United States: Indenture "No-Action" Clauses Bar Independent Claims By Securityholders

Two recent cases, from the Eleventh Circuit¹ and New York,² illustrate the limitations that "no-action" clauses in indentures place on the ability of Security holders³ to enforce claims against third parties. Indentures governing debt securities almost universally contain two clauses that address the rights of Security holders to enforce claims. The first is the "no-action" clause and the second is the "non-impairment" clause.

The Clauses

A typical formulation of a "no-action clause" is: Limitation on Suits. A Security holder may pursue a remedy with respect to this Indenture or the Securities only if:

(1) the Holder gives to the Trustee notice of a continuing Event of Default;

(2) the Holders of at least 25% in principal amount of the Securities make a request to the Trustee to pursue the remedy;

(3) such Holder or Holders offer to the Trustee indemnity satisfactory to the Trustee against any loss, liability or expense;

(4) the Trustee does not comply with the request within 60 days after receipt of the request and the offer of indemnity; and

(5) during such 60-day period the Holders of a majority in principal amount of the Securities do not give the Trustee a direction inconsistent with the request.

A Security holder may not use this Indenture to prejudice the rights of another Security holder or to obtain a preference or priority over another Security holder.⁴

The "no-action" clause is balanced by the "non-impairment" clause, often appearing as the next section of the indenture. A typical "non-impairment" clause reads:

Rights of Holders to Receive Payment. Notwithstanding any other provision of this Indenture, the right of any Holder of a Security to receive payment of principal and interest on the Security, on or after the respective due dates expressed in the Security, or to bring suit for the enforcement of any such payment on or after such respective dates, shall not be impaired or affected without the consent of the Holder.⁵

The Competing Interests

The competing interests embodied in these two sections of an indenture are, on the one hand, the right of each individual holder to receive payment on its security when due and, on the other hand, the collective enforcement of rights created under the indenture for the common benefit of all Security holders. The extremes are easy to illustrate. For a secured indenture, it is impractical for each Security holder to have the right to separately foreclose on the collateral shared by all to recover the sums due to that Security holder. Conversely, every Security holder has the right to file suit to recover the principal⁶ or interest that was not paid when due on its security. The rationale for "no-action" clauses is expressed in the Commentaries on Model Indenture Provisions:

The major purpose of this Section is to deter individual debentureholders from bringing independent law suits for unworthy or unjustifiable reasons, causing expense to the Company and diminishing its assets. The theory is that if the suit is worthwhile, 25% of the debentureholders would be willing to join in sponsoring it. The 25% figure is standard. An additional purpose is the expression of the principle of law that would otherwise be implied that all rights and remedies of the indenture are for the equal and ratable benefit of all the holders.

Note that this limitation is only on suits under the indenture€"the right of a debentureholder to sue on his debenture for payment when due is absolute and unconditional.⁷

As expressed in a Fifth Circuit decision in 1967, such clauses "are justified where they prevent rash, precipitate, or harassing suits by bondholders who disrupt corporate affairs by seeking to reach and deal with the security underlying the bond obligations."⁸

Objections to "No-Action" Clauses

Security holders prefer not to have to comply with the "no-action" clause for several reasons. The first hurdle is the need to identify and persuade 25 percent of the holders to join in the request for action by the trustee.⁹ The second is delay. The trustee is given a 60-day period to comply with a request by the holder to pursue a remedy. As in Akanthos, discussed in this article, the Security holders may believe that action is required to be brought sooner in order to protect their rights.¹⁰ The holders may prefer to control the pursuit of the claim rather than having the claim brought by the trustee.¹¹ Significantly, the holders must offer the trustee satisfactory indemnity against any loss, liability or expense that the trustee might incur in connection with the pursuit of the remedy. Such indemnity, in addition to the fees and expense of pursuing the action, might extend to the risk that the trustee would be subject to counterclaims or other consequential damages because of the pursuit of the claim.

The Akanthos Case

In both of the recent cases, Akanthos and Emmet, the court gave an expansive reading to the "no-action" clause in the applicable indentures to dismiss claims asserted by the Security holders against both the issuer of the securities and third parties.

In Akanthos the Security holders¹² asserted fraudulent transfer claims against CompuCredit Corporation, the issuer of the securities and against its officers and directors alleging that a dividend paid to shareholders and a planned spin-off of assets constituted fraudulent transfers under Georgia's version of the Uniform Fraudulent Transfer Act.¹³ The Seventh Circuit, addressing a certified question of law on an interlocutory appeal, reversed the district court and held that the fraudulent transfer claims were claims "with respect...to the securities"¹⁴ even though the claims were not for breach of express indenture provisions; there was no claim that the transfers breached a specific covenant in the indenture. The Eleventh Circuit panel said "[c]ourts applying New York law have consistently held...that no-action clauses bar fraudulent conveyance claims."¹⁵ The court went on to find that there was no reason to excuse the application of the clause on the facts of the case. There was no allegation that the indenture trustee was suffering from any conflict of interest that would prevent it from pursuing the claim.¹⁶ Nor were the plaintiffs excused from compliance because they had a majority of the securities or because there was insufficient time to wait for the 60-day period provided in the "no-action" clause for the indenture trustee to respond to a request that it bring an action on the claim.¹⁸

The Emmet Ruling

In Emmet, involving three separate indentures,¹⁹ the plaintiffs' claim was that a tender offer made by the issuers to purchase the bonds at 101 percent of principal, to be followed by a redemption of the bonds that were not tendered at 100 percent of principal, in each case plus accrued interest, violated the requirement in each indenture that redemptions be by lot€"made effectively pro rata to all Security holders since the securities that were purchased in the tender offer were not subject to the subsequent redemption, but remained outstanding.²⁰ The background was that the bonds had been "defeased" by escrowing sufficient government securities to pay all installments of principal and interest on the three series of bonds until maturity. Since the coupon interest payments on the bonds exceeded current market rates, the bonds traded at a premium that would be lost in the redemption.

On the eve of the closing of the tender offer and redemption, Emmet sought an injunction against the consummation of the transaction. The court did not grant a restraining order and the suit proceeded as an action for damages after the transaction closed. Since it saw the wrongful redemption claim as asserting the plaintiffs' rights under the indentures which provided for the redemption of the securities, the court gave short shrift to the argument that the indentures' "no-action" clauses did not apply.²¹ Looking then at the "non-impairment" clause, the court found the "non-impairment" clause did not excuse non-compliance with the "no-action" clause since the claim was for more than unpaid interest but also for principal that was not then due to the complaining Security holders.²²

In contrast with Akanthos, earlier cases have given "no-action" clauses strict construction when restricting the Security holder's right to sue. An early New Jersey case found the "no-action" clause did not prevent a Security holder from prosecuting an action to enjoin the distribution of corporate assets to shareholders that the plaintiff asserted would impair the ability of the issuer to pay the bonds at maturity.²³ Two older cases are split on whether a "no-action" clause prevents a Security holder from seeking to have a receiver appointed for the obligor.²⁴ A recent case holds that a "no-action" clause does not prevent a Security holder from acting as the petitioning creditor in a bankruptcy case.²⁵ Further, a 1992 New York case held that holders of subordinated notes had an absolute right to bring an action to enforce the repurchase of notes tendered pursuant to any early buy-back option in the indenture.²⁶

In further contrast with Akanthos, "no-action" clauses have been held to apply to suits brought by bondholders that involve contract rights under the indenture, but not to suits asserting Security holders' rights that arise under other laws.²⁷ For instance, where plaintiffs brought suit against the defendants for violations of federal securities law and common law seeking "benefit of bargain" damages for breach of promise to redeem shares at a premium in the event that the issuer was acquired without disinterested director approval, the Second Circuit upheld the district court's decision that the "no-action" clause in the indenture did not apply to the federal securities claims because it would have infringed on plaintiffs' substantive rights under the securities laws.²⁸ In that case, the "no-action" clause was applied to bar plaintiffs' state law claims for failure to comply with the clause.²⁹ Similarly, the Third Circuit held that failure to comply with the "no-action" clause did not bar plaintiff from suing for breach of fiduciary duties and self-dealing in violation of the Investment Adviser Act since the rights which the plaintiff sought to exercise derived from federal law, not the indenture.³⁰

Conclusion

The broad application of "no-action" clauses is a significant impediment to the pursuit by Security holders of claims based on their ownership of the securities. Compliance with the requirements of a request by 25 percent of the holders, tender of satisfactory indemnity to the trustee and a 60-day period for the trustee to respond significantly limit the ability of Security holders to take independent steps to react to actions by the issuer or others that Security holders perceive as threatening the value of their investments.

Footnotes

1 Akanthos Capital Mgmt., LLC v. CompuCredit Holdings Corp., 677 F.3d 1286 (11th Cir. 2012).

2 Emmet & Co., Inc. v. Catholic Health East, 951 N.Y.S.2d 846 (Sup. Ct. 2012).

3 This article uses the generic term security to cover the variety of debt securities that may be referred to as bonds, notes, debentures or some other designation.

4 Comm. on Developments in Bus. Fin., ABA Section of Corp., Banking & Bus. Law, Model Simplified Indenture § 6.06, 38 Bus. Law. 741, 757 (1983).

5 See Model Simplified Indenture § 6.07, 38 Bus. Law. at 757. The non-impairment clause is incorporated by operation of Sections 316 and 318 of the Trust Indenture Act, 15 U.S.C. §§ 77ppp(b) and 77rrr(c) (2000) in all indentures qualified under that act (principally for debt securities registered under the Securities Act of 1933). Both the non-impairment clause and the no-action clause have been in common use since before the enactment of the Trust Indenture Act and are ubiquitous in indentures for all categories of securities including those exempt from the application of the Trust Indenture Act such as the municipal indentures involved in the Emmet case discussed in this article.

6 Recognizing the right is limited to the amounts current due to that Security holder. If an installment of interest due before maturity has not been paid, the holder's right is limited to seeking payment of that installment. Acceleration of the principal requires action by the trustee or some specified proportion of the Security holders, typically 25 percent. See Model Simplified Indenture § 6.02, 38 Bus. Law. at 756-757.

7 American Bar Foundation, Commentaries on Indentures 232-33 (1971). "Of course, any suit by one debentureholder seeking to collect the principal of his debenture might prejudice other holders who do not bring such a suit but this kind of action is an absolute right of the debentureholder under the debenture and Section 508 of the Model Provisions. The reference in the latter part of Section 507 to disturbing or prejudicing rights under the indenture developed from mortgage indenture language in which there is concern over disturbing the lien securing the bonds. One example of how a holder may affect the rights of other holders under a debenture indenture might be a suit for reformation of the indenture." Id. at 234.

8 Watts v. Mos.-Kan.-Tex. RR. Co., 383 F.2d 571, 574-75 (5th Cir. 1967).

9 The cases do not discuss the difficulties presented by the requirement that the request for action be made by the registered Holders of the securities in an era where most securities are held through depositories with the actual investors several steps removed from record ownership.

10 Addressing these concerns, the Revised Model Simplified Indenture published in 2000 included language (which has not yet gained market acceptance) to facilitate requests made by beneficial owners of securities and to authorize shortening the 60- day period. Comm. on Developments in Bus. Fin., ABA Section of Corp., Banking & Law, Revised Model Simplified Indenture § 6.06, 55 Bus. Law. 1115, 1138 (2000).

11 Although, under another standard provision of the indenture, if the Security holders constitute a majority of the holders, they have the right, within limitations, to direct the trustee's exercise of remedies under the Indenture. Model Simplified Indenture § 6.05, 38 Bus. Law. at 757.

12 Identified as "a collection of hedge funds" in the opinion. Akanthos Capital Mgmt., LLC v. CompuCredit Holdings Corp., 677 F.3d 1286 (11th Cir. 2012).

13 Like most corporate indentures, the indenture chose New York law. Id.

14 There is no discussion in the opinion as to whether there was an Event of Default under the indenture. The first step in compliance with the "no-action" clause is notification to the Trustee of a continuing Event of Default. See Model Simplified Indenture §6.06(1), 38 Bus. Law. at 757 which suggests that a remedy that is not based on a breach of an Indenture covenant is not within the scope of the "no-action" clause.

15 Akanthos, 677 F.3d at 1294 (citing In re Enron Corp. Sec. Derivative & "ERISA" Litig., 2008 WL 744823, at *9 (S.D.Tex. Mar. 19, 2008), McMahon & Co, v. Wherehouse Entm't Inc., 859 F.Supp. 743, 749 (S.D.N.Y.1994), Victor v. Riklis, 1992 WL 122911, at *6 (S.D.N.Y. May 15, 1992)).

16 Id. at 1294 (citing CFIP Master Fund, Ltd. v. Citibank, N.A., 738 F.Supp2d 450, 477-78 (S.D.N.Y. 2010)).

17 Id. at 1295-96.

18 Id.

19 Although the indentures were governed by the law of three other states and each was phrased slightly differently, in the absence of a demonstration that their laws were different, the court applied New York law and generally treated all three claims together.

20 The bonds acquired by the Issuers through the tender would not be redeemed. Emmet, 951 N.Y.S.2d at 848.

21 Id. at 849.

22 Id. at 850-51. In Baybank Middlesex v. 1200 Beacon Props., Inc., 760 F. Supp. 957, 966 (D. Mass 1991) the court held that bondholders did not have a right to sue for future interest on bonds where the lenders accelerated the maturity date on the bond. The reasoning used by the court was that the future interest was unearned and therefore the bondholders were limited to sue for the principal of the bond and interest accrued through the acceleration date. See American Bar Foundation, Commentaries on Indentures, 234-235 (1965).

23 Hoyt. v. E.I. du Pont de Nemours Powder Co., 102 A. 666 (N.J. Ch. 1917).

24 Reinhardt, 63 A. at 1099-1100; Greene v. N.Y. United Hotels, Inc., 236 A.D. 647, 260 N.Y.S 405 (App. Div. 1932).

25 Envirodyne Indus., Inc. v. Conn. Mutual Life Co., 174 B.R. 986, 992-993 (Bankr. N.D. Ill 1994). The Notes to the Revised Model Simplified Indenture collect the other cases on point. Revised Model Simplified Indenture § 6.06, 55 Bus. Law. 1115 (2000).

26 Upic & Co. v. Kinder-Care Learning Centers, Inc., 793 F.Supp 448 (S.D.N.Y. 1992).

27 Comment to Section 6.06 of the Revised Model Simplified Indenture §6.06, 55 Bus. Law. at 1191.

28 McMahan & Co. v. Wherehouse Entm't Inc., 65 F.3d 1044 (2nd Cir. 1995).

29 Id.

30 Kusner v. First Pa. Corp., 531 F.2d 1234 (3rd Cir. 1976).

This article was previously published in The Banking Law Journal

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