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Girozentrale v. Tilton

Supreme Court of New York, First Department

February 23, 2017

Norddeutsche Landesbank Girozentrale, et al., Plaintiffs-Respondents-Appellants,
Lynn Tilton, et al., Defendants-Appellants-Respondents.

         Cross appeals from the order of the Supreme Court, New York County (Eileen Bransten, J.), entered March 17, 2016, which granted the part of defendants' motion seeking to dismiss the negligent misrepresentation claim, and denied the part of the motion seeking to dismiss the fraudulent misrepresentation claim.

          Gibson, Dunn & Crutcher LLP, New York (Caitlin J. Halligan, Randy M. Mastro, Lawrence J. Zweifach and Mark A. Kirsch of counsel), for appellants-respondents.

          Berg & Androphy, New York (Michael M. Fay, Jenny H. Kim and Chris L. Sprengle of counsel), for respondents-appellants.

          Angela M. Mazzarelli, J.P. Richard T. Andrias David B. Saxe Paul G. Feinman Judith J. Gische, JJ.


          MAZZARELLI, J.P.

         In January 2005, plaintiffs purchased $75 million of notes issued by the collateralized debt obligation (CDO) fund Zohar II 2005-1, Limited (Zohar II). In April 2007, plaintiff purchased $60 million of notes issued by CDO fund Zohar III, Limited (Zohar III and, together with Zohar II, the Funds). Pursuant to collateral management agreements with the Funds, defendant Patriarch Partners, LLC (Patriarch LLC) was engaged to select and manage the collateral to be held by the Funds. Defendants Patriarch Partners XIV, LLC (Patriarch XIV) and Patriarch Partners XV, LLC (Patriarch XV) are controlled by Patriarch LLC and defendant Lynn Tilton, and are the respective collateral managers of Zohar II and Zohar III. Tilton is the principal and controlling member of the Patriarch entities. At least as far as the indentures governing the Funds represented them to be, the Funds were ordinary CDOs, that is, they were supposed to hold debt obligations. Further, the Funds were "blind, " meaning that investors like plaintiffs did not know the identities of the companies to whom the loans that made up the Funds were made (the Portfolio Companies).

         In March, 2015, the Securities and Exchange Commission commenced administrative and cease-and-desist proceedings against defendants (as well as against one other Zohar fund not involved in this litigation), alleging that Tilton and the Patriarch entities defrauded the Funds and their investors "by providing false and misleading information, and engaging in a deceptive scheme, practice and course of business, relating to the values they reported for these funds' assets." The order commencing the proceeding directed that cease-and-desist proceedings be commenced to determine whether their allegations were true, and whether remedial action was appropriate in the public interest.

         According to plaintiffs, the SEC proceeding alerted them to the need to perform their own investigation into their investment in the Funds. They claim that, upon the completion of that investigation, they concluded that the Funds were not CDOs at all. Rather, plaintiffs contend that, unbeknownst to them because of deliberate concealment by defendants, the Funds were de facto private equity funds. Plaintiffs claim to have discovered that defendants used the proceeds from Fund investors to obtain controlling positions in the Portfolio Companies, which turned out to be distressed and already at risk of failure. Further, they discovered that defendants purposely siphoned off the value in the Portfolio Companies to the point that they collapsed, including by taking excessive management fees for themselves, causing significant losses to plaintiffs and other investors. Less than two months after the SEC commenced its proceeding, plaintiffs commenced this action. Their complaint asserts two causes of action, for fraudulent misrepresentation and for negligent misrepresentation.

         Defendants moved to dismiss the complaint pursuant to CPLR 3211(a)(5) and (a)(7). They argued that the claims are barred under the applicable six-year statute of limitations for fraud, because plaintiffs filed their complaint 10 years after they made their investments. They further argued that plaintiffs could not avail themselves of the fraud discovery toll, contending that they were on notice of their claims as early as 2009, based on numerous disclosures made to them by defendants over a lengthy period of time that should have alerted plaintiffs that the Funds were not garden variety CDOs. These disclosures included the indentures governing the issuance of the Funds. Defendants pointed out that the Zohar II indenture detailed CDOs to be acquired by Zohar II from another fund, and that with respect to 23 out of the 27 borrowers listed therein, the other fund "owns equity interests in each such borrower, which equity interests... are also being transferred to [Zohar II]."

         Defendants also directed the court to certain marketing materials released by them in February 2007 with respect to the Funds, known as the "Patriarch Presentation." The Patriarch Presentation disclosed that "[o]n January 13, 2005, Patriarch closed a $1.1 billion CDO, Zohar II, Limited, in order to purchase companies and originate loan assets to companies undergoing pervasive change." The Patriarch Presentation further showed Zohar II's projected equity interest in various Portfolio Companies. Zohar's projected equity interest in several of the companies was shown as 100%, and its interest in various other companies was reflected as high as between 80% and about 96%. The Patriarch Presentation also disclosed Zohar III's projected equity interests in various entities of up to 40%. Defendants assert that, in total, the Patriarch Presentation disclosed that the Funds' combined equity interests exceeded 50% for 23 Portfolio Companies, and amounted to a 100% interest in seven Portfolio Companies.

         The Patriarch Presentation further disclosed that the Funds' investment strategies included "[p]urchasing power to acquire companies by way of myriad sales processes including direct negotiations and acquisitions, Section 363 sales (in Bankruptcy) and Article 9 foreclosure sales (under the Uniform Commercial Code) with the subsequent re-levering of capital structures to meet such companies' and the Zohar funds' debt-financing requirements." In addition, it provided that "the Zohar asset yield is a product of a high yield current coupon combined with added loan accretion, preferred equity and common equity interests... the enhanced quality of the assets reduces the default probability of the portfolio and renders the added preferred loan and equity returns, in most cases, highly collectable."

         Defendants also relied on the transcript of a December 12, 2011 Zohar III investor call, in which plaintiffs participated and in which they declined an opportunity to ask questions. The purpose of the call was for Tilton to discuss Zohar III's performance with investors and to allow investors to ask Tilton any questions. Tilton explained that

"[the Funds] were raised to buy the loans and the equity of distressed companies. And when I say the equity, not buy the equity, but we agreed to contribute the equity of the companies that we purchased into these deals in whole or in part. And most of the time when the equity was purchased, it was purchased with my own money... these funds are completely dependent upon the upside potential [i.e., growth] of these companies, which is one of the reasons that we agreed to do that, because we buy very distressed companies, either in Article 9 foreclosure sales or through bankruptcy 363 sale or through asset sales, and the theory is always taking that long journey of rebuilding companies and creating values. And so the feeling for us would be that if you were only putting the loans and not the upside in, that, in my view, it would be taking a lot of risk without sharing the reward. And so these deals were always set up such that we would go out and we would buy these companies, the loans would be made from these funds, sometimes also with asset-based loans above them or have been used to replace them, and then a percentage of the equity would be contributed into these funds."

         Tilton cautioned that

"it's really important to understand that this is not like in any way typical CDOs, where you're owning pieces of publically traded loans where you can exit at a price. This is [illiquid][i.e., higher risk]. We need to actually create value in the companies and then we need to exit the value in the companies. That said, most CDOs also don't hold the equity value of the companies you don't see that anywhere."

         In arguing that plaintiffs had sufficient information to at least begin an inquiry into the true nature of the CDOs well before the commencement of the SEC proceeding, defendants further relied on a publicly available SEC disclosure released by them in February 2012. That disclosure revealed that Patriarch Partners "primarily invests on behalf of its CDO Clients in undervalued, distressed companies or divisions and other assets thereof" and often "seeks to make opportunistic investments on behalf of its CDO Clients with the primary purpose of obtaining influence over or control of financially troubled companies, focusing on turning around' these Assets by restoring their value." The filing contained the following several disclosures about the Funds' equity positions in Portfolio Companies, and the risks inherent therein. For example, it stated that:

"affiliates of the Investment Advisor often may take an equity position in these same companies. Despite being under no legal obligation to do so, these affiliates often transfer to CDO Clients the equity ownership of Assets in which the CDO Clients invest, thereby increasing the potential for returns on such Assets beyond the investments made by the CDO Clients. No credit is given to this equity ownership by the rating agencies and the value of this equity ownership is ...

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