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MBIA Ins. Corp. v. Patriarch Partners VIII, LLC

United States District Court, S.D. New York

June 10, 2013

PATRIARCH PARTNERS VIII, LLC, a Delaware limited liability company, and LD INVESTMENTS, LLC, a Delaware limited liability company, Defendants

Page 569

For Plaintiff: Jeffrey Q. Smith, Esq., Susan F. DiCicco, Esq., Kevin J. Biron, Esq., BINGHAM MCCUTCHEN LLP, New York, NY.

For Defendants: Charles A. Michael, Esq., David Elbaum, Esq., BRUNE & RICHARD LLP, New York, NY.

Page 570


Prior Proceedings

The Parties

Findings of Fact

I. The Background of the Transaction

II. The Agreements

1. The Master Agreement

2. The Indenture

III. The Performance of the Agreements by

the Parties

1. The Closing

2. The Change in Strategy for

Collateral Acquisition

3. The Supplemental Indentures

and the Rating of the A Notes

4. The Third Supplemental Indenture

and the Ratings Trigger for the

B Notes

5. Collateral Acquisition and the Rating

Process for Zohar II and III

6. The Ratings for the Zohar Notes

7. Alternatives to Rating the B Notes

8. The Dispute between MBIA and

Patriarch With Respect to Zohar III

9. MBIA Continued to Rely On the B


10. The Natixis Fee Payment Without Procuring a

Rating on the B Notes

11. Consideration of Alternatives

to the B Notes and Termination

of Discussion

IV. The Required Rating of the B Notes Was

Not Achievable

1. The Natixis Evidence Did Not

Establish Ratability

2. Froebe's Testimony Established

that the B Notes Were Not Ratable

3. Froebe's Testimony Was Not


V. The Fulfillment of the Debt for Tax

Conditions Was Not Achievable

VI. Witness Credibility

Conclusion of Law

I. Elements of the Breach of Contract Claim

and Burden of Proof

II. The Agreements Required Patriarch to

Use Commercially Reasonable Efforts to

Have the B Notes Rated as soon as Reasonably


1. The Drafting History of the


2. The Conduct of the Parties

3. Patriarch's Position Is Not

Supported by the Third Indenture

III. MBIA Did Not Establish that Patriarch

Failed to Use Commercially Reasonable


IV. The Conditions for Contributing the B Notes

Were Not Established

V. Anticipatory Breach Has Not Been



Page 571


This action was tried before the court over the course of fourteen days between October 15, 2012 and February 8, 2013. Upon all the prior proceedings, the findings of fact and conclusions set forth below, judgment will be entered in favor of the defendants Patriarch Partners VIII, LLC (" Patriarch" ) and LD Investments, LLC (" LDI" ) (collectively, " Patriarch" or the " Defendants" ) dismissing the causes of action of the plaintiff MBIA Insurance Corporation (" MBIA" or the " Plaintiff" ) for declaratory judgment, breach of contract and anticipatory breach of contract.

These parties are sophisticated, well-advised entities that engaged in 2003 in a complicated financial transaction involving the amelioration of certain troubled collateralized debt obligations (" CDOs" ) whose notes MBIA had previously agreed to insure. This action was commenced in 2009 after the parties disagreed as to the terms and effect of the agreements between them. Pre-eminent and able counsel have presented the issues and facts underlying this dispute with clarity and skill. Regrettably for MBIA, the evidence presented has not supported the causes of action alleged in the complaint.

Prior Proceedings

MBIA filed its complaint on April 3, 2009 alleging breach of contract, anticipatory repudiation, breach of the implied duty of good faith and promissory estoppel, and a declaratory judgment with respect to the enforceability of the agreements between the two parties and the scope of Patriarch's obligations under those agreements.

Discovery proceeded, and in an opinion of February 6, 2012 (the " February Opinion" ), summary judgment sought by Patriarch was denied on the basis of contract ambiguity, and certain defenses were dismissed on motion by MBIA. Reconsideration of the February 6 Opinion was denied on April 4, 2012. Evidence was presented from October 15, 2012 to November 13, 2012, and final argument and submissions were made on February 8, 2013.

The Parties

MBIA is a New York corporation headquartered in Armonk, New York. At the time of the events at issue, it was in the business of providing financial guaranty insurance on structured finance securities including senior notes issued as part of CDOs. In 2003 and 2004, it was a multi-billion dollar company and the largest monoline insurance company in the United States issuing insurance policies only on financial instruments such as CDO notes. Tr. [Mauer-Litos] 119-20[1] Amended Joint Pretrial Order (" PTO Stip." ) ¶ 9.

In exchange for premiums, MBIA agreed to pay noteholders principal and interest if the CDO ultimately failed to generate enough cash to do so, PTO Stip. ¶ 9, which is what occurred in the transactions under consideration here.

Patriarch is a limited liability company organized under the laws of the State of Delaware. PTO Stip. ¶ 2. Lynn Tilton

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(" Tilton" ) is the CEO of Patriarch, PTO Stip. ¶ 4; Tr. [Tilton] 498:12-14, and founded the company in 2000 after 20 years in the finance industry, Tr. [Tilton] 493, 495, 505-508. Tilton is well known in the financial industry and is reputed to have a personal net worth of over $1 billion.[2] Patriarch's sole member is Zohar Holdings LLC, whose sole members are Tilton and a trust for Tilton's daughter for which Tilton is the sole trustee. PTO Stip. ¶ 3. Patriarch is an affiliate of Patriarch Partners, LLC, a global investment firm formed and managed by Tilton. PTO Stip. ¶ 4. Patriarch Partners manages funds that make direct investments in distressed businesses. PTO Stip. ¶ 5. Patriarch Partners operates its business using a series of affiliated special purpose entities, including Patriarch, that have no employees of their own. See Tr. [Tilton] 497:6-504:1. " The money flows up from those affiliates" to Tilton, who ultimately controls the entire structure. Id. At all relevant times, Tilton was responsible for making all the important decisions for Patriarch. Id. at 497:6-13.

Patriarch and its affiliates specialize in the management of distressed assets and, among other things, serve as collateral managers for CDOs. PTO Stip. ¶ 5. As a collateral manager, Patriarch selects a portfolio of underlying assets for a CDO and manages those assets over the life of the CDO. PTO Stip. ¶ 21.

Defendant LD Investments, LLC (" LDI" ) is a limited liability company organized under the laws of the State of Delaware, with its principal place of business in Charlotte, North Carolina. PTO Stip. ¶ 6. Tilton, a Florida resident, is the manager and sole member of LDI. Tr. [Tilton] 498:13-14, 499:7-17, 500:13-14. LDI is a holding company for certain Patriarch Partners affiliates and their subsidiaries. Tr. [Tilton] 499:1-9.

Natixis (formerly known as CDC Financial Products, Inc. and later CDC Ixis) is not a party to this action, but was the investment banker for Patriarch in the transaction at issue. It is a French corporate and investment bank. Tr. [True] 202:17-22. Natixis' Structured Credit Products Group (or " SCPG" ) provided investment banking services for CLO transactions, which included structuring, documenting, obtaining ratings for, and selling securities to investors. Id. at 203:22-204:5, 204:20-205:18.


I. The Background Of The Transaction

A CDO is a type of securitization transaction in which a special purpose vehicle (generally referred to as the " Issuer" ): (i) issues secured notes and/or equity securities to investors, (ii) uses the proceeds of the issuance to acquire a portfolio of collateral (e.g., bonds or loans), (iii) pays the holders of the issued securities with the cash flows generated by the collateral and (iv) obtains insurance upon the performance of the notes in order to enhance marketability of its securities. PTO Stip. ¶ 8. If the proceeds generated by the collateral of a CDO are insufficient to pay amounts due on insured notes, the insurer is obligated to cover the shortfall and consequently bears the risk that the proceeds of a CDO will be insufficient to make required payments on the insured notes. See generally Tr. [McKiernan] 674:17-675:3, 675:17-676:20.

The MBIA CDO New Business group (" CNB" ) and the Insured Portfolio Management group (" IPM" ), were the two main groups within MBIA that dealt with

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Patriarch, Tr. [Mauer-Litos] 95:5-14; Tr. [Tilton] 531:10-22, 528:23-529:12. The personnel in the two groups were different, as were their functions. See Tr. [Mauer-Litos] 74:7-75:1.

CNB was responsible for identifying and securing opportunities for MBIA to issue new insurance policies on CDOs, see id., and was part of the Structured Finance group at MBIA. DX-291 [Zucker Tr.][3] 8:10-9:3, 9:20-10:9; Tr. [Mauer-Litos] 74:18-20.

IPM monitored transactions that MBIA had already agreed to insure, Tr. [Mauer-Litos] 77:16-78:11, and also was responsible for remediating transactions that are not performing well and had the potential to lead to a claim being filed under a policy issued by MBIA, id. at 77:19-78:25. The goal of IPM's remediation efforts was to avoid or reduce losses arising from MBIA's payment of an unreimbursed claim on an insured transaction. Tr. [Mauer-Litos] 79:1-7.

CNB first came in contact with Tilton and Patriarch Partners in 2001 in connection with a distressed debt CDO transaction known as Ark II, which was sponsored and managed by a Patriarch affiliate. Tr. [Tilton] 525, 528:20-529:12, PX-13 at 6; see also Tr. [Mauer-Litos] 80, 95:5-9. IPM first came in contact with Tilton and Patriarch shortly thereafter. PX-13. At that time, IPM was in the process of addressing certain legacy CDO transactions on MBIA's books. Tr. [Mauer-Litos] 79:9-80:2.

MBIA had issued financial guaranty insurance policies covering the senior notes issued by seven CDOs, Z-1 CDO 1996 Ltd. (formerly known as Cigna CBO 1996-1 Ltd. (" Z-1" ), Captiva CBO 1997-1 Ltd. (" Captiva" ), Ceres II Finance Ltd. (" Ceres" ), Aeries Finance II Ltd. (" Aeries" ), Amara-1 Finance Ltd. (" Amara-1" ), Amara-2 Finance Ltd. (" Amara-2" ) and Oasis Collateralized High Income Portfolios-I, Ltd. (together with Z-1, Captiva, Ceres, Aeries, Amara-1 and Amara-2, the " Identified CDOs" ).

By 2002, it appeared likely that the collateral in certain of the Identified CDOs would generate insufficient funds to satisfy the payment obligations on the MBIA-insured notes, which would eventually result in MBIA being required to make payments of principal and/or interest under the relevant insurance policies. PTO Stip. ¶ 11.

As a consequence, MBIA faced a substantial insurance exposure which created related accounting issues with respect to certain other CDO transactions it had insured. Tr. [Tilton] 529-32; DX-291 [Zucker Tr.] 15, 25.

The Identified CDOs were expected to have a shortfall on their insured notes of between $91 and $198 million according to MBIA's estimates, or even up to $287 million according to Patriarch's estimates. PX-13 at 3. MBIA began to explore plans to remediate the troubled CDO transactions. PTO Stip. ¶ 12. IPM rather than CNB was responsible for the remediation of the Identified CDOs, and at the time was not optimistic as to the likelihood of finding a way to achieve the desired remediation. See PX-13; Tr. [Mauer-Litos] 74:7-17, 107:16-18; PX-445 [Murtagh Tr.] 19:5-20:2. Michael Murtagh (" Murtagh" ), then director of IPM, id. at 7, noted to Amy Mauer-Litos (" Mauer-Litos" ), a managing director in IPM, Tr. [Mauer-Litos] 73, that " [IPM] would be hard pressed to find a manager that would take these deals and do something with them anyway." DX-20.

Mark Zucker (" Zucker" ), then Global Head of Structured Finance at MBIA,

Page 574

raised concerns about the loss reserves for the Identified CDOs with several members of MBIA senior management, including MBIA CEO Jay Brown (" Brown" ) and MBIA COO Gary Dunton (" Dunton" ). DX-291 [Zucker Tr.] 28, 54, 70-82, 298-99.

In July 2002, Mauer-Litos wrote to Murtagh that MBIA " can't recommend a new loss number" but if the existing number was " really pure bullshit," the issue would have to be escalated to Dick Weil (" Weil" ), the Vice Chairman of MBIA, DX-4; Tr.[Mauer-Litos] 11. In January 2003, Mauer-Litos stated in a memo regarding one of the worst performing of the Identified CDOs that Weil would " handle the lack of reserving." DX-14.

MBIA's senior management was sent a memo in April 2003 indicating that the loss reserves were not large enough to cover the expected shortfalls in the Identified CDOs. See Tr. [Mauer-Litos] 132-34; DX-26 (estimating losses between $91 million and $287 million while setting only $10 million in loss reserves); DX-291 [Zucker Tr.] 24-25.

In July 2003, Murtagh wrote to Mauer-Litos, stating that " [i]n the best of simulations--the Loss Reserve would be approx. $22M" for one of the troubled CDOs. Mauer-Litos wrote back: " Not sure we should be e[sic] mailing the simulations around." DX-39.

The reserves for the two worst of the troubled CDOs, referred to as Captiva and Z-1 (formerly Cigna), were of particular concern. Tr. [Mauer-Litos] 79; Tr. [Tilton] 530; DX-291 [Zucker Tr.] 70-72. MBIA did not want to have to increase its loss reserves which motivated MBIA to enter into the transaction with Patriarch. DX-291 [Zucker Tr.] 15, 24-25.

MBIA turned to Patriarch to remediate the Identified CDOs. Tr. [Tilton] 529; DX-291 [Zucker Tr.] 24-25. In March 2003, Tilton marketed Patriarch to MBIA, describing her company as a " solution provider" possessing the necessary structure and experience to repair and restore the Identified CDOs. PX-351. Tilton proposed a strategy consisting of multiple components: (i) MBIA would transfer management of the Identified CDOs to affiliates of Patriarch; (ii) Patriarch would create and manage a new CDO that would issue different classes of notes; (iii) MBIA would insure the senior notes in the new CDO; and (iv) Patriarch would contribute the junior notes from the new CDO (i.e., the Class B Notes) to the Identified CDOs as needed to enhance the collateral value of those transactions. PX-1; PX-13; see also PX-352. Unlike the prior Ark transactions, which had a static pool of collateral identified at the closing of each transaction, Patriarch proposed that it would actively manage the collateral pool of the proposed CDO. Tr. [Tilton] 536:3-19. Tilton informed MBIA that she expected the cash flows generated for the junior notes to " be substantial." PX-1; see also DX-291 [Zucker Tr.] 149:18-23.

After discussing various options, in April 2003 the parties agreed to a strategy with three basic components: (1) MBIA would replace the managers of the Identified CDOs with Patriarch affiliates; (2) MBIA would insure the senior notes of a new Patriarch sponsored CDO, Zohar I; and (3) a portion of any value created in the unfunded Zohar I junior notes (the B Notes) would be used, under certain conditions, to remediate the Identified CDOs. PTO Stip. ¶ 14; PX-1; see also Tr. [Mauer-Litos] 82-83, 90-92; Tr. [Tilton] 536-37; DX-291 [Zucker Tr.] 34; PX-445 [Murtagh Tr.] 518.

The parties originally considered having MBIA become an investor in the new CDO and pay cash for the B Notes. This would have made it more likely that the B Notes would pay out but would also have opened

Page 575

MBIA to the risk of investment losses. DX-10.

MBIA ultimately decided not to become an investor in Zohar I, and by April 2003, the parties had agreed that the transaction would " not require MBIA to contribute any new capital." PX-13 at 2; Tr. [Tilton] 556; Tr. [McKiernan] 731; Tr. [Froeba] 1456.

Patriarch anticipated that Zohar I would invest in distressed corporate loans, which were sold on the secondary market at a steep discount to their face value and could ultimately pay interest and principal. Specifically, Patriarch expected to have, after expenses, $450 million in cash to reach the " ramp up" target of assets with $750 million in face value. PX-13 at 4; Tr. [Mauer-Litos] 135-36; Tr. [Wormser] 460; DX-291 [Zucker Tr.] 33.

The plan intended that the assets would have to be bought, on average, at about 60 cents on the dollar and that if successfully implemented, enough value might be created not only to pay off the A Notes, but also to provide cash to pay off the unfunded B Notes. See id.

An internal MBIA memo stated that Zohar I would seek to " benefit from the steep liquidity premium associated with stressed/distressed loan assets" and recommended approving the transaction based on " the asset acquisition discount," DX-34 at 2-3). Another memo acknowledged that the success of Zohar I was " highly reliant" on this aspect of its strategy. DX-35 at 8; see also Tr. [Mauer-Litos] 83 (plan was for " loans that were purchased below par" to " repay par value" ); PX-13 at 5 (stating the claims on Zohar 7 will be " mitigated by the creation of Par value" in Zohar I loans).

The parties agreed that no more than 80% of the B Notes would be used to remediate the Zohar 7 and Patriarch retained the right to the remainder so that Patriarch and MBIA would both have the potential to benefit from the B Notes to " ensure that Patriarch's and MBIA's interests are aligned." DX-35 at 9. Both MBIA and Patriarch would gain if Zohar I overall and the B Notes in particular flourished. See Tr. [Tilton] 1274-76.

" MBIA wanted the B note rated because they wanted to include it for their remediation strategy, and Patriarch wanted to get the B note rated because [it] owned 20 percent of the B note at a minimum, and as the need for remediation got lower and the value got higher, it would have been a great tool . . . to use to give out to [Patriarch] employees as upside rather than just future residual value." Tr. [Tilton] 1275.

When Patriarch presented the structure for what came to be known as Zohar I to MBIA, it calculated an interest rate spread of 3.4%, which would generate excess interest of $12.25 million per year after fees, or $62.25 million projected over five years. Tr. [Mauer-Litos] 87:20-88:9. Patriarch projected that the new CDO would generate sufficient revenue to cover 1.65 times the amount of the $150 million of issued par value Class B Notes (referred to at the time as Class C Notes). Id. at 89:18-90:1, 90:8-22. Tilton expressed her belief that she would create value to the Class B Notes sufficient to cover any losses to the Identified CDOs. Id. at 90:23-91:8.

When negotiating the fees Patriarch would be paid for managing the Identified CDOs and the Zohar I CDO, Tilton stated to MBIA that " the Zohar transaction originated as a Patriarch solution to an IPM issue." PX-15; Tr. [Tilton] 549:16-24.

MBIA accepted Tilton's proposed remediation strategy. Tr. [Mauer-Litos] 90:2-4, 91:12-24. CNB and IPM both were involved in the negotiations with Patriarch. Id. at 95:5-11; DX-291 [Zucker Tr.] 12:3-12. Tilton negotiated business points on behalf of Patriarch, and both parties retained sophisticated counsel to

Page 576

negotiate a series of agreements. PTO Stip. ¶ 34; Tr. [Tilton] 558:8-559:15, 560:14-17.

In May 2003, MBIA transferred management of four of the Identified CDOs to Patriarch. PTO Stip. ¶ 16; see also PX-205 (Z-1 Collateral Management Agreement between MBIA and Patriarch Partners); PX-208 (Captiva Portfolios Management Agreement between MBIA and Patriarch Partners).

Three agreements governed the transaction as a whole, as well as the parties' respective rights to the B Notes: the Indenture (PX-5), the Collateral Management Agreement (PX-177) and the Master Agreement (PX-3). Patriarch, MBIA and the investment bank assisting them, Natixis, negotiated the terms of these agreements over several months. See PX-20, PX-21, PX-22, DX-238, DX-239, DX-240.

An early draft of the Indenture from October 24, 2003 contained a Section 9.8, which stated: " On or within [Five] Business Days following the Ramp Up End Date, the Collateral Manager (on behalf of the Issuer) shall request each of Moody's and Standard & Poor's to confirm in writing its initial rating of the Class B Notes within [30] days after the Ramp Up End Date." DX-238 at MBIA0330853. This draft assumed that the B Notes would receive an initial rating at closing. See DX-46 (" On the Closing Date, $150,000,000 of B Notes will be issued with a rating of 'Baa3/BBB-'." ). The Ramp Up End Date was the last day of the " ramp up" period, the time during which Zohar I was expected to acquire the assets that would make up its collateral pool. See PX-5 at § 7.13(a). The " initial rating" described in the draft is a rating based on the parameters set forth in the Indenture. Tr. [Froeba] 1568.

The first draft of the Master Agreement, circulated on October 29, 2003 set as a condition precedent to contributing the B Notes to the Identified CDOs that its initial rating be " confirmed as required under Section 9.8 of the Indenture." PX-20.

This version of the Master Agreement did not address when Patriarch was obligated to seek a rating other than the reference to Section 9.8 of the Indenture, which assumed the B Notes would have an initial rating at closing and set a specific deadline for obtaining a rating confirmation of the B Notes. See id.; DX-238 at MBIA0330853.

In the months prior to closing, Patriarch and Natixis worked together on presentations to S& P and Moody's (collectively, the " Rating Agencies" ) to obtain an initial rating on the Class A Notes. See DX-42 and DX-43 (Zohar I rating agency presentations).

In analyses discussed with the Rating Agencies shortly before the transaction closed, the parties estimated that only $100 million of the $150 million B Notes could be rated investment grade, even if Zohar I reached $750 million in assets. DX-42; DX-43; see also Tr. [Tilton] 586-87.

On October 31, 2003, a " cooperation clause" was inserted into the Master Agreement which required Patriarch and MBIA both " to cooperate and use all commercially reasonable efforts to procure as soon as reasonably practicable the satisfaction of the conditions" to Patriarch's obligation to transfer the B Notes. PX-22 § 3.04. The cooperation clause listed a series of examples of the kinds of actions both Patriarch and MBIA agreed to take " as soon as reasonably practicable" to satisfy the conditions precedent to transferring the B Notes including " amendments, waivers or other modifications to the Transaction Documents." PX-22 § 3.04. In this version, the rating obligation in the Master Agreement stated that " the initial rating of the B Notes shall have been confirmed by

Page 577

each of Moody's and Standard & Poor's as contemplated by Section 9.8 of the Indenture." Id.

The Indenture required Patriarch to obtain an initial rating of the B Notes at closing, to be confirmed at the same time as the A Notes, 30 days after the end of the ramp up period. DX-239 § 7.13. The rating process for both the Class A and B Notes in this version of the Indenture was a single defined term (" Rating Confirmation" ). See id. When the cooperation clause was inserted, the parties anticipated that the B Notes would have already received its initial rating at the time the Master Agreement was executed, and that the sole action remaining would be for the rating to be confirmed by a date certain, on the exact same schedule as the A Notes. See DX-239 § 7.13(b); DX-46 (Item 5); Tr. [Wormser] 361-62; Tr. [Medvecky] 458; Tr. [Tilton] 586-87.

II. The Agreements

On November 13, 2003, MBIA, Patriarch and LDI entered into the Master Agreement[4] (PX-3), the Indenture (PX-5) and Collateral Management Agreement (PX-177).

1. The Master Agreement

The Master Agreement, in § 3.04, provided that Patriarch " use commercially reasonable efforts" to contribute up to $120 million of the $150 million (i.e., 80%) face amount of the Class B Notes to the Identified CDOs as needed to satisfy their payment obligations on the MBIA insured notes. PX-3 § 3.04.

(i) to cause Octaluna, LLC to transfer to Patriarch VIII (or to one or more of its affiliates), (ii) to contribute (or to cause such Patriarch VIII affiliate to contribute) and (iii) to cause the applicable Manager(s) [(including the Patriarch affiliates serving as managers of Z-1 and Captiva)] of the Identified CDOs to cause the relevant Identified CDO to accept, from time to time prior to May 15, 2012, in each case, a portion of the Class B Notes (each such contribution of Class B Notes to an Identified CDO, a " Contribution" ) in the manner described in this Section 3.04, such that (in the sole judgment of Patriarch VIII (and such applicable Manager)) any shortfall or perceived shortfall in the assets available to such Identified CDO to pay interest and ultimate principal on the notes and/or other securities issued by such Identified CDO would be eliminated or substantially reduced (it being the intent of Patriarch VIII and the applicable Manager to use [up to $120 million face amount of the Class B Notes] to the extent reasonably possible to remediate each such Identified CDO).

PX-3 § 3.04.

The Class B Notes were to be the primary form of remediation for the Identified CDOs. See PX-445 [Murtagh Tr.] 99:7-100:14, 122:1-14 (primary remediation strategy for Z-1 and Captiva was the Class B Notes); see also Tr. [Mauer-Litos] 90:23-91:24, 94:14-23. Once the Class B Notes were contributed to an Identified CDO, the payment on or sale proceeds from the B Notes would be used to make payments on the MBIA-insured notes or to reimburse MBIA for payments made under the relevant insurance policies. See PX-445 [Murtagh Tr.] 99:7-100:14, 122:1-14 (primary remediation strategy for Z-1 and Captiva was the Class B Notes), 514:23-515:11; Tr. [Mauer-Litos] 90:23-91:24, 94:14-23.

The Master Agreement provided that Patriarch's obligation to cause the contribution of the Class B Notes (the " Contribution Obligation" ) is subject to the condition that the rating of the Class B Notes

Page 578

must be " at least 'Baa3' by Moody's and 'BBB-' by Standard and Poor's as contemplated by Section 7.13(b) of the Indenture" (the " Rating Condition" and such ratings, the " Ratings" ), id., that the Class B Notes " constitute debt for United States federal income tax purposes as evidenced by an opinion of nationally recognized tax counsel" (the " Debt-for-Tax Condition" ), PTO Stip. ¶ 33; PX-3 § 3.04, that, at the time of Contribution, " the Class B Notes being contributed to such Identified CDO shall be free and clear of all liens, claims and encumbrances except those created by the Transaction Documents" (the " No Lien Condition" ), PX-3 § 3.04, and that " the satisfaction of all applicable transfer, acquisition and/or contribution restrictions (A) imposed by Law [(the " Legal Transfer Condition" )] and (B) contained in (x) the Transaction Documents, the constitutive documents of Octaluna, LLC and any other governing documents with respect to the Class B Notes and (y) the indenture and other applicable governing documents . . . of the applicable Identified CDOs [(the " Document Transfer Condition" )] (collectively, the " Contribution Conditions" ). PX-3 § 3.04.

Section 3.04 of the Master Agreement also provided as follows:

Each of MBIA (solely in its capacity as Controlling Party under the Zohar Indenture or similar capacity with respect to the Identified CDOs) and [Patriarch] agrees to cooperate and use commercially reasonable efforts to procure as soon as reasonably practicable the satisfaction of the conditions specified in clauses (ii), (iv) and (v)(B) of the preceding sentence, including without limitation consenting to and otherwise supporting supplemental indentures, amendments, waivers or other modifications to the Transaction Documents and/or the Identified CDO Agreements with respect to each applicable Identified CDO and taking such other action as may be necessary to effectuate the intention of and/or facilitate the performance of [Patriarch's] obligation to make Contributions hereunder. (Underlining added.)

PX-3 § 3.04 (emphasis added).

It is the language underlined above that is at the source of the parties' dispute.

Section 4.02 of the Master Agreement provided in relevant part:

The failure of any party at any time to require performance by another party of any provision of this Agreement shall in no way affect that party's right to enforce such provision, nor shall the waiver by any party of any breach of any provision of this Agreement be taken or held to be a waiver of any further breach of the same provision or any other provision.

PX-3 § 4.02.

Section 4.04 of the Master Agreement provided in relevant part:

No delay or omission in insisting upon the strict observance or performance of any provision of this Agreement, or in exercising any right or remedy, shall be construed as a waiver or relinquishment of such provision, nor shall it impair such right or remedy. Every right and remedy may be exercised from time to time and as often as deemed expedient.

PX-3 § 4.04.

Section 4.05 of the Master Agreement provided:

This Agreement constitutes the sole agreement between the parties concerning the subject matter hereof. Except as otherwise set forth herein, all previous agreements between these parties concerning the subject matter hereof, whether oral or written, have been integrated into this Agreement.

PX-3 § 4.05.

Section 4.07 of the Master Agreement provided in relevant part:

Page 579

No amendment or modification of this Agreement shall be effective unless such amendment or modification is in writing and is signed by all of the parties hereto.

PX-3 § 4.07.

2. The Indenture

The Indenture governed the types of investments Zohar I could make, when and how the cash flows from those investments could be used to pay expenses or to pay interest and principal to noteholders, and the process by which the Class A and B Notes would be rated by the Rating Agencies. PX-5 § § 12.1, 11, 7.13(a)-(b).

The Indenture also provided that the issuer and the holders of the B Notes agreed initially to treat them as equity, that with the consent of MBIA and Patriarch the Indenture could be amended to modify the tax treatment provision without the consent of the Noteholders to effectuate the conditions in the Master Agreement, PX-5 § 8.1(i)(4); PX-3 § 3.04, and that the B Notes were not transferrable, PX-5 § 2.4(c), 91; PX-3 § 3.04.

Patriarch's obligation to transfer the B Notes was expressly conditioned on the B Notes (1) having obtained an investment grade rating from Moody's and Standard & Poor's " as contemplated by Section 7.13(b) of the Zohar Indenture," and (2) having been deemed debt for federal tax purposes, as confirmed by a debt-for-tax opinion from a nationally recognized tax lawyer. PX-3 § 3.04; PTO Stip. ¶ 33.

Under the Indenture, during the nine-month ramp up period following closing, Patriarch was to use " commercially reasonable efforts" to cause Zohar I to purchase a portfolio of assets with a face value of $750 million, and, within 30 days after reaching that amount, seek to have the initial ratings of the A Notes " confirmed" by the Rating Agencies. PX-5 § 7.13(a)& (b). After ramp up, Zohar I had a five-year " reinvestment period," during which proceeds from the investments that were not used for expenses (such as fees and periodic interest to noteholders) could be redeployed to new investments. PX-5 at 52-53. Collateral acquired during the ramp up period and during the reinvestment period had to meet certain eligibility criteria. Tr. [Tilton] 1264-65; PX-5 § 12.1(a). Following the reinvestment period, any excess funds were to be used to pay down on the A Notes. PX-5 § § 11.1(a)(ii)(F)-(J), 11.2(a)(v)-(xi). Holders of the A Notes were entitled to interest every quarter, and to payment in full of their principal by November 2015. PX-5 § 2.2(b).

The Collateral Management Agreement gave Patriarch discretion to allocate collateral among Patriarch-managed CDOs, and waived any conflicts arising from Patriarch or its affiliates purchasing similar investments for other CDOs and provided that Patriarch and its affiliates " may invest for their own accounts or on behalf of other clients (including clients with business objectives and structures and loans identical to [Zohar I]) in securities, obligations, loans or other assets that would be appropriate as investments for [Zohar I]." PX-177 § 6.2.

III. The Performance of the Agreements By The Parties

Pursuant to the Master Agreement, MBIA agreed to, (and did) cause one or more affiliates of Patriarch to be appointed as the replacement collateral managers for the remaining Identified CDO issuers (Amara-1, Amara-2 and Oasis). PX-3 § § 3.01-3.03.

In connection with such appointments, MBIA agreed to (and did) enter into separate agreements whereby it paid the Patriarch affiliates an amount based on the periodic premiums MBIA received under

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the relevant insurance policies. See id.; PX-445 [Murtagh Tr.] 335:4-25, 337:5-9.

MBIA performed all its obligations that came due under the Master Agreement. Tr. [Tilton] 562:19-563:3.

1. The Closing

At closing, the Class A Notes received an initial rating of AAA/AA by S& P and Aaa/Aa2 by Moody's, indicating a low risk of default. See PX-227; PX-259; PX-260 (initial rating letters from S& P and Moody's). The Rating Agencies provided the initial rating on the Class A Notes based on a model portfolio of then unidentified -- and unpurchased -- collateral that reflected the criteria set forth in the Indenture. See Tr. [Wormser] 288:18-289:1; PX-5 at § 12.1 (eligibility criteria).

After Zohar I closed and initial ratings were assigned on the Class A Notes, a ramp up period began. See Tr. [Tilton] 578:19-579:2. " Ramping up" involved locating and purchasing Zohar I's collateral pool. Tr. [Wormser] 289:2-5, 295:8-16.

As noted above, the Indenture required Zohar I to use " commercially reasonable efforts" to acquire the requisite initial collateral pool during the " ramp up" period, which was originally scheduled to end no later than August 2004 or at any earlier date directed by Patriarch. PX-5 at § § 1.1 (" Ramp Up End Date" ), 7.13(a). The Indenture further required that the Issuer request a confirmation of the initial ratings from the Rating Agencies at the end of the ramp up period, to ensure that the amount and nature of the collateral ultimately purchased conformed to the parameters set out in the Indenture. See Tr. [Wormser] 289:6-8; Tr. [Medvecky] 415:8-25.

At closing, Zohar I issued the B Notes in a face amount of $150 million to an affiliate of Patriarch called Octaluna. PX-5 § 2.2(b); PX-195; Tr. [Tilton] 520, 556. The B Notes paid no interest, did not mature until November 2018. PX-5 at 67 n.6; PX-445 [Murtagh Tr.] 268-69, and were issued for no cash. Tr. [Tilton] 556. The B Notes were fully subordinated to the A Notes, and had no right to payment until after the A Notes were repaid in full. PX-5 § 11.2(a)(viii); PX-445 [Murtagh Tr.] 268-69.

The Identified CDOs did not mature until future dates -- in the case of the worst performing, Z-1 and Captiva, in 2008 and 2009, respectively -- and there was no way to know in 2003 if or how the B Notes would be allocated among the Identified CDOs. See Tr. [Mason] 1139. Moreover, even if the contribution conditions were satisfied and the B Notes were transferred, they would be transferred to the Identified CDOs insured by MBIA, rather than to MBIA itself. Tr. [Mauer-Litos] 187; Tr. [McKiernan] 799.

At closing, Natixis' arranger fee was withheld until at least $50 million of the B Notes received an investment grade rating. PX-5 § § 1.1 (definition of " Class B Rating Condition" ), 10.6A(Z) (Deferred Class B Structuring Fees.; Medvecky 420:18-421:24. The purpose of withholding the arranger fee was to incentivize Natixis to provide the assistance necessary to obtain promptly the ratings on the B Notes. Tr. [Medvecky] 418:24-419:11; Tr. [Tilton] 566:3-10; PX-48 (Natixis internal e-mail noting that " [w]e are NOT entitled to any of these arranger fees until we get at least $50mm of the BBB Notes rated. This criteria was meant to hold us to what we represented we [could] get rated." ). Ken Wormser (" Wormser" ), a senior banker at Natixis, testified that $50 million was chosen because it was the minimum amount to ensure Natixis did a proper job, noting that anything less than that " was sort of too easy and [we] wouldn't get paid for it." Tr. [Wormser] 307:4-10.

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The parties understood it might not be possible to obtain ratings on the entire face amount of the B Notes when the ratings were initially sought. See, e.g., Tr. [Tilton] 1363:4-1364:10; PX-3 § 3.04; PX-5 § 7.13(b)(4); see also PX-444 [Tilton Tr.] 123:22-124:19; Tr. [Tilton] 597:4-598:23 (same); PX-445 [Murtagh Tr.] 287:16-288:7 (stating that MBIA believed that contribution of the B Notes would occur at the time of a perceived shortfall in Z-1 and Captiva and that the remainder would become the Class C Notes).

Accordingly, the Indenture provided that if the ratings were obtained on less than the full $150 million Class B Notes -- referred to in the Indenture as a " Rating Failure" -- the Class B Notes would be reissued in the ratable amount and new Class C Notes would be issued for the then-unrated amount. PX-5 § 7.13(b)(4) (Indenture provision addressing creation of Class C Notes).

2. The Change in Strategy for Collateral Acquisition

After Zohar I closed, the market for distressed debt changed in a way that impaired Patriarch's ability to carry out the original strategy of buying distressed loans. See, e.g., Tr. [Mauer-Litos] 98-99. By February 2004, " the market for opportunity in buying discounted distressed loans had closed," because " [o]thers had found the opportunity and increased the price levels." Tr. [Tilton] 1286; see also id. 569-70, 1239, 1286-87. As Murtagh testified, " [t]he market was rallying [in 2004], and that's not good for a distressed buyer. And that generally is what was happening at that time frame. The price -- bond prices were going up, and Patriarch's platform was at the time to buy distressed debt." PX-445 [Murtagh Tr.] 101.

That Zohar I was not able to buy suitable loan assets as had been contemplated threatened not only Patriarch's ability to build value for the B Notes, but also its ability to ramp up and obtain a rating confirmation of the A Notes. MBIA was aware that Patriarch was not going to be able to reach the $750 million ramp up target given the market change. Tr. [Mauer-Litos] 158-59.

Failure to confirm A Notes' rating would constitute an Event of Default under the Indenture that could have resulted in an immediate liquidation of Zohar I, at which point MBIA would have been required to pay claims to the holders of the A Notes to the extent that the interest and principal could not be repaid from the cash flows from Zohar I. PX-5 § § 5.1(o), 5.2(a); Tr. [Mauer-Litos] 164-65; Tr. [Tilton] 1375-76.

To save the Zohar I deal from failing, Patriarch proposed a revised investment strategy. Rather than buy loans on the secondary market at a steep discount, Zohar I would originate loans and lend money to companies at or close to 100 cents on the dollar and seek in return equity " kickers," such as warrants or stock. If the borrowers could improve their financial performance, the kickers would increase in value. Tr. [Mauer-Litos] 99; Tr. [Tilton] 571, 1238-40.

In April 2004, Mauer-Litos sent an email to Tilton regarding the proposed change in strategy that Tilton understood as questioning Patriarch's right to alter the initial distressed-debt business model. PX-26. Tilton did not react well to the email. Id.; Tr. [Tilton] 572:10-573:2. She responded by insisting the strategy change was permitted under the Zohar I Indenture, and reminding MBIA that it was facing a $200 million loss in the Identified CDOs and assuring MBIA that the strategy change was driven by her " deep desire" to help MBIA with " 80% of the upside." PX-26. Mauer-Litos understood Tilton's reference to " 80% of the upside" as meaning

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80% of the Zohar I Class B Notes. Tr. [Mauer-Litos] 105:1-8. Mauer-Litos also understood Tilton to be saying that MBIA was dependent on Patriarch because Patriarch was going to build value in the Class B Notes. Id. at 105:15-23.

Tilton outlined the new strategy to MBIA executives at a meeting held in May 2004 and explained that the new investment strategy was a necessary reaction to market conditions and that the building of collateral would require long-term work to turn around distressed companies. Tr. [Tilton] 1239-40; DX-291 [Zucker Tr.] 54-56. While building value would be more time-consuming and more laborious than the initial strategy, DX-291 [Zucker Tr.] 53-56, the options at that point in time were either to change the strategy or terminate the transaction altogether, and " the change in strategy was [MBIA's] best hope to . . . close any potential hole" in (i.e., remediate) the distressed CDOs, id. at 50-51, 77.

As noted by Murtagh in an internal email dated September 30, 2004, the implementation of the revised investment strategy would mean " basically rewriting the whole deal," and it was understood that the changes would have significant implications with respect to the ratability of the B Notes. DX-90. The core of the old strategy ( i.e., discount purchases of distressed debt) was a key driver of ratings, Tr. [Froeba] 1461, 1476; in stark contrast, the core of the new strategy ( i.e., equity investments in the borrowers) was not given any credit whatsoever in the ratings process, see Tr. [Carelus] 1068; Tr. [Froeba] 1427-28; Tr. [Mason] 1112.

While MBIA conducted no formal analysis to measure how the revised strategy would affect the ratability of the B Notes. PX-445 [Murtagh Tr.] 108 & 466, Zucker discussed with MBIA's CEO and other members of MBIA's senior management that the B Notes were significantly less likely to be rated than had initially been the case. DX-291 [Zucker Tr.] 54-56, 58-59, 78. Zucker also testified that he shared his doubts about the ratability of the B Notes with others at MBIA. Id. at 63-64.

Tilton told MBIA's Mauer-Litos that the shift in business model would positively impact Patriarch's ability to mitigate losses in the Identified CDOs by way of the B Notes, but did not tell Mauer-Litos the change in strategy could jeopardize getting the B Notes rated. Tr. [Mauer-Litos] 101:9-19.

The new strategy could not have been implemented without MBIA's approval, and MBIA did ultimately approve. PX-424 at 1; DX-291 [Zucker Tr.] 53. MBIA recognized that the B Notes would not pay off until well into the future (if at all), and that the new strategy would further delay any payments on the B Notes. In an email to Mauer-Litos and Murtagh from April 2004, Christopher Weeks (" Weeks" ) of MBIA wrote: " [T]he B note on Zohar is going to be very back-ended. . . . I think it is fair to conclude that any residual i.e. B piece won't be seen until close to 12 year's [sic] time i.e. 2014 or 2015." DX-75. Murtagh understood that the B Notes would not begin paying out until several years after Z-1 and Captiva (two of the troubled CDOs) matured in 2008 and 2009. PX-445 [Murtagh Tr.] 172, and tied this delay directly to the change in Zohar I's investment strategy: " {t]he deal was amended, the ramp up was slower than expected, so it pushed out the timing of the payout of the B notes." Id. at 301.

No witness contradicted the evidence that this new strategy: (1) was explained to MBIA as necessary to save Zohar I from failing; (2) was successful in preventing a ramp-up failure and resultant liquidation of Zohar I; and (3) made the accumulation of collateral for an the rating of

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the B Notes a lengthier and more arduous process.

3. The Supplemental Indentures and the Rating of the A Notes.

Patriarch's drastic shift in investment strategy for Zohar I necessitated extensive Indenture amendments, accomplished by way of several supplemental indentures (the " Supplemental Indentures" ).

Tilton advised MBIA in August 2004 that " [t]he deal flourishes but the timing to complete these types of investments mandates that we need a little more time to complete the ramp up." PX-28. Patriarch proposed in the First Supplemental Indenture to extend the ramp up period by two months. Id.; see also Tr. [Tilton] 578:19-579:10.

The Rating Agencies confirmed that the First Supplemental Indenture did not adversely affect Zohar I's assigned ratings. PX-228 (S& P confirmation letters); PX-264 (Moody's confirmation letters).

Following discussions with Tilton, MBIA approved Patriarch's request and executed the First Supplemental Indenture on August 10, 2004. PX-7; PX-28; Tr. [Tilton] 581:22-582:5. The First Supplemental Indenture extended the Ramp-Up End Date until no later than October 29, 2004 and retained Patriarch's ability to specify an earlier date. PX 7; PX-5 § 1.1 (definition of " Ramp-Up End Date" ).

Thereafter, Natixis approached the Rating Agencies to procure a confirmation of the initial ratings on the Class A Notes. See Tr. [Medvecky] 461:6-462:6.

Patriarch and Natixis negotiated with the Rating Agencies to identify changes to the Indenture that would be sufficient to procure a confirmation of the initial rating on the Class A Notes under the revised strategy. E.g., PX-31 (Natixis to S& P re: calculating Adjusted Collateral Balance); PX-32 (Natixis to Patriarch re: collateral balance and recovery of 25 buckets); PX-34-36 (further Patriarch and Natixis communications with the Rating Agencies.; Tr. [Medvecky] 415:6-416:8 (explanation of rating confirmation and Natixis' generally involvement), 425:12-440:4 (description of negotiations related to the rating confirmation), 426:18-427:19 (obtaining the confirmation required changes to rating criteria set forth in the transaction documents); see also PX-424 (MBIA summary of amendments); PX-39 (MBIA spreadsheet comparing amendments discussed in PX 424). Tilton was " deeply involved" in these negotiations. Tr. [Tilton] 1240:9-24.

In response to concerns raised by the Rating Agencies, Patriarch identified collateral available in the market sufficient to achieve a collateral balance of approximately $667 million. Tr. [Medvecky] 432:19-433:15, 434:10-435:16 (including October 14, 2004 email). Patriarch and Natixis also proposed that some collateral would be transferred out of Zohar I at its initial purchase price, in order to permit Patriarch to acquire different assets at a greater discount to par. PX-31 (Natixis e-mail to S& P stating " [t]he assets that Patriarch will be transferring to Zohar 2 will be mostly the par assets and the proceeds from the sales will be invested in discount assets which will allow the transaction to build up the overall amount of assets." )

In October 2004, Patriarch and Natixis proposed two amendments to the Indenture, referred to as the Second Supplemental Indenture and the Third Supplemental Indenture. PX-424 (MBIA internal summary of second and third amendments); PX-39 (MBIA internal spreadsheet related to PX 424); see also Tr. [Mauer-Litos] 108:7-19.

The Second Supplemental Indenture addressed credit issues identified by the Rating Agencies. See PX-8; Tr. [Mauer-Litos]

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108:7-13; see also PX-31; PX-34; PX-35 (Natixis and Patriarch communications with S& P regarding credit issues and proposed amendments in connection with ratings confirmation).

Among the changes to the Zohar I Indenture called for in the Second Supplemental Indenture were a lowering of various collateral tests, including the " Diversity Test," the " Minimum Average Recovery Rate Test," the " Moody's Weighted Average Rating Factor Test," the " Standard & Poor's Average Recovery Rate," the " Weighted Average Purchase Price Test," and the " Weighted Average Spread Test." In addition, the Second Supplemental Indenture lowered the amount of collateral necessary to obtain a ratings confirmation as of the Ramp Up End Date from $750 million to $543 million. PX-8 § 2.

According to Tilton, the parties " basically had to rewrite the entire deal in terms of eligibility criteria." Tr. [Tilton] 1241:5-10. She explained that the collateral that was acquired reflected both higher interest rates and a higher credit quality than originally expected, but was purchased at a smaller discount to the par value of the loans. Id. at 1241:2-10. The new eligibility criteria reflected her expectation that the transaction could reach $650 million in total collateral level, as opposed to the $750 million expected under the original Indenture. Id.

Tilton also testified as to her motivation to obtain a ratings confirmation on the Zohar I Class A Notes, see Tr. [Tilton] 1289:1-1291:3, and stated that securing the rating confirmation was important to her because it would allow Patriarch to collect its subordinated management fees and would trigger payments to the Preferences Shares that Patriarch owned in part. Tr. [Tilton] 1289:6-14. The parties had to change the Indenture when the strategy ...

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