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Bank of New York Trust Company, N.A. v. Franklin Advisers, Inc.

United States Court of Appeals, Second Circuit

August 1, 2013

THE BANK OF NEW YORK TRUST COMPANY, N.A., AS TRUSTEE, Plaintiff,
v.
FRANKLIN ADVISERS, INC., Defendant-Appellee, FRANKLIN CLO II, LTD., FRANKLIN CLO CORP., CHASE MANHATTAN BANK LONDON NOMINEE FOR SEIRA 13, AS NOMINEE, DEUTSCHE BANK SECURITIES INC., AS A NOMINEE, GENSEC IRELAND LIMITED, AS A NOMINEE, HARE & CO., AS NOMINEE, MAC & CO., MASSACHUSETTS MUTUAL LIFE INSURANCE CO., SUN LIFE INSURANCE CO. OF CANADA, AS A NOMINEE, TEMPLETON GLOBAL ADVISORS, LTD., AS A NOMINEE, "JOHN DOE 1, " THROUGH "JOHN DOE" 12, THE LAST TWELVE NAMES BEING FICTITIOUS AND UNKNOWN TO PLAINTIFF, THE PERSONS OR PARTIES INTENDED BEING THE BENEFICIAL OWNERS OF THE PREFERRED SHARES, THE SERIES I COMBINATION SECURITY AND THE CLASS C2 NOTES UNDER COMPLAINT, Defendants,
v.
CDO PLUS MASTER FUND, LTD., MERRILL LYNCH, PIERCE, FENNER & SMITH INC., AS A NOMINEE, Defendants-Appellants.

Argued: March 1, 2013

Merrill Lynch, Pierce, Fenner & Smith Inc., together with CDO Plus Master Fund, Ltd., (collectively, the "Shareholders"), appeal an order of the United States District Court for the Southern District of New York (Marrero, J.) denying their motion for summary judgment and granting partial summary judgment to Franklin Advisers, Inc. ("Franklin"), in a dispute over the payment of a contingent collateral management fee. The Shareholders argue that the district court erred in relying on extrinsic evidence and concluding that Franklin, as collateral manager, was entitled to the contingent fee after the portfolio produced a twelve-percent internal rate of return, according to the terms of the governing indenture. The Shareholders also appeal Franklin's award of attorney's fees and statutory prejudgment interest. For the following reasons, we affirm the grant of summary judgment and the award of attorney's fees, vacate the award of prejudgment interest, and remand with the instruction to award actual interest on the judgment.

JAMES C. MARTIN, Reed Smith LLP, New York, New York (James C. McCarroll and C. Neil Gray, on the brief), for Appellants.

JONATHAN L. HOCHMAN, Schindler Cohen & Hochman LLP, New York, New York (Matthew A. Katz, on the brief), for Appellee.

Before: JACOBS, Chief Judge, POOLER, Circuit Judge, and VITALIANO, District Judge.[**]

DENNIS JACOBS, Chief Judge:

This interpleader action was initiated by The Bank of New York Trust Company, N.A. ("BNY"), as Trustee of an investment portfolio of collateralized loan obligations, to resolve a contract dispute between certain shareholders and the manager of that portfolio, Franklin Advisers, Inc. ("Franklin"). In dispute are the terms of the underlying indenture and, specifically, terms governing distribution of a Contingent Collateral Management Fee (the "Contingent Fee" or the "Fee"), which was payable to Franklin only if distributions reached a twelve percent internal rate of return ("IRR"). Franklin claimed the Fee (exceeding $7 million) when the portfolio's return surpassed twelve percent upon an optional redemption voted by the shareholders.

On cross-motions for summary judgment, the United States District Court for the Southern District of New York (Marrero, J.) ruled that: (1) the Fee can be paid on an optional redemption; (2) proceeds of an optional redemption should be included in calculating the IRR; and (3) the indenture ("Indenture") is ambiguous as to when the Fee begins to accrue, i.e., whether the fee begins to accrue from the closing date forward, or from the date the portfolio's IRR exceeds twelve percent (an issue the parties resolved by arbitration). On appeal, Merrill Lynch, Pierce, Fenner & Smith Inc. ("Merrill Lynch") and CDO Plus Master Fund, Ltd. ("CDO Plus") (collectively, the "Shareholders")[1]argue that each of those rulings was error. They also challenge the court's award of fees and costs, and its award of prejudgment interest at a rate of nine percent pursuant to N.Y. C.P.L.R. § 5001(a). We vacate the award of statutory prejudgment interest and direct that interest be paid only as actually accrued. In all other respects, we affirm.

I

A. The Transaction

The $600 million collateral loan obligation from which this dispute arises, titled "CLO II, " closed on July 26, 2001. The securities were collateralized by a pool of leveraged commercial loans and then sold to investors who were paid based on cash flow from the underlying loans.

As collateral manager for CLO II, Franklin was responsible for structuring the transaction with the underwriter and for the active management of the portfolio. Merrill Lynch was engaged as underwriter, and two special-purpose investment vehicles were formed as issuer and co-issuer: Franklin CLO II, Ltd. and Franklin CLO Corp. (the "Issuers"). BNY, as Trustee (and stakeholder here), was responsible for collecting principal and interest payments, paying fees and expenses, and then distributing the remaining proceeds to investors.[2]

On the day of closing, the Trustee and the Issuers executed an Indenture drafted by deal counsel, Cleary Gottlieb Steen & Hamilton LLP ("Cleary"). The same day, Franklin and the Issuers executed a Collateral Management Agreement, incorporating all relevant provisions of the Indenture. Merrill Lynch as underwriter sold the CLO II securities to investors on the secondary market. The securities consisted of (1) notes divided into different levels of risk, held by CLO noteholders, and (2) shares of CLO II's equity, held by CLO II shareholders. As portfolio manager, Franklin assembled and maintained CLO II's assets, which, in the main, were leveraged, secured loans made to below-investment-grade borrowers. These loans served as collateral for CLO II's debt obligations to the CLO II noteholders.

B. Provisions in Dispute.

1. The Article 11 "Waterfalls".

The Indenture provides that proceeds from the portfolio were to be distributed by BNY according to two sets of detailed payment priorities on defined, quarterly distribution dates. The two payment priorities, set out in Article 11, are called "Waterfalls" because the payments cascade downward to a pool at the bottom for distribution to the shareholders. The first governs distribution of interest proceeds (the "Interest Proceeds Waterfall") and the second governs distribution of principal proceeds derived from obligations paid at maturity or upon liquidation of CLO II (the "Principal Proceeds Waterfall"). The priorities are (1) expenses, (2) noteholders, and (3) shareholders, in that order. Id.

2. Franklin's Fees.

Franklin was to be paid three types of fees for its work as collateral manager. Two of them were guaranteed and are not at issue here: the Base Collateral Management Fee and the Subordinated Collateral Management Fee.[3] The dispute is over the Contingent Collateral Management Fee, a performance-based fee contingent on the shareholders having "received an internal rate of return of 12% per annum . . . on the amount of the initial purchase price of the Preferred Shares for the period from the Closing Date through [the] Distribution Date, " JA 79-80, [4] a precondition designated the "IRR Hurdle." The base calculation of the Fee is approximately equal to 0.25 percent per annum of the value of the collateral and cash in the deal for a given period.

3. Optional Redemption Provision.

CLO II was structured to reach maturity on August 28, 2013. However, Section 9.1(a) of the Indenture provided that, before then, the holders of a majority of the CLO II preferred shares could call for an optional redemption, directing Franklin to sell CLO II's assets, pay its expenses, redeem outstanding notes, and distribute any remaining proceeds to the shareholders.

C. The Redemption Controversy.

In January 2007, a majority of CLO II shareholders called for an optional redemption, to take effect February 28, 2007. On February 7, 2007, Franklin auctioned off CLO II's portfolio.

It is undisputed that prior to this liquidation Franklin had not achieved the twelve percent rate of return necessary to surmount the IRR Hurdle and earn the Contingent Fee. However, if proceeds on liquidation were included in the calculation, the IRR would have reached 17.7 percent per annum. CDO Plus notified BNY and Franklin of its position that the Fee should be calculated pre-liquidation and that Franklin therefore was not entitled to the Fee.[5] Controversy arose when Franklin submitted a claim for a Contingent Fee to BNY, totaling more than $7 million.[6]

Faced with that dispute, BNY asked deal counsel for a formal opinion interpreting the Indenture. Cleary concluded that Franklin was entitled to the Fee. Anticipating litigation between Franklin and the ...


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