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

• Decision Date: 29 September 2021
• Docket Number: 17-cv-307(PKC)
• Parties: ZOHAR CDO 2003-1, LTD., et al., Plaintiffs, v. PATRIARCH PARTNERS, LLC, et al ., Defendants.
• Court: U.S. District Court — Southern District of New York

ZOHAR CDO 2003-1, LTD., et al., Plaintiffs,
v.
PATRIARCH PARTNERS, LLC, et al ., Defendants.

No. 17-cv-307(PKC)

United States District Court, S.D. New York

September 29, 2021

OPINION AND ORDER

P. KEVIN CASTEL, SENIOR UNITED STATES DISTRICT JUDGE: ^[1]

Third-Party Defendants MBIA Insurance Corp. (“MBIA”), MBIA, Inc., ^[2] Alvarez & Marsal Zohar Management, LLC (“AMZM”), U.S. Bank, N.A.; Credit Value Partners, LP, Halcyon Capital Management LP, Coöperative Rabobank U.A. (“Coöperative”) and Värde Partners, Inc. (“Värde” and together with Credit Value Partners, Halcyon, and Coöperative, “Zohar III Controlling Class”) move to dismiss a smorgasbord of claims brought by Defendants, Counterclaim-Plaintiffs, and Third-Party Plaintiffs Lynn Tilton, Patriarch Partners, LLC (“Patriarch Partners”), Patriarch VIII, LLC (“Patriarch VIII”), Patriarch XIV, LLC (“Patriarch XIV”), Patriarch XV, LLC (“Patriarch XV” and together with Patriarch Partners, Patriarch VIII, and Patriarch XIV, “Patriarch”), Octaluna, LLC (“Octaluna I”), Octaluna II, LLC (“Octaluna II”), and Octalunda III, LLC (“Octaluna III” and together with Octalunas I and II, “Octalunas”), Ark II CLO 2001-1, Limited and Ark Investment Partners II, L.P. (together “Ark”, and, together

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with Tilton, Patriarch, the Octalunas, and Ark, “Patriarch Parties”). For the reasons that follow, Third Party Defendants' motions are granted in part in denied in part.

BACKGROUND

Unless otherwise noted, the following facts are derived from the third-party complaint and are accepted as true for purposes of this motion. All reasonable inferences will be drawn in favor on the non-movants.

I. Formation and Structure of the Zohar Funds

In 2000, Lynn Tilton founded Patriarch Partners to develop investment solutions for financial institutions holding large portfolios of nonperforming and distressed loans. (Third-Party Complaint, ECF No. 88 (“TPC”), ¶ 34). To invest in distressed loans, Tilton, through Patriarch, created numerous collateralized loan obligations (“CLOs”). (TPC ¶ 34.) Under Tilton's CLO model, a CLO used borrowed funds from investors (“noteholders”) to purchase a portfolio of loans and, through actively managing and restructuring the underlying companies using a “collateral manager, ” repay noteholders their principal plus interests, with any residual value going to Tilton as preference shareholder. (TPC ¶ 35.)

In 2003, Tilton created a CLO called Zohar I. (TPC ¶ 39.) Octaluna I, which is wholly owned by Tilton, held all of Zohar I's preference shares. Patriarch VIII, which is also wholly owned by Tilton, acted as the collateral manager of Zohar I. While Zohar I initially focused solely on purchasing distressed senior secured loans, over time, its focus shifted to originating loans for distressed companies alongside Tilton's personal investment vehicles. (TPC ¶ 40.) Tilton, ^[3] acting through her wholly owned entities, would obtain controlling equity

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positions in the distressed companies (“Portfolio Companies”) by acquiring or creating a controlling stake in their equity and then manage those companies in an effort to turn them around and repay the principal and interest owed on the loans to Zohar I. (TPC ¶ 40.)

Tilton created Zohar II and Zohar III in 2005 and 2007, respectively, based on the same investment strategy as Zohar I. (TPC ¶ 42.). Zohar II's collateral was managed by Patriarch XIV and its preference shares were owned by Octaluna II, both wholly owned by Tilton. Zohar III's collateral was managed by Patriarch XV and its preference shares were owned by Octaluna III, again, both wholly owned by Tilton.

Zohar I, Zohar II, and Zohar III (“Zohar Funds”) were each governed by a separate Indenture, Collateral Management Agreement (“CMA”), and Collateral Administration Agreement (“CAA”). (TCP ¶ 43.) The Indentures described the terms of the offering, including maturity dates of the notes, reporting requirements, priority of payments, the rights of the parties, and the responsibilities of the collateral manager. (TPC ¶ 44.) The CMAs were contracts between the Zohar Funds and their respective collateral managers. (TPC ¶ 44.)

To raise capital, the Zohar Funds issued notes entitling noteholders to periodic interest payments over time and return of the note's principal at a pre-set maturity date. (TPC ¶ 47.). Interest payments and other proceeds paid to the Zohar Funds were distributed according to a “waterfall” provision in the government documents. (TPC ¶ 48.) Under the terms of the waterfall, funds were generally distributed first, for the payment of certain fees; second, for interest and principal payments to noteholders; and third, a capped distribution to the Zohar Fund's preference shareholder (the Octalunas, and by extension Tilton). (TPC ¶ 48.) After all noteholders were repaid in full, the preference shareholder would receive any remaining funds. (TPC ¶ 48.) As preference shareholder and sole equity owner of the Zohar Funds, Tilton

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(through the Octalunas) was entitled to the residual value of the Zohar Funds after all noteholders were repaid. (TPC ¶ 58.) Until that time, Tilton was entitled only to a capped amount of dividends, reached in November 2005, April 2007, and September 2010 for Zohar I, Zohar II, and Zohar III respectively. (TPC ¶ 58.)

MBIA served as “credit enhancer” for Zohar I and Zohar II as defined in their respective Indentures. (TPC ¶ 46.) This meant that MBIA provided an “insurance guaranty” that if Zohar I or Zohar II defaulted on its repayment obligations, MBIA would repay the Class A noteholders of the defaulting fund. (TPC ¶ 46.) But in such an event, the noteholders' interests in the Zohar Funds would be subordinated to MBIA's. (TPC ¶¶ 46, 110.) And MBIA would have the right to auction off the Zohar Funds' collateral. (TPC ¶¶ 46, 110.)

In order to eliminate potential disputes with other lenders or equity owners, Tilton, through the Octalunas and other entities, acquired a controlling interest in both the loans and the equity of the Portfolio Companies. (TPC ¶ 50.) This allowed Tilton to execute a strategy intended to improve operations, pay off debt, and increase value. (TPC ¶ 50.).

While Tilton's CLO strategy required obtaining controlling equity positions in the Portfolio Companies, independent ratings agencies-whose ratings were required for the Zohar Funds' notes to be marketable-“refused to permit CLOs to invest in equity, with only narrow exceptions.” (TPC ¶ 59.) This general prohibition stemmed from the incompatibility of equity ownership with the rating agencies' methodology, as well as tax liability concerns. (TPC ¶ 61.) To address these concerns, Tilton alleges that she structured the Zohar Funds such that the Octalunas, rather than the Zohar Funds, would own, hold, and control the equity. (TPC ¶ 62.) This meant that the Octalunas (and by extension Tilton) would also bear all tax consequences of

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ownership. (TPC ¶ 62.) Indeed, Tilton has personally reported-and paid-income and other taxes associated with owning both the Zohar Funds and the Portfolio Companies. (TPC ¶ 70.)

Since the Zohar Funds' formation, Tilton has actively managed and controlled the Portfolio Companies through roles as either manager or director of virtually every Portfolio Company. (TPC ¶¶ 67-68.) Tilton has also exercised the ownership rights of the Portfolio Companies' equity since inception of the Zohar Funds. (TPC ¶ 68.)

The terms of the Indentures reflect this structure by generally prohibiting the Zohar Funds from owning equity. (TPC ¶ 64.) However, Tilton listed the Zohar Funds as the “record holder” of the Portfolio Company equity “to memorialize a limited right granted to the Funds by Tilton: that the net proceeds from any sale of equity in the portfolio companies would flow through the Zohar Funds' waterfall.” (TPC ¶ 66.)

In 2015, Tilton amended the LLC agreements for the Portfolio Companies that are LLCs so that the voting control would go to the taxpayer, i.e., Tilton. (TPC ¶ 115.) Tilton also executed irrevocable proxies for the Portfolio Companies that are corporations granting Tilton a twenty-year exclusive right to vote the companies' shares. (TPC ¶ 115.) The Patriarch Parties allege that these amendments were intended to be made in 2011 but were not due to oversight. (TPC ¶ 114.)

The Patriarch Parties allege that the equity ownership structure was known and accepted by MBIA, the government, and investors. Indeed, MBIA allegedly confirmed, in prior litigation, its understanding that Tilton owns the Portfolio Companies' equity MBIA now claims was or is owned by the Zohar Funds. (TPC ¶ 76.) Further, Tilton has represented to both the IRS and FTC that she, not the Zohar Funds, owns the Portfolio Companies. (TPC ¶¶ 77-78.)

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Finally, Tilton has explained to investors that the Zohar Funds hold only “upside equity” in the Zohar Funds. (TPC ¶ 79.)

II. Negotiations Regarding Restructuring the Zohar Funds

In summer 2012, Tilton and MBIA began negotiations to restructure the Zohar Funds in light of the economic downturn. (TPC ¶ 91.) These discussions, which lasted over two years, included a potential extension of the Zohar I maturity date as well as a potential transaction whereby Tilton, through affiliates, would purchase all outstanding Zohar I, II, and III notes. (TPC ¶ 91.) However, the Patriarch Parties allege that, due to financial struggles of their own, MBIA leveraged these negotiations to further “a years-long effort” to seize the equity ownership in the Zohar I collateral (including the Portfolio Companies) from Tilton.^[4] (TPC ¶¶ 84-85.) The Patriarch Parties also allege that MBIA worked in cahoots with the SEC to obtain confidential information regarding the Zohar I collateral (seemingly, the value of the Portfolio Companies). (TPC ¶¶ 92-93.)

In order to ensure that Tilton did not sell any Zohar I collateral, including the Portfolio Companies, before...