Zohar CDO 2003-1, Ltd. v. Patriarch Partners, LLC (In re Zohar III, Corp.)

631 B.R. 133

IN RE: ZOHAR III, CORP., et al.,

Debtors.

Zohar CDO 2003-1, Limited; Zohar II 2005-1, Limited; and Zohar III, Limited, Plaintiffs,

v.Patriarch Partners, LLC ; Patriarch Partners VIII, LLC; Patriarch Partners XIV, LLC ; Patriarch Partners XV, LLC ; Phoenix VIII, LLC; Octaluna LLC; Octaluna II LLC; Octaluna III, LLC; Ark II Clo 2001-1, LLC; Ark Investment Partners II, LP; Ark Angels VII, LLC; Patriarch Partners Management Group, LLC; Patriarch Partners Agency Services, LLC; and Lynn Tilton, Defendants.

Case No. 18-10512 (KBO)(Jointly Administered)

Adv. Proc. No. 20-50534 (KBO)

United States Bankruptcy Court, D. Delaware.

Signed June 18, 2021

Ryan M. Bartley, Shane M. Reil, Michael R. Nestor, Joseph M. Barry, Young Conaway Stargatt & Taylor, LLP, Wilmington, DE, for Plaintiff.

G. David Dean, Norman L. Pernick, Patrick J. Reilley, Cole Schotz P.C., Wilmington, DE, Alexandra G. Elenowitz-Hess, Jennifer X. Luo, Vikram Shah, Michael Tremonte, Theresa Trzaskoma, Sher Tremonte LLP, New York, NY, for Defendant.

MEMORANDUM OPINION

Karen B. Owens, United States Bankruptcy Judge

TABLE OF CONTENTS

I. SUMMARY OF THE ALLEGED FACTS ...150

A. The Parties ...150

B. Tilton's Alleged Misuse of the Funds and Portfolio Companies...152

1. Overcollateralization Test...152

2. Voting/Control Actions...153

3. PPMG Agreements and Phantom Equity Agreements ...154

4. Ownership of Equity ...155

II. APPLICABLE LEGAL STANDARD ...155

III. LEGAL DISCUSSION ...156

A. Statute of Limitations...156

1. Counts 4 and 28 ...157

2. Counts 9, 10, 31, and 32 ...159

B. Preclusion of the OC Test Claims...161

C. Viability of the Tortious Interference Claims in Light of Defendants' Positions and Interests...164

1. Tortious Interference by a Director or Officer (Counts 5, 16, 17, and 28) ...165

2. The Economic Interest Doctrine (Counts 5, 16, 17, 26, 27, and 28) ...167

D. Failure to Plead Fraudulent Transfer Claims ...168

1. Failure to Adequately Allege the Transactions Sought to be Avoided (Counts 9, 10, 31, and 32)...170

(a) Counts 9 and 10 ...170

(b) Counts 31 and 32 ...172

2. Failure to Adequately Allege Insolvency (Counts 10, 12, 20, 22, and 32) ...172

3. Failure to Adequately Allege Badges of Fraud (Counts 9, 11, 19, 21, and 31) ...174

4. Failure to Allege Creditor Status (Counts 31 and 32)...175

E. Duplicative Tort and Quasi-Tort Claims ...175

1. The Unjust Enrichment Claims (Counts 13, 14, 24, and 33)...176

2. Breach of Fiduciary Duty Claims (Counts 6 and 7) ...178

F. Viability of Claims Arising From the "Check the Box" Election ...179

1. Lack of Standing (Counts 15, 16, 17, 19, 20, 21, 22, and 23) ...180

2. Octaluna Entities Were Permitted to Act (Counts 15, 16, 17, 19, 20, 21, 22, and 23) ...181

3. CTB Election Did Not Result in a Transfer of the Funds' Property That May be Avoided (Counts 19, 20, 21, and 22)...183

G. Mootness of Counts 9 and 10...185

1. The September 2015 Transfers ...185

2. Voting/Control Transfers Related to Dura Automotive Systems, LLC and Its Affiliated Debtors...186

H. Remaining Individual Claim Issues ...186

1. Count 1 – Declaratory Judgment of Equity Ownership....186

2. Count 2 – Declaratory Judgment That Voting/Control Actions Were Ineffective ...186

3. Count 3 – Declaratory Judgment (PPMG Agreements) ...187

4. Count 4 – Breach of CMAs and Indentures....189

(a) Voting/Control Actions...190

(b) November 2017 Written Consents...191

(c) Section 2.2(f)(iv)...192

5. Count 8 – Conversion of Zohar Funds' Property...193

6. Count 17 – Tortious Interference with Indentures Based on the CTB Election ...195

7. Count 18 – Conversion of Tax Dividends ...195

8. Count 23 – Permanent Injunction ...196

9. Counts 25 and 27 – Breach of the Portfolio Company LLC Agreements and Tortious Interference...197

(a) Standing ...198

(b) Breach of the LLC Agreements ...200 10. Counts 29 and 30 – Breach of Fiduciary Duty and Aiding and Abetting Breach of Fiduciary Duty...202

I. Patriarch Partners ...203

IV. CONCLUSION ...203

This adversary proceeding relates to the bankruptcy cases of the above-captioned debtors and Plaintiffs, Zohar CDO 2003-1, Limited ("Zohar I"), Zohar II 2005-1, Limited ("Zohar II"), and Zohar III, Limited ("Zohar III" and together with Zohar I and Zohar II, the "Funds"). The Funds' cases were commenced under chapter 11 of title 11 of the United States Code (the "Bankruptcy Code") on May 11, 2018 (the "Petition Date"). On March 9, 2020 (the "Commencement Date"), shortly less than two years after the Petition Date, the Complaint was filed. As the Court will discuss more thoroughly herein, the Complaint contains thirty-three counts alleging a variety of claims against the Defendants. On September 21, 2020, the Defendants moved to dismiss (the "Motion to Dismiss") the Complaint in its entirety and with prejudice pursuant to Rule 12(b) of the Federal Rules of Civil Procedure (the "Federal Rules"), made applicable to this proceeding by Rule 7012 of the Federal Rules of Bankruptcy Procedure (the "Bankruptcy Rules"). Briefing on the Motion to Dismiss was completed on December 18, 2020.² The Complaint and all briefing related to the Motion to Dismiss was under seal until March 2021, when the parties filed redacted versions after revisiting confidentiality given the progression of the bankruptcy cases. Argument on the Motion to Dismiss was held on April 21, 2021, and the matter is ripe for adjudication.³

I. SUMMARY OF THE ALLEGED FACTS

A. The Parties

The Funds are a series of collateralized loan obligation funds formed in the mid-2000s by Lynn Tilton ("Tilton").⁴ Each Fund was created to raise capital through the issuance of secured notes, primarily for the purpose of acquiring or originating loans from and to a portfolio of various distressed companies (collectively, the "Portfolio Companies").⁵ In connection with making or restructuring the loans to the Portfolio Companies, the Funds received equity in the Portfolio Companies.⁶ Over $1.5 billion was raised by the Funds from third-party investors through the issuance of notes, which was invested in approximately 40 Portfolio Companies.⁷

The investment thesis for the Funds was that through active management, Tilton and her affiliates could rehabilitate the underlying Portfolio Companies.⁸ To do so, Tilton used the Funds' controlling equity positions and was installed as director, officer, and/or manager of the Portfolio Companies.⁹ Moreover, several of her affiliates contracted with the Funds and the Portfolio Companies to provide services.¹⁰ While not all Portfolio Companies could be successfully turned around, the hope was that the value generated from those that were a success would repay the Funds' noteholders either through repayment of the loans or returns on the equity.¹¹ Until that time, the noteholders were to receive quarterly interest payments generated from payments the Portfolio Companies made on account of the Funds' loans and equity.¹²

Defendant Patriarch Partners VIII, LLC ("Patriarch VIII"), Patriarch Partners XIV, LLC ("Patriarch XIV"), and Patriarch Partners XV, LLC ("Patriarch XV") (collectively, the "Patriarch Managers") each served until March 3, 2016 as a collateral manager for a Fund.¹³ Among other things, they acted for and on behalf of the Funds in deciding the investments to make and in managing, effectuating, and disposing of those investments and other assets of the Funds.¹⁴ Defendants Octaluna LLC ("Octaluna I"), Octaluna II, LLC ("Octaluna II"), and Octaluna III LLC ("Octaluna III" and, together with Octaluna I and Octaluna II, the "Octaluna Entities") each own the preferred stock of a single corresponding Fund¹⁵ and certain notes issued by the Funds.¹⁶ Defendant Patriarch Partners Agency Services, LLC ("PPAS") served as the Funds' agent under the various loan agreements with the Portfolio Companies (the "Credit Agreements").¹⁷ Defendant Patriarch Partners Management Group, LLC ("PPMG") purportedly provided management and consulting services for the Portfolio Companies since as early as 2006 pursuant to various agreements (collectively, the "PPMG Agreements").¹⁸ Patriarch Partners, LLC ("Patriarch Partners") contracted with the Patriarch Managers to provide employees, office space, and other operating expenses.¹⁹ Tilton entirely owned, managed, and controlled these entities.²⁰

Each Fund is governed by a set of documents that includes an indenture (each an "Indenture" and, collectively, the "Indentures"), a collateral management agreement (each a "CMA" and, collectively, the "CMAs"), and a collateral administration agreement.²¹ Each set of documents is substantially identical.²² The Indentures set forth, among other things, the rights of the Funds' noteholders, the obligations of the Funds to the noteholders, and the responsibilities of the Patriarch Managers as collateral managers.²³ The CMAs were entered into between the applicable Patriarch Manager and Fund. They set forth the roles and obligations of the Patriarch Managers as collateral managers, which Tilton performed through her control.²⁴ The CMAs also set forth the standards that would govern the Patriarch Managers' actions for the Funds.²⁵

As a result of the foregoing structure, Tilton, herself or through the web of her affiliated entities, entirely controlled and managed the affairs and operations of Funds (including their capital raises and investments) and the Portfolio Companies (including their corporate activities and business strategies).²⁶ Moreover, Tilton and her affiliates received collateral management fees, management fees, and distributions on the preference shares held by the Octaluna Entities.²⁷ In addition, Tilton, as the ultimate owner of the Funds, received valuable tax attributes generated by certain Portfolio Companies' substantial operating losses that could be used to offset the income she and her affiliates earned in connection with the Funds and their investment activities.²⁸ These attributes flowed to her because the Funds were intended to be, and originally were structured, as disregarded entities for tax purposes and...