On September 30, 2016, the US District Court for the Southern District of New York held in Deutsche Bank Trust Co. v. American General Life Ins. Co., et al. that a detailed waterfall provision in a security agreement dictated priority of payments in a collateralized debt obligation (CDO) distribution dispute between two noteholders of different series of notes within the same class ( (S.D.N.Y. Sept. 30, 2016)).

The dispute arose between holders of two series of CDO notes, the Class I-MM Notes and Class I-A Notes, held by American General Life Insurance Company (AGL) and Serengeti Opportunities MM LP and Serengeti Lycaon MM LP (collectively, Serengeti), respectively, which were co-issued by Northlake CDO I, Ltd., and Northlake CDO I Corp. (collectively, Northlake) pursuant to a trust deed between Northlake and Deutsche Bank Trust Co. (trustee). The dispute centered on whether AGL had priority of payment, or if payments were to be distributed pro rata to AGL and Serengeti.

The trustee initiated an interpleader action, and AGL and Serengeti each filed cross-motions for judgments on the pleadings. The court granted AGL's motion for judgment on the pleadings, holding that AGL possessed priority to the payments under a waterfall provision included in the CDO security agreement.

In February 2003, Northlake issued over $1 billion of notes in three classes, Class I Notes, Class II Notes, and Class III Notes, ranking in order of priority. The Class I Notes were issued in two series, the Class I-MM Notes and the Class I-A Notes. As of December 2014, AGL held all of the Class I-MM notes, valued at more than $26 million, and Serengeti held almost 82% of the Class I-A notes, valued at nearly $41 million. In July 2014, Northlake notified the trustee that an event of default had occurred under the security agreement on June 30, 2014, and subsequently, all the classes of notes issued in the CDO became immediately due and payable.

The security agreement included a detailed waterfall provision that was structured so that funds were to be paid out in a specified order of priority (priority of payments). The priority of payments provision detailed how payments would be distributed to the various classes of noteholders. Pursuant to this provision, holders of Class I Notes, which included the Class I-MM and I-A Notes, were to be paid before the Class II and III Notes.

AGL asserted that under the priority of payments provision, the Class I-MM Notes must be paid from the CDO liquidated assets pool before the Class I-A Notes. While Serengeti agreed that the priority of payments generally provided for the payment of the Class I-MM Notes before the Class I-A Notes, it disputed that the Class I-MM Notes were senior to the Class I-A Notes in the event of an acceleration of the transaction

Serengeti asserted that following an acerbation of the transaction, payments on the Class I-MM and I-A Notes should be made from the CDO assets on a pro rata basis, without regard to the waterfall provision.

Serengeti further argued that the:

The court held that the priority of payments waterfall provision applied at all times, including following acceleration. Thus, the Class I-MM Notes were required to be paid prior to the Class I-A Notes.

The court noted the following:

The court concluded that Serengeti's argument that Section 7.01(a) provided a special rule for distribution following acceleration was unpersuasive. The court reasoned that Section 7.01(a) did not establish a special distribution rule between the two series of Class I Notes.

Furthermore, the court noted that the security agreement expressly provided that in an event of default, payments were to be made in accordance with the priority of payments provision. Thus, Serengeti's argument that the priority of payments did not apply in the event of acceleration was otherwise inconsistent with the security agreement, which stated that "[a]ll amounts due and payable with respect to the Notes shall be paid in accordance with the Priority of Payments." The provision made no reference to a special rule in the event of acceleration.

In addition, the priority of payments provision stated that in the event that the Senior Par Value Test and the Senior Interest Coverage Test were not satisfied, the Class I-MM Notes were still to be paid before the Class I-A Notes. The court founds that Serengeti's argument that the Class I-MM Notes were to receive payment before the Class I-A notes only if the tests were satisfied misread the language of the clause. The court emphasized that the natural reading of the entire text in addition to other provisions in the security agreement indicated that Class I-A Notes were subordinate to Class I-MM Notes when there was a failure of the coverage tests under the agreement.

The court held that the language of the documents indicated that the Class I-A Notes were subordinate to the Class I-MM Notes, including in the context of an acceleration of the CDO.

In this case, the court emphasizes the importance of a clear waterfall provision guiding payments under asset-backed securities (ABS) transactions. The court expressed a reluctance to grant credence to isolated provisions that were inconsistent with the priority of payment schedule set forth in the transaction documents.

While most ABS waterfall provisions are already often voluminous, convoluted, and arduously drafted, this case is another reminder to practitioners to include as much detail and clarity as possible in ABS waterfall provisions to minimize litigation of distribution provisions.

For more information on CDOs and other types of ABS, see Practice Note: US Securitization: US Overview.

For more information on waterfall provisions, see Practice Note, Structuring Waterfall Provisions.

For more information on events of default, see Practice Note: Loan Agreement: Events of Default.