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LTD. v. Patriarch Partners, LLC

United States District Court, S.D. New York

December 29, 2017

ZOHAR CDO 2003-1, LTD., et al., Plaintiffs,
PATRIARCH PARTNERS, LLC, et al., Defendants.

          OPINION & ORDER


         Defendants Patriarch Partners, LLC, Patriarch Partners VIII, LLC, Patriarch Partners XIV, LLC, Patriarch Partners XV, LLC (together, “Patriarch”), Octaluna LLC, Octaluna II LLC, Octaluna III LLC (together, “Octaluna”), Ark II CLO 2001-1, LLC, Ark Investment Partners II, L.P. (together, “Ark”), and Lynn Tilton (“Tilton”) move to dismiss Plaintiffs Zohar CDO 2003-1, Ltd. (“Zohar I”), Zohar II 2005-1 Ltd. (“Zohar II”), and Zohar III, Ltd.'s (“Zohar III”) (together, “Zohar”) complaint.

         Zohar asserts a dozen claims against Defendants predicated on a massive racketeering conspiracy involving the investment and management of Zohar's assets. The remedies that Zohar seeks through its common law claims include compensatory damages, declaratory relief, an accounting, and restitution. But all such relief is eclipsed by Zohar's request for treble damages under the Racketeering Influenced and Corrupt Organizations (“RICO”) Act, 18 U.S.C. § 1964(c). Defendants seek dismissal of this action in its entirety, both for failure to state a claim under Rule 12(b)(6) and lack of subject matter jurisdiction under Rule 12(b)(1). For the reasons that follow, Defendants' motion to dismiss is granted.


         This civil RICO action arises from an alleged fraudulent investment scheme orchestrated by Tilton and her firms. At bottom, Zohar alleges that Defendants engaged in a wide-ranging conspiracy to enrich themselves by pillaging Zohar's funds and impairing its assets, ultimately rendering it unable to repay investors. Over the course of five years, Defendants created three special purpose vehicles-Zohar I, Zohar II, and Zohar III-that raised and invested more than $2.5 billion dollars in an assortment of distressed companies. Imbued with the authority to act on Zohar's behalf, Defendants made virtually every investment decision-they chose the companies to whom Zohar would lend, monitored the collateral underlying the loans, and provided the companies with consulting and management services. But instead of acting in Zohar's interest-to maximize repayment to noteholders-Defendants exploited their fiduciary status to expropriate Zohar's equity in its portfolio companies, pay themselves dividends, and deceive Zohar and its investors into paying exorbitant fees by misreporting the value of Zohar's collateral.

         Because Zohar's complaint (the “Complaint”) focuses on the predicate acts alleged in support of its civil RICO claim, the threshold issue in Defendants' motion to dismiss is whether the alleged scheme is actionable as fraud in the purchase or sale of securities. Indeed, if any one of the predicate acts involves the purchase or sale of securities, the entire claim is foreclosed by the securities fraud bar codified in the RICO statute. Resolving this question requires a more detailed recitation of the Complaint's allegations, which are presumed true on a motion to dismiss.

         I. Zohar's Creation and Purpose

         Zohar-three special purpose vehicles created by Tilton-raised over $2.5 billion dollars[1] from the sale of collateralized loan obligations (“CLOs”), which are essentially investment notes backed by a pool of loans. Zohar used the offering proceeds to make loans to dozens of distressed companies with the aim of rehabilitating their businesses and maximizing profits. (Complaint (“Compl.”), ECF No. 1, ¶¶ 40-41.) Zohar loaned money under various arrangements. Some involved standard repayment of principal and interest while others included equity investments in portfolio companies. The latter arrangement-obtaining equity in exchange for a loan-was of paramount importance to Zohar because it offset losses arising from a defaulted loan and offered enormous upside if a portfolio company turned profitable. (Compl. ¶ 41.)

         II. Defendants' Roles

         Tilton's role in the CLO transactions extended well beyond creating Zohar. She and her investment companies-namely, Patriarch-assumed a panoply of roles in overseeing Zohar's investments. Patriarch's chief task was to manage Zohar's collateral. (Compl. ¶¶ 30- 31.) As collateral manager, Patriarch selected loans and other investments making up the collateral pool. (Compl. ¶ 28.) Patriarch also assigned some of its affiliates to oversee Zohar's assets-Patriarch Partners Agency Services collected and processed loan payments, and Patriarch Partners Management Group provided management and consulting services to the portfolio companies. (Compl. ¶ 37.)

         Tilton's other entities played pivotal roles in perpetrating the fraudulent scheme. Ark assumed debt or equity positions in portfolio companies alongside Zohar, and Octaluna held preference share rights or interests in Zohar's assets. (Compl. ¶ 38.) As the conspiracy unfolded, Ark and Octaluna were instrumental in expropriating and obscuring Zohar's ownership interests in portfolio companies.

         Despite the amalgam of entities involved, Tilton exercised unchecked authority and control over all of them as sole director or managing member. As a practical matter, Tilton made virtually every single investment decision for Zohar. (Compl. ¶¶ 12-20, 37-38.)

         III. Collateral Management

         As with most secured transactions, the parties' activities were governed by a key set of operative documents: the (i) Indenture governed the rights and obligations of the Zohar Fund vis-à-vis the noteholders, credit enhancer, and controlling party; and (ii) the Collateral Administration Agreement memorialized an agreement between Zohar, Patriarch, and a national bank, as collateral administrator, to provide administrative services concerning the collateral. (See Compl. ¶ 31; see, e.g., Declaration of Akiva Shapiro in Support of Motion to Dismiss (“Shapiro Decl.”), ECF No. 55, Exs. 1, 3.)

         A third document-the Collateral Management Agreement-enumerated Patriarch's duties, responsibilities, and privileges as collateral manager. (Compl. ¶¶ 31-33.) Chief among Patriarch's duties was the covenant “not [to] take any action which [it] knows or should be reasonably expected to know in accordance with prevailing market practices [that] would . . . adversely affect the interests” of the noteholders. (Compl. ¶ 33 (internal citation omitted).) And like all investment advisors, Patriarch owed a number of implied fiduciary duties to Zohar, including the duties of care and loyalty. (Compl. ¶ 34.)

         One of Patriarch's most important duties as collateral manager was to report Zohar's financial condition and performance through monthly reports and quarterly note valuation reports (“Monthly Reports”) to stakeholders, including rating agencies and Zohar's noteholders. (Compl. ¶ 36.) The purpose of these communications, prepared by the collateral administrator, was to apprise noteholders about the condition of the collateral underlying the CLOs. (Compl. ¶¶ 36, 56.)

         To ascertain this information, Patriarch performed an Overcollateralization Test (“OC Test”), which was designed to calculate the ratio between the outstanding amounts due on the loans in Zohar's portfolio and the principal balances on the senior notes. (Compl. ¶ 56.) The OC Test results were a barometer of Zohar's ability to collect sufficient amounts on outstanding loans to meet its obligations to senior noteholders. (Compl. ¶ 56.) Thus, a passing OC Test signaled that the value of the underlying collateral exceeded the balance of the outstanding senior notes, and could be used to satisfy those notes if one of Zohar's loans defaulted. Conversely, a failing OC Test triggered a number of consequences designed to conserve funds, such as suspending payments to certain classes of noteholders and reducing the collateral management fee. (Compl. ¶¶ 56-57.) The OC Test results constituted a key component of the Monthly Reports.

         As a collateral manager, Patriarch charged a fee to select and monitor the collateral, and replace any deficient assets. Under the operative Indenture agreements, Patriarch charged a senior management fee and a subordinated management fee, each calculated as 1% of the outstanding principal amount of assets held by Zohar. (Compl. ¶ 57.) Thus, Patriarch received a 2% management fee, which could be halved if the OC Test produced failing results. (Compl. ¶ 57.) A severe failure of the OC Test, which the Indenture categorized as an “Event of Default, ” resulted in even more devastating consequences to Patriarch-the controlling parties[2]were entitled to terminate Patriarch and step in to control Zohar's assets, thus jeopardizing Patriarch's lucrative position to collect “hundreds of millions of dollars in management fees and preference share distributions.” (Compl. ¶¶ 57, 65-66.)

         Beginning in 2009, Zohar alleges that the OC Test should have produced failing results in view of the “significant deterioration” of the loans in its portfolio. (Compl. ¶ 58.) Rather than reporting those dismal results, Patriarch and Tilton manipulated the OC Test to yield passing results in the Monthly Reports. (Compl. ¶ 58.) Patriarch inflated the value of the collateral in two ways. First, based on Tilton's subjective and biased judgment, Patriarch routinely misclassified certain portfolio companies as posing a low credit risk when, in reality, many were on the verge of default. (Compl. ¶¶ 59-60.)

         Second, Patriarch fraudulently valued Zohar's debt at par even though Zohar had previously purchased the debt at a significant discount. (Compl. ¶ 63.) For example, Zohar once purchased a portfolio company's debt originally valued at $29 million for only $5.3 million, reflecting an 82% discount. (Compl. ¶ 64.) But when calculating the OC Test, Patriarch valued the company's debt at the full $29 million while also rating the distressed company as a low credit risk. (Compl. ¶ 64.) Patriarch also gave that company a more favorable credit risk rating after restructuring its loans despite the company's inability to make interest payments. Unsurprisingly, that company defaulted seven months after restructuring its debt. (Compl. ¶ 64.)

         Zohar alleges that Patriarch manipulated the results of the OC Test to facilitate the payment of more than $700 million in fees over the life of the Zohar funds and to preserve its position as collateral manager. (Compl. ¶ 65.) To that end, a successful OC Test kept other stakeholders-namely the Controlling Party and Controlling Class-at bay.

         IV. Equity Interests and Equity Distributions

         The second component of Defendants' alleged scheme involved misappropriating Zohar's equity in its portfolio companies to reap the benefits of equity ownership, such as receiving “tens of millions of dollars or more” in dividend and equity distributions. (Compl. ¶ 50.) Because of their fiduciary position, Defendants played both sides of Zohar's investment decisions-they selected the company which Zohar invested in and then installed Tilton as the company's officer or director to facilitate the exchange of equity for Defendants' benefit.

         Capitalizing on a ploy rife with self-dealing, Defendants executed their equity misappropriation scheme in four different ways. First, Defendants used Zohar's funds to obtain equity positions in their name. (Compl. ¶ 49.) In other words, instead of giving Zohar the equity it should have received in exchange for its loan, Defendants took a slice of the equity for themselves “without making any contributions, or with only disproportionate or minimal contributions.” (Compl. ¶ 49.)

         Second, as their equity holdings grew, Defendants siphoned dividends and other distributions that the companies made to their shareholders instead of re-directing those funds to Zohar “for ultimate distribution to the Zohar Funds' noteholders.” (Compl. ¶ 50.) As a result, Defendants reaped an unearned profit estimated in the tens of millions of dollars. (Compl. ¶ 50.)

         Third, in some instances, Defendants simply re-assigned Zohar's equity holdings to themselves. By way of example, in 2009, Patriarch reported that Zohar owned 100% of a certain portfolio company. Three years later, however, after the company was sold for $199 million, Zohar was left empty-handed. To justify this outcome, Patriarch disavowed its previous representations that Zohar ever had an interest in the company and maintained that Defendants were its rightful owners all along. (Compl. ¶ 51.)

         Finally, Defendants stole voting and other rights associated with Zohar's equity interests. (Compl. ¶ 52.) Although they kept the equity in Zohar's name, Defendants essentially deprived Zohar of its ability to control its companies by agreeing to contract provisions, on Zohar's behalf, that gave Defendants “control over the Zohar Funds' assets without any apparent benefit provided to the Zohar Funds.” (Compl. ¶ 70.) For example, Defendants required Zohar to obtain the consent of Patriarch Partners Agency Services-Zohar's agent under its loan agreements-before making any loan assignments, a condition that effectively robbed Zohar of the ability to unilaterally sell its loans. (Compl. ¶ 70.) Patriarch also amended dozens of loan agreements between Zohar and its portfolio companies which had adverse consequences for Zohar, like subordinating its loans to Ark's loans and reducing the interest that borrowers paid on Zohar's loans. (Compl. ¶ 73.)

         Beginning in September 2015, Tilton executed a series of legal documents transferring Zohar's voting and other rights in its equity to Tilton's entities. These valuable rights were transferred by way of irrevocable proxies or amendments to the LLC or stockholder agreements. Thus, Zohar was forced to relinquish a bevy of rights normally conferred through ownership-the right to change directors or managing members, the right to effect a sale of a company, or the right to veto another party's attempt to exercise equity rights. (Compl. ¶ 74.)

         In November 2015, Tilton entered into another round of amendments depriving Zohar of its ability to declare an event of default against a portfolio company, and instead conferred that privilege on herself and her companies. (Compl. ¶ 75.) And in February 2016, Tilton, by way of amendments to the operative agreements, conferred discretion on Ark to make revolving credit loans and reduced commitment fees that portfolio companies were obligated to pay Zohar. (Compl. ¶ 76.)

         After resigning its post as collateral manager in February 2016, Patriarch aggressively laid claim to Zohar's assets. Rather than stealing equity outright, Patriarch began obscuring and concealing the true extent of Zohar's ownership in its companies. When the replacement collateral manager requested Zohar's books and records, Patriarch produced an incomplete set of documents that muddled Zohar's claim over its assets. When the replacement collateral manager confronted Patriarch about these issues, Patriarch continued to obfuscate Zohar's equity holdings. And once the replacement collateral manager commenced a lawsuit to obtain the relevant books and records, Patriarch and Tilton steadfastly maintained that they owned the companies, further clouding Zohar's title. (Compl. ¶¶ 81-83.)

         V. SEC Enforcement Action

         In March 2015, the Securities and Exchange Commission (the “SEC”) commenced an enforcement action against Tilton and Patriarch, alleging violations of the Investment Advisers Act (“IAA”). In essence, the SEC's action presaged many of the allegations in this action, but focused principally on the “categorization” issue-namely, Patriarch's misrepresentations concerning the value and quality of Zohar's collateral. Under the SEC's theory of liability, although Defendants were required to provide “valuation categorizations of [Zohar's] assets and financial statements purportedly reflecting the financial position of each” of Zohar's funds, they instead “directed that nearly all valuations of these assets be reported as unchanged from their valuations at the time the assets were originated.” (In re Lynn Tilton, et al., Order Instituting Administrative and Cease-and-Desist Proceedings Pursuant to Sections 203(e), 203(f), and 203(k) of the Investment Advisers Act of 1940, and Section 9(b) of the Investment Company Act of 1940, and Notice of Hearing, Release No. 4053, dated Mar. 30, 2015 (“SEC Order”), at ¶¶ 3-4.) By miscategorizing Zohar's investments, flouting the categorization methodology set forth in Zohar's governing documents, and misleading investors, the SEC alleges that Defendants reaped “almost $200 million” in management fees and retained their control over Zohar's activities. (SEC Order at ¶ 6.)


         I. ...

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