great W. Ins. Co. v. Graham
    • United States
    • U.S. District Court — Southern District of New York
    • 22 de junho de 2020
    ...lacks standing or is otherwise precluded from asserting a valid claim under the securities laws." Zohar CDO 2003-1, Ltd. v. Patriarch Partners, LLC, 286 F. Supp. 3d 634, 643 (S.D.N.Y. 2017); see also MLSMK Inv. Co., 651 F.3d at 277. To determine whether a given predicate act constitutes "co......
  • Request a trial to view additional results

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT