Bank of NY Trust v. Franklin Advisers: Indenture Permits CLO Manager's Fee upon Redemption

Practical Law Legal Update 8-537-0365 (Approx. 6 pages)

Bank of NY Trust v. Franklin Advisers: Indenture Permits CLO Manager's Fee upon Redemption

by Practical Law Finance

Background

On July 26, 2001, the following parties closed a $600 million CLO transaction referred to as CLO II, which (as is typical of a CLO) was collateralized by a pool of leveraged commercial loans:

Franklin Advisors, Inc. (Franklin), the CLO II collateral manager and the party responsible for structuring CLO II with the underwriter.
Merrill Lynch (Merrill), underwriter of the CLO II transaction and a preferred shareholder of CLO II.
The Bank of New York Trust Company (BNY), the indenture trustee for the CLO II transaction, responsible for collecting principal and interest payments on the underlying loans, paying transaction fees and expenses, and distributing the remaining proceeds to investors.
Two special purpose vehicle (SPV) issuers, Franklin CLO II, Ltd. and Franklin CLO Corp.

As in a typical CLO transaction, the issuers were to pay investors in the notes issued under the CLO based on the cash flows generated by the underlying securitized loan portfolio, which was a dynamic (changing) loan portfolio managed by Franklin. On the closing date, the parties executed two documents:

The CLO II indenture, executed between the issuers and BNY, as indenture trustee.
A Collateral Management Agreement, which incorporated all relevant provisions of the indenture executed between Franklin and the issuers.

As underwriter, Merrill sold two types of securities from the CLO II transaction:

Notes, which were held by the CLO II noteholders.
Residual equity shares, which were held by the CLO II shareholders.

The priority-of-payments waterfall provisions outlined in the indenture provided detailed directions for the payment by BNY as indenture trustee of transaction expenses first, then payments to the CLO II noteholders and finally payment to the CLO II shareholders.

The CLO II indenture also included an optional redemption provision, which provided that the holders of a majority of the CLO II preferred equity shares could direct Franklin to sell the assets of CLO II and redeem their shares before the maturity date of the CLO II notes.

For its management of CLO II, Franklin was entitled to three types of compensation, two of which were guaranteed and undisputed. The third type of compensation was a contingent collateral management fee (contingent fee), which was payable only if the CLO II shareholders received an annual internal rate of return (IRR) of 12% or more on the initial purchase price of the preferred shares from the closing date of the CLO II transaction until the distribution date. However, neither the indenture nor the collateral management agreement addressed:

How the IRR would be calculated in the event of an early redemption.
From which date the contingent fee was to accrue.

In January 2007, a majority of the CLO II preferred shareholders elected to redeem their shares under the optional redemption provision and Franklin liquidated the CLO II collateral loan portfolio. Prior to the redemption date, CLO II had not earned an IRR of 12%. However, if the proceeds from the redemption were included in the calculation, the IRR would have exceeded 12% and Franklin would be entitled to its contingent fee.

Certain CLO shareholders took the position that the redemption proceeds should not be included in the IRR calculation and Franklin therefore was not entitled to the contingent fee. Franklin disagreed and submitted a claim to BNY for the contingent fee, which totalled over $7 million. BNY filed this interpleader action to resolve whether Franklin was entitled to the contingent fee.

The US District Court for the Southern District of New York (SDNY District Court) held that the contingent fee was payable upon an optional redemption and that the proceeds from the optional redemption should be included in the IRR calculation, entitling Franklin to the contingent fee. However, the SDNY District Court held that the indenture was ambiguous as to when the fee began to accrue, which would either be from:

The closing date of the CLO II transaction.
The date upon which the IRR reached 12%.

The SDNY District Court referred this outstanding question to arbitration and the arbitration panel found that the contingent fee began to accrue on the closing date of the CLO II transaction. The SDNY District Court confirmed the arbitration award.

Merrill and various other CLO II equity shareholders (collectively, the CLO II shareholders), appealed.

Outcome

Extrinsic Evidence in Indenture Interpretation

As a threshold issue, the Second Circuit held that the interpretation of indentures under New York law is a matter of basic contract law. First and foremost, the Second Circuit explained, plain language controls. However, as a matter of basic contract law, in the event of a contractual ambiguity, courts may accept extrinsic evidence to determine the intent of the parties when the contract was formed.

The CLO II shareholders argued that, under the Sharon Steel case, courts should avoid the use of extrinsic evidence when interpreting boilerplate clauses because boilerplate clauses do not depend upon particularized intentions of the parties. The Second Circuit dismissed this argument because:

There was no evidence to suggest that the clauses at issue were boilerplate.
Sharon Steel embraces basic principles of contract interpretation for indentures.
Even if the terms at issue were boilerplate, Sharon Steel acknowledged that a course of dealing may create a question of fact as to the interpretation of a boilerplate indenture clause.

The CLO II shareholders also invoked the Contra Proferentem doctrine (under which a contract should be construed against its drafter), arguing that the indenture should be construed against Franklin, which they claimed was the drafter of the document. However, the Second Circuit noted that it was deal counsel that drafted the CLO II indenture, ruling that this argument had no effect on the interpretation of the CLO II indenture.

As a result, the Second Circuit affirmed the SDNY District Court's use of extrinsic evidence in interpreting the indenture, consistent with Sharon Steel.

The Optional Redemption Clause Does Not Govern the Payment of the Contingent Fee

The CLO II shareholders argued that Article IX of the CLO II indenture, which governed the terms of the optional redemption, provided for a separate priority-of-payments waterfall which did not provide for payment of the contingent fee. However, the Second Circuit found that the language of Article IX of the CLO II indenture worked in conjunction with Article XI of the indenture, did not provide for an alternate distribution scheme and did not deprive Franklin of the contingent fee.

Most notably, the Second Circuit held that the parties' expectations regarding the contingent fee would be upset if the CLO II shareholders could avoid payment of the contingent fee at their option. An optional redemption could occur for multiple reasons and could be the result of both a positive (to lock in early gains) or a negative (to avoid losses) managerial performance. The Second Circuit therefore found that a blanket depravation of the contingent fee upon an optional redemption would not comport with the overall incentive compensation structure of the CLO II indenture. Moreover, if the CLO II shareholders' interpretation of the indenture was correct, an optional redemption would preclude all fees, including management fees that were guaranteed.

Optional Redemption Proceeds Are Included in the Calculation of the IRR

The CLO II shareholders argued that, due to the structure of the waterfall payments, the proceeds of the optional redemption should not be taken into account in determining the annual IRR. According to the CLO II shareholders, the calculation of the IRR (and the contingent fee) took place at step J of the waterfall under the CLO II indenture, while the proceeds from the optional redemption were not included in the pool of distributable assets until step L of the waterfall, precluding the optional redemption funds from "flowing up" the waterfall to the IRR calculation.

Reprimanding the CLO II shareholder for interpreting the term "waterfall" too literally, the Second Circuit noted that under the CLO II indenture the calculation of the IRR was to be based on proceeds from the closing date of the CLO II transaction through the distribution date. Since the distribution date would necessarily occur after any optional redemption took place, the proceeds from the optional redemption must be included in the IRR calculation.

The Contingent Fee Accrues From the Closing Date

The CLO II shareholders argued further that the contingent fee only began to accrue once the IRR had reached the 12% threshold, while Franklin argued that the fee began to accrue upon the closing of the CLO II transaction. The SDNY District Court found the indenture ambiguous on this point and referred the matter to arbitration. The arbitrators found that the evidence indicated that the fee accrued from the closing date of CLO II and the SDNY District Court affirmed the arbitrator's ruling.

The Second Circuit noted that if the contingent fee began to accrue only upon the annual IRR reaching 12%, once the IRR had reached the requisite 12%, the CLO II shareholders could avoid any potential fee by simply electing to cash out under the optional redemption provision. The Second Circuit rejected this interpretation.

The Second Circuit did acknowledge that the CLO II indenture could be interpreted in accordance with the CLO II shareholders' view. In contrast to a provision on the guaranteed managerial fee to be paid under the transactions, which explicitly stated that it accrued from the closing date, the contingent fee provision was silent on the date the fee began to accrue. The absence of any language regarding the contingent fee accrual date in contrast to an explicit statement that the non-contingent fee accrued upon closing supported the CLO II shareholders' interpretation that the contingent fee did not begin to accrue until the 12% IRR was reached.

Due to the CLO II indenture's ambiguity, the arbitration panel relied on extrinsic evidence. Among other things, the arbitration panel relied upon industry practice and Merrill's internal calculations that began accrual of the contingent fee on the closing date. While the Second Circuit declined to comment on the arbitration panel's factual findings, it found no error with its reliance on extrinsic evidence and therefore affirmed the arbitration's findings.

Practical Implications

Though this is a fairly fact-specific case based on specific indenture language, the provisions at issue in this case are common to many securitization indentures. Similarly, the structure of many CLO and ABS indentures is similar to the CLO II structure, so the case provides useful insight into how New York courts (commonly selected as having jurisdiction over ABS documents) interpret a typical CLO/ABS indenture.

While somewhat complex, ABS indenture agreements are examined by courts like any other contract under New York law. Courts will examine the plain language of the agreement, and if ambiguity exists, the court will avail itself to the use of extrinsic evidence to try to determine the parties' expectations when the agreement was entered into.

The case also illustrates that courts (and arbitrators) are often reluctant to construe ambiguous provisions in favor of equity holders to relieve them of burdens associated with their shares, especially in ABS transactions where the shareholders are qualified institutional investors who bargained for the riskiest piece of the transaction. This consideration appears particularly relevant to the Second Circuit's interpretation of the contingent fee date-of-accrual provision, which, the court acknowledged, could have been read either way.

Portfolio and collateral managers in managed ABS transactions should take care to ensure that contingent fee provisions are drafted so that it is clear when these fees begin to accrue. Conversely, issuer's counsel may prefer ambiguity in these provisions, as equity tranches are often retained by affiliates of the issuer, often by the underwriter itself.

For details on the various parties to a securitization transaction, see Practice Note, Securitization: US Transaction Parties and Documents.

For information on securitization mechanics and transaction structures, see Practice Note, Securitization: US Overview.

For information on CLOs, see Practice Note, Current Issues Facing CLO Managers.

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